Apple Settlement Shows Why California Needs a Sales Tax Overhaul

A sales tax settlement involving Apple Inc. and Cupertino, Calif., demonstrates the flawed system in which municipalities are making fiscal decisions and why sales tax reform in the Golden State is long overdue.

Under the agreement, Apple’s hometown can keep the $75 million it already collected but will collect less going forward because the company must start allocating some sales tax revenue to other jurisdictions where sales took place. The city is now projecting a deficit and is continuing to cut costs.

This shows why state lawmakers must modernize and broaden the sales tax base for today’s personal consumption of services, digital items, household utilities, and entertainment. These tax-exempt categories tend to represent purchases by higher-income taxpayers, making today’s system inequitable. Broadening the base can allow a lower rate, make the system fairer among different income levels of consumers, and help cities generate tax dollars from a wider range—and location—of sellers and employers.

It’s also time to re-examine the current sales tax allocation system for the local portion of the sales tax to see how it can better match the local government costs of hosting a seller and buyers.

California’s sales tax system, in place since the 1930s, has two main weaknesses. The first is that the base—what is subject to tax—is mostly the consumption of tangible personal property. This 20th-century model makes little sense when, for decades, consumption of personal services and digital goods has risen steadily with fewer dollars spent on tangibles.

Another weakness involves the rules for where a buyer’s local sales tax dollars go. This allocation system is convoluted and doesn’t necessarily benefit the consumer’s city or the city that incurred costs to make a sale in that city possible (such as providing roads for delivery trucks or for buyers driving to a store in another city).

Together, these two weaknesses can lead cities such as Cupertino to take steps that only make sense within a flawed system. California cities have limited revenue options because they can’t impose an income tax, have state-imposed limits on the rate of their sales tax and the base it can apply to, and must ask voters to approve tax increases. These are limitations that state lawmakers don’t face.

Recent legislative changes and proposals have focused on sales tax revenue-sharing agreements that some cities have with large sellers of tangible goods. AB 2854, signed into law on Sept. 28, requires cities to report sales tax revenue transfers to retailers and post the information on their municipal websites. These transfers are part of revenue-sharing agreements that generally require the seller to maintain a sales office in the city with a percentage of the generated local sales tax returned to the seller.

Perhaps greater transparency of these tax-sharing arrangements will lead to new laws to end them, but local governments in California would still face sales tax weaknesses.

In California, the local portion of the sales tax goes to the city where the store is located. If a seller has multiple locations, the sales tax is allocated to the location where principal negotiations occurred. If a seller has no location in California but is required to collect sales tax (called a use tax in this situation), the tax is allocated to a countywide pool.

However, if this seller decides to open an office in California to handle the sales, the sales tax will be allocated to the city where the office is located. This system encourages cities to recruit certain types of sellers to their city to handle in-person and online sales with the local tax going to that city.

As an enticement, the city might offer to rebate part of the sales tax to the seller. This means that a portion of the sales tax paid by the buyer isn’t going to pay for government services. While the city is receiving more tax revenue than it would otherwise, Californians as a whole have fewer dollars to fund government services.

But the weaknesses mentioned earlier, such as the narrow sales tax base and limits on other revenue options, encourage cities to recruit sales offices and shopping malls even at the expense of sharing some of that tax revenue with the seller.

If legislation eventually ends revenue sharing between cities and sellers, more tax dollars will go to local governments. However, the seller will have less interest in remaining in that city, particularly if the sales are generated by a sales office that can be relocated to a city with lower operating costs.

Such a move could devastate some cities. Efforts to replace that revenue would be challenging due to the need to bring in another seller, or to create a new tax or increase an existing tax—assuming voters approve it.

Taxes help cover costs of government services, and use of government services warrants payment of taxes by the beneficiary. Taxes from sales at shopping malls go to the cities that host them, but little or no sales tax is collected when a city hosts fitness centers, hair salons, sellers of software, and other sellers of services and digital items. And when residents buy taxable items online, there is no guarantee that the local sales tax will go to the buyer’s city or any of the cities that delivery trucks used.

Let’s finally take a serious look at improving a tax that was created nearly a century ago and still operating as such. This review should consider modernizing the sales tax base; requiring greater disclosure or ending tax-sharing agreements; and discussing how the local sales tax should be allocated among cities and counties (or perhaps regions) to better address costs cities incur in serving sellers and buyers, resident needs, and principles of good tax policy. Such reforms would bring logic to an illogical system.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Annette Nellen is a professor in and director of San José State University’s graduate tax program.

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