What Is Discretionary Tax and How Is It Calculated?

A discretionary tax is a government charge on non-essential goods and services. Consumers purchase these items with discretionary income, which is the money left after paying for necessities like housing and food. This form of taxation generates revenue from “wants” rather than “needs,” allowing governments to fund public services.

Beyond raising funds for infrastructure or schools, these taxes can also influence consumer behavior. They can be structured to discourage the purchase of certain products or to stimulate specific economic sectors. This differs from taxes on income or essential goods, which are tied to earnings or basic needs.

Categories of Discretionary Taxation

General Sales Tax

A general sales tax is a broad-based tax on the retail sale of many goods and some services. Applied at the state and local levels, the rate varies by jurisdiction. The tax is calculated as a percentage of the sale price and collected by the seller. To lessen the burden on lower-income households, most jurisdictions exempt necessities like groceries and prescription medications.

A use tax complements the sales tax, applying to items bought from an out-of-state seller where no sales tax was collected. If you buy an item online from a retailer that doesn’t collect sales tax for your state, you must pay a use tax to your state’s revenue agency. The use tax rate is the same as the sales tax rate, ensuring that in-state and out-of-state businesses compete on a level playing field.

Excise Tax

An excise tax is a targeted tax on specific goods, calculated on a per-unit basis instead of as a percentage of the price. For example, governments levy excise taxes on gasoline per gallon, cigarettes per pack, and alcohol per bottle. Unlike sales tax, excise taxes are often built into the product’s sticker price and are less visible to consumers.

These taxes, sometimes called “sin taxes,” are often used to discourage the consumption of products with negative health or societal impacts. The revenue from specific excise taxes can be earmarked for related public services. For example, gasoline taxes are commonly dedicated to funding road and transportation projects.

Luxury Tax

A luxury tax is an excise tax on high-end, non-essential goods and services like expensive vehicles, private jets, yachts, and fine jewelry. This progressive tax is paid by individuals with higher levels of disposable income. The taxing authority sets the threshold for what qualifies as a luxury item, such as a specific price for a car or boat.

The purpose of a luxury tax is to generate revenue from those with the greatest ability to pay. However, these taxes can have unintended economic consequences. These may include shifts in consumer spending to avoid the tax or negative impacts on the industries producing the high-end goods.

Tourism and Hospitality Tax

Tourism and hospitality taxes target travelers and visitors. These taxes apply to services and goods tourists purchase, including hotel stays, rental cars, and airline tickets. The tax is a percentage of the service cost and is collected by the provider at the time of payment.

Revenue from these taxes is almost always reinvested into the local community to support the tourism industry. Funds may be used for tourism promotion, maintaining convention centers, or improving local infrastructure used by residents and visitors. This system allows the tourism industry to help fund its own growth and the public services it uses.

Calculating the Tax Liability

Ad Valorem vs. Specific Taxes

The calculation of a discretionary tax depends on if it is an “ad valorem” or a “specific” tax. An ad valorem tax, Latin for “according to value,” is a percentage of an item’s price. For example, if a product costs $100 and the sales tax is 7%, the tax is $7. The tax amount changes in direct proportion to the item’s price.

A specific tax is a fixed fee on a physical unit of a product, regardless of its price. For instance, a state might impose an excise tax of $0.50 per gallon of gasoline. A purchase of 10 gallons would result in a $5 tax, whether the gas price is $3 or $5 per gallon. This method provides a predictable revenue stream for governments that is not affected by price fluctuations.

Determining the Tax Base

The “tax base” is the total value or amount subject to taxation. For sales tax, the tax base is the retail price of all taxable items in a transaction. Not all items in a purchase may be taxable; for example, a grocery bill might include taxable soft drinks and non-taxable bread, so tax is only applied to the taxable goods.

Discounts and coupons can also affect the tax base. The rules for how discounts are applied can vary by jurisdiction and the type of discount. For example, some rules require tax to be calculated on the final, reduced price, while others require it on the full, pre-discount price. Correctly identifying the tax base is a necessary step before applying the tax rate.

Combined Tax Rates

In many parts of the U.S., the total sales tax rate is a combination of rates from different levels of government. A single purchase can be subject to state, county, and city or special district taxes. These individual rates are added together to create the total combined tax rate applied to the purchase.

For example, a 6% state tax, a 1% county tax, and a 0.5% city tax result in a combined rate of 7.5%. A business in that location must collect 7.5% on all taxable sales. This layering of taxes explains why sales tax rates can vary significantly between nearby towns.

Business Collection and Remittance Obligations

Information Gathering and Preparation

Businesses must first implement a system to accurately track all sales transactions, distinguishing between taxable and non-taxable items. At the end of each reporting period, which can be monthly, quarterly, or annually, the business calculates its total gross sales. It then subtracts exempt sales to determine the total taxable sales and the amount of tax collected from customers.

The next step is to obtain the necessary tax return forms from the appropriate government agency, such as a state’s Department of Revenue. These forms require specific data points, including gross sales, non-taxable sales, taxable sales, and the final amount of tax due.

The Filing and Payment Process

After completing the tax return, the business must file it and pay the collected taxes. Most states mandate or encourage electronic filing through an online government portal. This involves entering the return data online and submitting it electronically, though some jurisdictions still permit filing by mail.

Payment is also commonly handled electronically through an electronic funds transfer (EFT) or the state’s online portal. If filing by mail, a check is usually sent with the paper return. After payment, the business will receive a confirmation receipt.

These records, including filed returns and payment confirmations, must be kept for several years. They are necessary in the event of a sales tax audit.