Don’t Just Tax the Internet, Reform Taxes

Later today, the Senate is expected to begin consideration of a proposal that would give states long-sought authority to require out-of-state retailers to collect taxes on online purchases. Although proponents have pitched this proposal as an important reform to promote tax fairness and economic growth, we have been struck by how little actual tax reform the proposal would accomplish.

Under a long line of U.S. Supreme Court rulings, states are prohibited from placing “undue burdens on interstate commerce.” In the context of state taxation of interstate commerce, the Supreme Court held in Quill Corp v. North Dakota that businesses lacking a “substantial nexus” or link to a state through a physical presence or an employee or agent cannot be subject to that state’s sales and use tax requirements.

Undeterred, states have tried to enact changes to tax rules that aim to capture revenue by creating nexus to obligate out-of-state companies to collect taxes at the time of sale. Some states have chosen to deem an arrangement called “affiliate marketing” – an agreement by which an in-state website displays an advertisement or link to an out-of-state retailer and collects a commission for referrals – as sufficient nexus. Recently, the New York Court of Appeals upheld a law as a constitutional exercise of the tax laws, but courts in Illinois and Colorado reached the opposite conclusion.

Stymied by the Constitution, several states and brick-and-mortar retailers have sought Congressional authority to go over state lines to force online retailers collect tax revenues. Article I, Section 8 of the U.S. Constitution provides that “Congress shall have the power…to regulate commerce…among the several states.”

But rather than getting at the root of the online tax problem – a lack of required remittance by consumers – by reforming federal and state tax rules in a truly equitable manner, proposals before Congress aim to impose the old complicated tax code to the dynamic, global Internet, one of the few bright spots in our economy; according to market research firm comScore, U.S. retail e-commerce sales reached $186.2 billion in 2012, an increase of 15 percent – the strongest annual growth rate since before the recession.

What’s most troubling is that the proposals threaten to undermine states’ ability to experiment, innovate, and compete with each other through their tax codes, a hallmark of federalism. Consider the state of Montana and Red Oxx Bags, an adventure luggage company based in Billings and maker of the popular Air Boss carry-on sold largely via the Internet. Montana does not have a sales tax and Red Oxx does not have to worry about tax collection in other states so they can focus on making and selling a great product to travelers. But under the proposals before Congress, a small company like Montana’s Red Oxx must figure out and be ready to comply with at least 9,600 tax jurisdictions, with different rates and definitions, across the country and be prepared to face as many as 46 different tax audits per year.

Our organization supports constitutional nexus requirements for state taxation obligations and believes states are barred from imposing tax reporting or collection duties on out- of-state businesses where such businesses only connection to the state involve the use of common carriers such as the mail service or the licensing of software to an in-state resident. Attempts to tax beyond their boundaries run contrary to important principles of sound taxation and federalism.

At the same time, the Exchange Council recognizes that tax rules may have to change as the economy changes; tax rates for using buggy whips in 2013 makes little sense. But it is important that changes to the tax code be real reforms to promote equity and economic growth, and to preserve the federal system. Towards that end we have been hosting discussions between policymakers, businesses, and experts to brainstorm ideas. Some ideas that have been discussed so far include origin-based sourcing, single statewide sales tax rates, simplified remittance, and more designed to ease the compliance burden for retailers and consumers. It is our hope that these discussions will yield a consensus on a way forward.

Though time consuming, we believe these organic, bottom-up discussions will yield the best result in the end for sound tax policy for the states and the economy.

John Stephenson and Jonathan Williams are respectively the Directors of the Communications and Technology and Tax and Fiscal Policy Task Forces at the American Legislative Exchange Council.