Getting Internet Sales Tax Right
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While Amazon has somewhat softened its stance against state-level efforts to collect sales tax on internet sales, the fight over how internet sales will be taxed is far from resolved. Amazon and other online retailers have some valid complaints about states’ efforts to make them remit tax, particularly that sales tax compliance is unduly burdensome. But the status quo, where taxes due on a large fraction of online sales go unremitted, is undesirable from either a conservative or liberal perspective.
America needs a federal online sales tax policy that ensures that taxes owed are collected, but without imposing an unreasonable compliance burden. That means a new federal law that gives states the power to collect sales tax from out-of-state retailers, so long as they take certain steps to simplify their sales taxes.
What The Law Is Today
Contrary to popular belief, if a good or service is subject to sales tax when you buy it in a brick-and-mortar store, it’s also taxable if you buy it online. In some situations, an online retailer has no legal obligation to collect and remit tax on such a sale. But in these situations, the consumer is legally supposed to pay tax on the purchase, ordinarily by reporting a liability for “use tax” on his or her state income tax return.
However, while states have success in collecting use tax for certain large, out-of-state purchases (like auto sales), in practice, taxes not collected by the retailer very often go unpaid. Prof. William Fox of the University of Tennessee estimates that $24 billion of owed sales and use tax on remote purchases goes unpaid each year. That’s a substantial sum—for comparison, general sales tax collections by states and localities totaled just $291 billion in 2009.
This online sale loophole goes back to a 1992 Supreme Court decision called Quill vs. North Dakota. Quill was a catalog seller with customers in North Dakota, but no physical presence in the state. North Dakota attempted to require Quill to collect and remit sales tax, but the Supreme Court ruled that the state had no authority to require Quill to do so. Importantly, the Quill case does not say that a requirement for out-of-state retailers to collect sales tax is unconstitutional, just that federal law does not currently authorize it. In essence, Congress could pass a law allowing states to require out-of-state retailers to collect and remit sales tax.
Under the Quill regime that’s in place today, only some online retailers get to avoid collecting sales tax. If a business has a physical presence in a state, it is required to collect tax on remote sales into that state. That means that retailers like Wal-Mart and Best Buy, which have substantial online sales and a physical presence in substantially every state, collect sales tax on all or nearly all of their taxable online sales. Even pure online retailers like Amazon and Overstock have physical presences in some states, where they must collect tax.
And increasingly, states have been using creative strategies to force online retailers to pay tax. Several states have passed laws deeming that affiliate marketers for online retailers constitute a physical presence, creating a “nexus” which requires the retailer to collect and remit sales tax. At first Amazon and Overstock responded aggressively to these laws, suing to block their enforcement and in many cases severing ties with their affiliate marketers in affected states to avoid creating a nexus.
But in recent months, Amazon has softened its stance, reaching agreements with several states (including California) to start collecting sales tax after a delay. Amazon has also signaled its support for a federal law that would create uniform rules for online sales tax collections.
With the softening of Amazon’s stance, we are starting to see an emerging consensus on online sales taxes. States would like a federal law that allows them to make retailers like Amazon collect sales tax. They should get this—but only if the law also effectively addresses the cost of complying with different sales taxes all over the country.
How To Address Compliance Costs
The best argument that Amazon and other retailers raise against requiring them to collect and remit sales tax is that doing so is burdensome. Sales taxes are collected by 45 states and the District of Columbia, each with different rates and different rules about what is taxable.
These rules can get incredibly picayune and complicated. See this 1,437-word memo from the Wisconsin Department of Revenue, providing ten examples of cases in which the sale of an ice cream cake (or a slice thereof) might or might not be taxable. One of the examples hinges on the ratio of ice cream layers to cake layers –in Wisconsin, having too much ice cream in your ice cream cake can lead to a tax liability.
And one state’s picayune rules don’t necessarily conform to other states’ equally picayune rules. Both New York and New Jersey apply sales tax to candy but not to most other food, yet they have different definitions of what “candy” is. A Twix bar is taxable candy in New York, but in New Jersey it’s a non-taxable baked good. An online retailer has to keep up with this morass not in just one state, but in all of them.
More dauntingly, there are over 8,000 local sales taxing jurisdictions in the country, again with their own rates. New tax jurisdictions are created frequently and their boundaries do not necessarily conform to Zip or even Zip +4 boundaries. A few states, such as New York, even allow local jurisdictions to determine their own tax bases. One particularly relevant example for online retailers is that New York State does not charge sales tax on clothing and footwear under $110, but most counties in New York do – and sometimes a city has different sales tax rules than the county it is in.
Cleaning Up This Mess
Online retailers rightly point out that it would be a burden to comply with sales tax in 8,000 different jurisdictions. It is not an insurmountable burden, as demonstrated by the fact that Wal-Mart and Best Buy already do it. But if we are going to apply this requirement to more retailers, and to smaller ones, the federal government should require states to make compliance somewhat easier. There are three key rules that would have that effect.
First, in order to tax sales from out of state, states should have to join the Streamlined Sales Tax Project. This is an interstate compact whose members agree to uniformity in certain aspects of the sales tax—for example, every member has to use the same definition of candy. Streamlined sales taxes are not exactly the same, but they have fewer variations, which brings down the burden of compliance.
Second, if they want to make retailers remit local sales taxes, states should have to use a uniform sales tax base across all local jurisdictions. There are important public policy reasons for having variable sales tax rates across various jurisdictions in a state, but allowing municipalities to modify their tax bases simply adds complexity with no economic value. SSTP rules require uniform local tax bases, but this requirement is sufficiently important that it should also be in federal law, so that SSTP’s members cannot vote to change it later.
Third, states should provide a tool that allows retailers to easily determine what jurisdictions are entitled to tax which sales. Because one zip code may fall within several different sales tax jurisdictions, each with a different rate, the burden should be on state governments to enable retailers to determine what rates apply to any given address.
Why We Like Sales Tax Compliance
If states take these three steps, then the federal government should allow them to require remittance of sales tax due, even from retailers with no physical presence in the state. This will improve compliance with sales tax and provide needed revenue in states facing fiscal shortfalls.
There is an instinctive tendency for conservatives to resist new taxing power—if the current online sales tax regime allows consumers to pay less tax, is that such a bad thing? But this is misguided thinking, for two reasons. First, states need to finance themselves somehow, and the erosion of the sales tax may lead to greater reliance on income tax, which is less economically efficient.
Second, over the last few decades, shrinking sales tax bases have not even led to sales tax relief. Since the 1970s, the typical general sales tax base has gone from covering nearly 60 percent of GDP to just 37 percent today. Yet general sales tax collections as a percentage of state and local revenues have actually ticked upward by two percentage points since 1977.
That is because states have responded to the erosion of the tax base—partly due to online sales, partly due to economic shifts toward untaxed services—by raising sales tax rates. The mean state sales tax rate was 3.5 percent in 1970. That had risen to 5.2 percent in 2003 and 5.6 percent in 2011.
Broad based taxes with low rates are much better for the economy than narrow based taxes with high rates. Allowing comprehensive taxation of online sales is an important step for maintaining broad sales tax bases, and people across the political spectrum should welcome such a policy so long as it comes with measures to mitigate the cost of compliance.
Josh Barro writes on fiscal and economic policy for Forbes and also periodically contributes to National Review Online, City Journal and the New York Daily News.