States collected $157.4 billion in sales taxes from businesses on their input purchases in 2017, accounting for 41.7 percent of total state and local sales taxes, according to a study prepared by Ernst & Young LLP (EY) for the Council On State Taxation (COST) and its affiliate, the State Tax Research Institute (STRI). The tax on business inputs creates "pyramiding" by taxing business-to-business transactions multiple times prior to final consumption.  

"State sales taxes apply to 21 percent of household consumption while taxing all business inputs, which would be exempt under a true consumption tax," said Douglas Lindholm, COST President and Executive Director. "These taxes on business inputs have economic consequences, and are not transparent in the total tax imposed on goods purchased by consumers. These issues have presented challenges when states have attempted comprehensive base-expansion legislation due to the proposed inclusion of business purchases in their sales tax bases."

State sales tax collections on business inputs in fiscal year 2003, the first year this study was released, totaled 42.8 percent of all state and local sales taxes.

The accumulation of taxes as goods move through the supply chain on their way to final consumers can occur in a variety of ways across different types of consumer purchases. This pyramiding is often unrecognized as both increasing the effective sales tax rate above the statutory rate and leading to significant differential taxation across types of consumer purchases depending on the extent of pyramiding, the study said.

Overall state and local sales taxes generated $377 billion in 2017, of which businesses paid $157 billion. At the state level, sales taxes made up 29.5 percent of total tax collections. State sales taxation on business inputs vary significantly by state ranging from 32 percent in both Idaho and Indiana to 60 percent in New Mexico due to differences in state economies and sales tax systems.

"Most efforts to revamp the state sales tax bases over the past three decades to tax more services have failed to exempt the intermediate services purchased by businesses, exacerbating the economic distortions already created by state sales tax systems," said Andrew Phillips, Principal, Ernst & Young LLP and with EY's Quantitative Economics and Statistics (QUEST) practice. "These issues are magnified when sales tax is extended to more services without exempting business purchases."

Many states have been attempting to modernize their sales tax base to include taxation of a greater number of services. Purchases of services account for 31 percent of total input purchases by businesses, and several services are primarily purchased by businesses, resulting in greater pyramiding.

Taxation of business inputs vary by type of business and by industry due to factors such as general taxability of each type of good or service, the amount purchased by businesses, and the degree to which these goods and services receive specific exemptions. Among major types of business inputs, those that are most significantly taxed are:

47 percent of business purchases of utility services are subject to tax

36 percent of business purchases of information services are subject to tax  

20 percent of business purchases of manufactured goods are subject to tax

By comparison, purchases least commonly taxed when purchased by business are:

2 percent of business purchases of transportation services and construction services; and

1 percent of business purchases of financial services.