Virginia Considers Expanding Its Sales Tax Base to B2B Digital Services

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Virginia Sales Tax Reform Proposal: B2B Digital Services

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What is the difference between good and bad taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities.
policy? Sometimes that dividing line is buried deep in abstruse definitions and complex procedures. Other times, two words in a bill are enough to make a good policy go awry. This is the case in Virginia, where the Senate amended the Governor’s budget bill (S.B. 30 as introduced and as amended) such that, if adopted, it would include all business-to-business (B2B) digital services in the sales taxA sales tax is levied on retail sales of goods and services and, ideally, should apply to all final consumption with few exemptions. Many governments exempt goods like groceries; base broadening, such as including groceries, could keep rates lower. A sales tax should exempt business-to-business transactions which, when taxed, cause tax pyramiding.

Here is exactly how the Senate altered the language in the bill: “Taxable [digital] service does not includes any service transaction where the purchaser or consumer of the service is a business, or any other service otherwise exempt under this chapter.” By changing “does not include” to “includes,” the Senate hurts its own state’s competitiveness.

What Exactly Do Senate Amendments Change?

In December 2023, we wrote about Virginia Governor Youngkin’s (R) comprehensive tax plan for the state. Essentially, it included three structural elements: a reduction in the individual income taxAn individual income tax (or personal income tax) is levied on the wages, salaries, investments, or other forms of income an individual or household earns. The U.S. imposes a progressive income tax where rates increase with income. The Federal Income Tax was established in 1913 with the ratification of the 16th Amendment. Though barely 100 years old, individual income taxes are the largest source of tax revenue in the U.S.
rate, a 0.9 percentage point increase in the sales tax rate, and the broadening of the sales tax baseThe tax base is the total amount of income, property, assets, consumption, transactions, or other economic activity subject to taxation by a tax authority. A narrow tax base is non-neutral and inefficient. A broad tax base reduces tax administration costs and allows more revenue to be raised at lower rates.
to include some “new economy” digital services used for personal consumption. Both the House and the Senate dropped the first two components from their amended budget bills, but the discussion about the third component has gained momentum.

According to the governor’s plan, several digital services primarily used for final personal consumption would be included in the sales tax base. These include software applications services, computer-related services, website hosting and design services, data storage services, and streaming services. As highlighted above, there was a specific provision in the governor’s proposal that would exclude B2B digital service transactions from the sales tax base.

While the House agreed with this provision, the Senate decided to include all business purchases of digital services in the base. This dramatically changes the revenue impact of this component (potentially considerably increasing revenues from the taxation of digital services) and has negative implications for businesses and final consumers alike. Among the categories included in the proposal, only streaming services can be classified exclusively as final consumption services, while many businesses extensively use website hosting, software applications, and data storage services in their production process.

Risks of Taxing Business Inputs

As pointed out in our recent sales tax guide for Kentucky, there is a consensus among public finance scholars and practitioners that taxing business inputs (or B2B transactions) can cause economic distortions, lead to nonneutral and nontransparent tax burdens, increase regressivity, and disguise the true cost of government.

When some business inputs are taxable and some are not, it may influence the choice of the method of production (e.g., an IT firm may opt for a cheaper but less efficient local data storage technology instead of using cloud data storage services) and impose a penalty on investment (for instance, in modern cloud technology).

Many IT firms that provide services directly to consumers (such as video games, smartphone apps, or different types of paid subscriptions) themselves consume various digital services from other companies. As a result of the amended budget bill, many of their business inputs may become taxable under the new sales tax regime. In our sales tax guide, we provide an example of tax pyramidingTax pyramiding occurs when the same final good or service is taxed multiple times along the production process. This yields vastly different effective tax rates depending on the length of the supply chain and disproportionately harms low-margin firms. Gross receipts taxes are a prime example of tax pyramiding in action.
, which demonstrates that if a large share of business inputs is taxable, effective sales tax rates for final consumers may be 50-100 percent higher than statutory rates. In Virginia, this could imply the possibility of a combined effective sales tax rate exceeding 10 percent (while the statutory rate in most jurisdictions is 5.3 percent) for some transactions.

But it’s not only tech-oriented companies that consume digital services. These days, almost all businesses purchase digital products—subscriptions, analytics, processing, storage, software, etc.—and Virginia, under this proposal, would adopt a uniquely broad taxation of these purchases. When Virginia firms subject to these extra layers of taxation compete with other businesses across the country, they will find themselves at a competitive disadvantage, as their costs will be higher than their peers. Where a good or service must be provided locally, Virginia consumers are likely to bear the additional costs of “tax pyramiding,” where the tax is embedded multiple times over in the final purchase price.

Small and mid-size businesses, moreover, will be hit harder than their larger rivals. Whereas a large company might bring more of its production process in-house to avoid creating intermediate transactions subject to tax, that may be inefficient or impossible for smaller businesses, which need to focus on what they do best and not try to become tech companies on the side.


While broadening the sales tax base might move the existing sales tax in Virginia closer to an ideal sales tax, it would happen only if the base were expanded to additional final consumption services (such as streaming or personal software applications services). If, as proposed by the Senate, B2B digital service transactions are included in the sales tax base, it would increase the business share of state and local sales taxes (which, according to COST and EY, is already at 40 percent in Virginia), lead to tax pyramiding, hide the true cost of government, and make the sales tax system much less neutral and transparent.

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