A sales tax is a type of

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What is a Sales Tax?

The sales tax is an indirect tax levied on the sale of goods and services. This tax liability falls on the business entity, i.e., the seller, vendor, or retailer. But ultimately, the burden falls on the customer.

Sellers collect the sales tax from the customers at the point of sale and hand it over to the government. Any firm engaged in the sale or supply of goods or services in a particular state is liable to sales tax—depending on the applicable state laws and jurisdiction.

• The sales tax is an indirect form of tax imposed on goods and services at the point of sale. Although it is paid by the seller, it is later charged to the customer.
• It is applied to retail sales also. However, customers who purchase raw materials for manufacturing or resale are exempted.
• The tax amount is computed as a percentage of the net price of goods. Also, the final price of the goods after tax is the sum of the net price and sales tax amount.

How Does Sales Tax Work?

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The sales tax is a type of indirect taxIndirect tax, also known as consumption tax, is the type of tax the person does not directly bear. In contrast, the incidence of such taxes is passed on to the end consumer of goods or services by adding such taxes to the value of those goods or services, like Excise duty, Service tax, VAT, etc.read more charged on the sale of commodities. The seller collects it from the buyer and pays it to the government—therefore, referred to as an indirect tax. It can have an immediate impact on the products and services. Often, it is seen as a regressive taxA regressive tax is the system of taxation where all citizens in the country are taxed at the same rate without considering their income levels. As a result, a more significant percentage of the income of the low-income group is charged as tax compared to the high-income group.read more—a burden on the lower-income group.

Sometimes, governments exempt a particular product from taxes. Also, when goods are procured as raw material, they are exempt from taxes. They are considered inventory and not finished goods.

In the U.S., businesses are responsible for the tracking, collection, and submission of taxes from customers. More than 30 U.S. states have adopted economic nexus policies (including California, Florida, and Texas). Moreover, tobacco and alcohol are heavily taxed. However, some states like Montana, Alaska, Delaware, Oregon, and New Hampshire don’t charge these taxes.

Types of Sales Tax

Primarily there are three subtypes:

#1 – Retail Transaction Taxes

It is the most common method of levying taxes. A tax percentage is charged on the final price of the retail goods. The seller amasses the applicable tax amount from the customer. Once collected, paying the government is the seller’s responsibility.

#2 – Vendor Privilege Taxes

These taxes are imposed on retailers by the state in which they operate. So, it is like a licensing tax—for conducting business in that particular state. However, sellers may decide to pass on the burden to customers.

#3 – Consumer Excise Taxes

The excise taxExcise tax is the tax applied to the sale of particular goods and services like tobacco, fuel, and alcohol. It is not directly paid by an individual consumer, instead, the tax department levies the tax on producer or merchant of products.read more is charged on goods that are hazardous to health—cigarettes, and alcohol. It is paid by producers or wholesalers. The purpose of this tax is to discourage the negative impact on society and public health.  

How is Sales Tax Calculated?

The following formula is used for tax calculation:

Alternatively, one can make use of tax calculators to evaluate the product’s final price.

Examples

Let us look at some examples to better understand the practical application of the concept.

Example #1

XYZ is a business operating in Washington D.C. The state levies a total sales tax of 8% (state tax of 5% + country tax of 3%). Before-tax, the product is priced at $340. What will be the selling price of the product?

Solution:

Example #2

XYZ is a business operating in Washington D.C. The state levies a total sales tax of 10% (state tax of 6% + country tax of 4%) on cosmetic products. Before taxes, the product is priced at $200; what will be the product’s final price?

Solution:

Pros and Cons

It generates considerable revenueRevenue is the amount of money that a business can earn in its normal course of business by selling its goods and services. In the case of the federal government, it refers to the total amount of income generated from taxes, which remains unfiltered from any deductions.read more for the government. Compared to other taxes, the collection is easy—it is attached final price paid by the buyers. Unlike income tax, tax evasion is rare. Also, a heavy sales tax on harmful goods limits consumption. Also, the burden on customers depends on quantity consumed.

There are certain drawbacks; the tax structure is very complex. It varies from state to state. For the customer, this tax increases the cost of the productProduct cost refers to all those costs which are incurred by the company in order to create the product of the company or deliver the services to the customers and the same is shown in the financial statement of the company for the period in which they become the part of the cost of the goods that are sold by the company.read more. In some scenarios, customers are subject to double taxationDouble Taxation is a situation wherein a tax is levied twice on the same source of income. It usually occurs when the same income is taxed both at corporate as well as at the individual level.read more. For example, customers have already paid taxes on personal incomePersonal income refers to the total earnings of the individuals and households of a nation through multiple sources such as salary, wages, business profits, bonus, investment returns, dividends, rental receipts, employer contribution in provident or pension funds, etc.read more. When they go to spend that income, they are again taxed by the government for the product—the customer is paying the government twice for the same amount.

This tax increases the final price, and therefore, decreases manufacturers’ profit marginProfit Margin is a metric that the management, financial analysts, & investors use to measure the profitability of a business relative to its sales. It is determined as the ratio of Generated Profit Amount to the Generated Revenue Amount. read more. It is very regressive in nature—every person who purchases the product needs to pay, whether rich or poor. Unfortunately, many sellers are engaged in tax evasion practices; they collect the amount from customers but don’t pay the government.

Frequently Asked Questions (FAQs)

How to calculate sales tax?

It is imposed as a percentage of the net price of the goods and adds to its final price. The formula is as follows:

1. Tax Amount = Net Price x (Sales Tax Rate / 100)
2. Final Price = Net Price + Sales Tax Amount

What is sales tax used for?

The local and state governments use the collected amount for public welfare activities—infrastructure development, education, security, health, cleanliness, and emergency services.

Who pays the sales tax, buyer or seller?

Customers bear the burden of consumer excise tax on every transaction. Yet, the seller is responsible for tax acquisition and submission. However, the vendors may or may not transfer the burden of the supplier privilege tax to the customers.

Recommended Articles

This article has been a guide to Sales Tax and its Definition. We discuss sales tax types, rates, calculators & examples from California, Florida, Texas, New Jersey, & Virginia. You can learn more about accounting from the following articles: –

• Proportional Tax
• Tax Loss Carry Forward
• Tax to GDP Ratio
• Tax Wedge