State tax policies and the digital economy

Daniel E. Megathlin, Chris Engels
State tax policies and the digital economy

As traditional sources of state tax revenues continue to decline, more jurisdictions are turning their eyes to the digital economy.

Digital products and services traditionally have escaped the sales tax nexus, but the tide is turning. Several states have instituted new taxes on digital advertising and media in the past few years. Because other states are likely to follow, the adoption of these new taxes could quickly gain momentum, as did e-commerce sales taxes after the South Dakota v. Wayfair case.

Organizations that operate in the digital economy should now monitor the states in which they operate and assess their potential exposure to new tax liabilities.

Growth of the digital economy

Growth of the digital economy

The digital economy has expanded significantly over the past two decades as more products and services are delivered virtually. Since the introduction of online retail in the mid-1990s, the world has rapidly moved to a digitally based economy of software, applications, media, and digitally delivered products.

According to the U.S. Bureau of Economic Analysis, in 2021, the digital economy represented 10.3% of U.S. gross domestic product (GDP), or $2.4 trillion. This economy includes the value of hardware, software, e-commerce, margins, and priced digital services. Between 2016 and 2021, the digital economy grew at an average annual rate of 6.7%.1

The digital economy is defined by four major categories of goods and services:

Four major categories of goods and services in the digital economy

  • Infrastructure. The basic physical materials and organizational arrangements that support the existence and use of computer networks and the digital economy, primarily information and communications technology (ICT) goods and services.
  • E-commerce. The remote sale of goods and services over computer networks.
  • Priced digital services. The services related to computing and communication that are performed for a fee charged to the consumer.
  • Federal nondefense digital services. The services represented in the annual budget for federal nondefense government agencies whose services are directly related to supporting the digital economy.

The COVID-19 pandemic spurred increased growth in the digital economy in recent years, pushing more products and services online. While e-commerce surged due to the initial shutdown in 2020, many other sectors, including financial services, healthcare, tech, and hospitality, adopted new digital full-time or part-time software and solutions to support digital delivery. In addition, the number of remote workers has skyrocketed since 2020, and millions of Americans are now working from home full time or part time.2

The digital economy is forecast to grow even faster in the coming years as new artificial intelligence (AI) applications come online. These applications and new AI-driven software can support customer interactions, generate creative content for marketing deals, and draft computer code based on natural language prompts.

With a growing number of use cases, these new intelligent products and services could grow the global economy by 7%, or nearly $7 trillion, in the next decade.3

An attractive source of state tax revenues

An attractive source of state tax revenues

The rise of new digital business models has taken some traditional products out of the tax nexus in many states. For example, e-commerce has overtaken many small retailers, while new software and remote services have reduced the need for office space, material goods, and other things that typically generate state taxes.

States experienced strong tax revenue growth in 2021 and 2022, but state tax revenues declined 0.2% from July 2022 to January 2023, and forecasts are looking weaker.4

Crowe observation

Inflation, a weakening economy, and other factors also could hamper revenues in the coming years. As many traditional sources of tax revenues dry up, states will increasingly look to the digital space for untapped opportunities.

To replace these lost sources of tax revenues, many states are looking for low-hanging fruit, such as how to tax nonresidents through hotel occupancy taxes. But the digital space is an attractive target because it helps states to go after a new tax on a sector that generates significant revenues. Thus, a small tax that might seem marginal to consumers can yield a financial windfall for states.

Over the years, the tax world has undergone several evolutions in response to new technologies. For example, while computers were a novelty in the 1980s, tax departments started changing their view in the 1990s as these technologies became more mainstream and as software became a multibillion-dollar industry. At the time, software was delivered on floppy discs, so states targeted software by taxing it as tangible personal property. However, by the early 2000s, most software moved to a digital delivery model over the cloud. In most cases, users paid for a license and did not even receive a product host on their machine, making it difficult for states to tax under traditional tax law. In response, many states have moved to require sales tax collection on software as a service (SaaS) products over the past few years.

E-commerce went through a similar evolution. Before 2018, a taxpayer typically had to have property, agents, or physical operations in a state for sales tax nexus to be conferred upon it. Yet the explosion of remote sellers and a shift to a service-based economy led many state regulators to reconsider sales tax nexus. In 2018, the U.S. Supreme Court ruled in South Dakota v. Wayfair5 that South Dakota could require internet retailers to collect sales taxes on sales to its residents. Since then, every state in the country that imposes a sales tax has enacted Wayfair rules for remote sellers.

As occurred in the world of software and e-commerce, state legislatures now are seeking new ways to tax the digital economy. In early 2021, Maryland enacted the first tax of its kind on digital advertising revenues attributable to the state. The digital advertising gross revenues tax started in the tax year 2022 and applies to businesses with global revenues of more than $100 million, with rates ranging from 2.5% to 10%. Any company expecting its gross revenues derived from digital advertising services in the state to exceed $1 million for the calendar year must make estimated quarterly payments using Form 600D, “Declaration of Estimated Digital Advertising Gross Revenues Tax.”6

Two companies challenged the tax in court, arguing that the tax was unconstitutional and violated the Constitution’s commerce clause, which gives Congress broad authority to regulate business among the states. Additionally, because it applied only to companies with an excess of $100 million in revenues, the tax was levied upon only about a dozen companies. However, the Maryland Supreme Court threw out the case in May 2023, saying the plaintiff brought the case to court prematurely without going through the administrative process.7

Other states also have taken action in the digital economy. In August 2022, New Mexico reaffirmed its stance that digital advertising is subject to a gross receipts tax that all forms of advertising are subject to. The state published proposed updated regulations to reflect changes in technology and ensure that rules covering digital advertising are consistent with rules covering other forms of advertising.8 And in May 2023, Georgia Gov. Brian Kemp signed legislation Senate Bill (SB) 56, which requires retailers to collect sales tax on in-state sales of digitally downloaded products, such as video games, music, photographs, and artwork. The new tax is estimated to bring in $172 million in extra tax revenues in the first year.9

Growing momentum for a digital tax

Growing momentum for a digital tax

As more products and services move to digital models, the next taxation revolution awaits, with states seeking nexus in the digital economy. Most states waited on the sidelines but soon might act when they see other states successfully capturing much-needed revenue with new taxation models.

The Georgia legislation requiring retailers to collect sales taxes on digital products is particularly interesting because Georgia typically is noted as a business-friendly, low-tax state. However, the legislature might have seen itself as taking a leading step in what might be an inevitable move, as happened with e-commerce. Indiana, Massachusetts, Connecticut, and New York also have introduced new tax bills targeting social media, search engines, and data mining:

  • Indiana’s House Bill (HB) 1517 would tax social media companies’ advertising services gross income at 7% and charge $1 per active account holder each calendar year.10
  • In Massachusetts, legislators are considering two taxes that affect the digital economy. House Docket (HD) 1683 would impose an excise tax of 6.25% on annual gross revenues from digital advertising, with an exemption on the first $1 million.11 HD 3052 would use an excise tax on the sale of digital advertising services to create trust funds supporting early childhood education and local newspaper journalism.12
  • Connecticut’s HB 5673 would impose a 10% tax on the annual gross revenue of large businesses making more than $10 billion from digital advertising services.13
  • In New York, SB S1845 would impose a flat tax of 5% of the gross income generated from data mining.14

Many other states also are considering such legislation. While most of these laws appear to be targeting cash-rich tech companies, plans could change should states encounter more budget issues.

What businesses need to do

What businesses need to do 

Five years into the nationwide adoption of individual state sales taxes on e-commerce goods, local jurisdictions now are targeting more digital products and services. Companies that do business across the country via the digital economy can expect further actions in the coming years.

As companies focus on bringing new technologies to market, they also must think about the sales and use tax implications. Most digital products and service companies view themselves as a service provider not subject to local sales taxes. Yet many states argue the taxes are intended simply to level the playing field for small, local businesses, and that the taxes, relative to the volume, are fair.

The situation could change rapidly in the coming years as states reach critical mass in taxing digital services. Organizations must perform due diligence on the issue to protect themselves from surprises and significant tax liabilities. Due diligence is especially important for digital economy startups that might want to put themselves up for sale in the future, as potential tax issues are likely to come out in the due diligence process. Companies must clearly define what they are selling and conduct due diligence to assess their tax liabilities.

Organizations that operate in the digital economy should take several key steps:

  • Define, from a state and local tax standpoint, the types of products and services the company is providing to its customers. This process helps identify how states could potentially define the organization’s products and services. For example, while Maryland and Massachusetts target digital advertising, New York legislation targets data mining.
  • Monitor sales activity and the company’s footprint to determine if the company has established nexus for sales and use tax purposes. While Maryland’s digital sales tax applies only to companies with more than $100 million in annual global revenues, Massachusetts’ proposed HD 1683 offers an exemption on the first $1 million.
  • Monitor the tax laws for each state and local jurisdiction in which the company operates. As the taxation of e-commerce quickly changes, so too does the taxation of many digital services. Several states are floating legislation now that could be enacted in 2024.
  • Monitor the company’s sales in each state, specifically those that would fall under a new digital economy tax. The CFO, controller, or whoever is responsible for the tax function should continually monitor and collect sales tax data, which is then weighed against the rules to assess potential liability.

As momentum grows for states to tax more digital products and services, organizations must conduct due diligence on what they sell and what taxes could be imposed upon them in the coming years. Organizations that act now can work to reduce potential tax liabilities and better prepare for the future.

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1 "Digital Economy," Bureau of Economic Analysis, Nov. 22, 2022,
2 Kim Parker, "About a Third of U.S. Workers Who Can Work From Home Now Do So All the Time," Pew Research Center, March 30, 2023,
3 "Generative AI Could Raise Global GDP by 7%," Goldman Sachs, April 5, 2023,
4 Lucy Dadayan, "State Revenue Forecasts Look Bleak as Revenue Boom Subsides," Tax Policy Center, March 14, 2023,
5 South Dakota v. Wayfair, Inc., et al., Supreme Court of the United States, June 21, 2018,
6 "Digital Advertising Gross Revenues Tax," Comptroller of Maryland,
7 Bryan A. Sears, "State Supreme Court Overturns Digital Ad Tax Ruling," Maryland Matters, May 9, 2023,
8 "Gross Receipts Tax and Digital Advertising in New Mexico," Taxation and Revenue Department of New Mexico, Nov. 2, 2022,
9 Jon, Shirek, "Georgia To Tax Digital Download Purchases Beginning in January," 11Alive WXIA Atlanta, May 3, 2023,
10 House Bill 1517, "Social Media," Indiana General Assembly, Session Year 2023,
11 House Docket 1683, "An Act Establishing a Tax for Online Advertising," Commonwealth of Massachusetts, 193rd General Court,
12 House Docket 3052, "An Act Relative to Taxation of Digital Advertising Services," Commonwealth of Massachusetts, 193rd General Court,
13 Proposed H.B. No. 5673, "An Act Concerning the Reformation of Certain Taxes and Tax Equity," Connecticut General Assembly, Session Year 2023,
14 Senate Bill S1845, "An Act To Amend the Tax Law, in Relation to a Tax on Gross Income Upon Every Corporation Which Derives Income From the Data ... ," New York State Senate, 2023-2024 Legislative Session,

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Dan Megathlin
Daniel E. Megathlin
Principal, Indirect Tax Leader
Chris Engels
Partner, Tax