Senate Bill 122 is projected to raise roughly $2 billion annual tax increase on the software businesses use to operate, and its costs will spread far beyond company software bills. Since software as a service supports nearly every part of the modern economy, businesses will have to absorb those higher costs somehow – through higher prices, smaller margins, or less money available for hiring and investment. And customers may end up paying through higher prices.
Gavin Newsom signed SB 122 on June 29, and its digital software provisions take effect January 1, 2027. The law expands California’s definition of tangible personal property to include prewritten software regardless of whether it is delivered on a disc, downloaded, or accessed remotely. That last category includes software as a service, commonly known as SaaS.
Prewritten software generally refers to standardized programs developed for sale to multiple customers, while custom software created for a particular client remains exempt. California is not simply taxing a new physical product. It is extending the sales and use tax into remotely accessed software that has become a basic tool of modern business.
Implementation is already proving complicated. On July 21, the California Department of Tax and Fee Administration held a workshop to identify which parts of SB 122 require clarification and which issues may need emergency regulations before the tax takes effect. Questions include how to calculate the tax when software licenses are used in multiple locations and how to apply an exemption for certain electronically delivered services involving substantial human effort. CDTFA’s July agenda anticipated additional informal rulemaking beginning in August. Businesses now have less than five months to prepare for a tax whose administrative details are still being worked out.
The burden will fall largely on businesses because they purchase most of the software covered by the law. During a Senate Budget Committee hearing, Department of Finance official Colby White testified that software is predominantly purchased by businesses and estimated that they account for roughly three-quarters of software purchases.
These programs are not luxuries limited to technology companies. Restaurants use subscription software for payroll and scheduling. Medical offices use it for billing and patient administration. Manufacturers use it to track inventory. Small businesses rely on software for accounting, communication, marketing, customer management, and countless other daily operations.
The tax may be easy for most Californians to overlook because it will first appear on a business’ software bill rather than a customer’s receipt. That does not mean consumers will escape the cost.
This isn’t simply an argument made by tax opponents. The nonpartisan Legislative Analyst’s Office warned that a large share of the newly taxed transactions will be business-to-business sales and that taxing business purchases. That’s a problem because businesses don’t simply make those costs disappear. The LAO says taxes on businesses purchases can raise costs for consumers and also favor large, vertically integrated companies over smaller firms that have to purchase software and services from outside vendors.
The size of the expected revenue shows that this is not a minor update to an outdated definition. The administration estimates the tax will raise $450 million for the General Fund and $560 million for local governments during its first six months. Those figures rise to $900 million and $1.1 billion annually once fully implemented, for a combined total of roughly $2 billion per year.
Video games, e-books, streaming video, and music remain outside the tax today, and extending the tax to those products would require new legislation. SB 122 nevertheless establishes the definitions, sourcing rules, and collection mechanisms for taxing remotely delivered or accessed digital products.
Some say the state should consider going further. In the name of eliminating distinctions between taxed and untaxed products, the LAO has recommended extending the sales tax to a broader range of digital products rather than limiting it to software. When lawmakers next face a budget shortfall, they will not need to build an entirely new system for taxing digital commerce. Future lawmakers could simply amend those exclusions and expand the framework now being put in place.
Government should not treat every untaxed transaction as a problem waiting to be corrected. Yet SB 122 does more than make an essential business input more expensive. It builds much of the machinery California would need to tax other parts of the digital economy.
Today, Netflix, Spotify, e-books and downloaded video games are outside that system. The LAO has already recommended bringing a broader range of digital products into it. Californians shouldn’t be surprised if today’s software tax becomes tomorrow’s tax on the rest of our digital lives.
Anthony Velasquez, MBA, is Pacific Research Institute’s Communications Specialist.
