For decades, the principle of “nexus” has prevented state governments from taxing people and businesses without a physical presence in the taxing state. However, many states are now trying to circumvent, or directly challenge, this standard so they can collect sales taxes on internet commerce. Several states – including Alabama, Hawaii, South Dakota, and Tennessee – are directly challenging the physical presence standard by requiring all online retailers to pay state sales taxes, regardless of whether the seller has a presence in the state. By adopting so-called “Kill Quill” bills, these states are effectively overriding the Quill Corp. v. North Dakota case that established the nexus standard in 1992.
The U.S. Supreme Court’s decision in Quill determined a state must prove a company has a “substantial nexus” within a state before taxes can be imposed. The nexus, or “physical presence,” standard has been respected by states and an important taxpayer protection for 26 years. Yet, the renewed legal debate over the nexus standard will be reconsidered in the Supreme Court case South Dakota v. Wayfair, which was argued before the U.S. Supreme Court on April 17 and will likely be decided in the summer. The Supreme Court agreed to hear the case in January 2018, their first sales tax authority case since Quill Corp. v. North Dakota in 1992.
Another creative approach states are using to get around the physical presence standard is by utilizing a “cookie nexus” standard. Under this approach, the internet cookies retailers place on customers’ computers count as physical presence in the state. This strategy, which was first introduced in Massachusetts and recently adopted in Ohio, argues that cookies – the lines of code that are created on a customer’s computer when they visit a company’s website – represent a tiny piece of local real estate that establishes physical presence under the Quill standard.
Under the Massachusetts law, physical presence is created when a consumer makes contact with certain in-state factors, such as in-state software, in-state cookies, or working with a content distribution network or in-state representatives. In the Bay State, all vendors meeting these dubious criteria are required to collect and remit Massachusetts sales tax if their internet sales met or exceeded $500,000 to Massachusetts customers or if the vendor delivered 100 or more internet transactions to customers in Massachusetts. The authors of the Massachusetts law argue their law should survive regardless of the Supreme Court’s ruling this summer.
Applying sales taxes to internet transactions produces significant consequences. First, the power state governments wield over retailers outside their borders would dramatically expand. Moreover, since individual states have very different definitions and rules on sales taxes, confusion and uncertainty for out-of-state buyers and sellers is inevitable. The cookie nexus is even more problematic because, in theory, it would give states the power to tax any online store on the planet.
In short, removing the physical presence standard for sales taxes would reduce state accountability to taxpayers and enables a vast expansion of state taxing powers. “Once the online sale of real goods is taxed, it will be only a matter of time before digital products, such as iTunes, apps, ring-tones, digital books, and movies will also be taxed,” wrote John Nothdurft, The Heartland Institute’s government relations director, in a Policy Tip Sheet. “States will see the Internet as a practically unlimited source of tax income by charging low rates on large numbers of transactions.”
Supporters of online taxes argue these taxes are needed to restore a competitive balance between online and bricks-and-mortar retailers. But the imposition of sales taxes on internet sales would slow the growth of the e-commerce industry, one of the key future growth sectors of the U.S. economy. In addition, requiring online retailers to charge a sales tax in states in which they do not have a physical presence would force consumers to pay a tax to a government with which they have no political voice and from which they receive no government benefits or services.
Instead of forcing out-of-state businesses to serve as government tax collectors, state legislators should implement a sales tax system based on where the product was sold, known as an origin-based tax system. This would encourage economic growth by bringing simplicity and certainty to the state sales tax quandary as well as truly leveling the playing field because online and brick-and-mortar retailers would pay the same tax.
The following documents examine state internet sales taxes in greater detail.
Previewing SCOTUS South Dakota v. Wayfair Online Sales Tax Case
https://taxfoundation.org/previewing-scotus-south-dakota-v-wayfair-online-sales-tax-case/
details of the South Dakota v. Wayfair case and speculates how the justices may rule based on previous cases.
Understanding an Internet Sales Tax
https://cei.org/content/understanding-internet-sales-tax
Jessica Melugin of the Competitive Enterprise Institute examines the effort by states to expand their internet sales taxes to draw more revenue from taxpayers. Melugin argues in favor of the origin approach of taxation, a sales tax system where the sales tax is determined based on where the product was sold.
Taxes on Remote Sales
https://heartland.org/publications-resources/publications/taxes-on-remote-sales
This election brief from the Kem C. Gardner Policy Institute at the University of Utah examines the complexity of online sales, including the legal context and the growth of online sales, and provides some policy options for consideration.
Policy Tip Sheet: Myth vs. Fact – Internet Taxes
https://heartland.org/publications-resources/publications/policy-tip-sheet-myth-vs-fact—internet-taxes?source=policybot
In this Heartland Institute Policy Tip Sheet, John Nothdurft examines several myths and facts about Internet taxes.
Should Congress Act Before SCOTUS On Online Sales Taxes?
https://taxfoundation.org/congress-act-scotus-online-sales-taxes/
Joseph Bishop-Henchman of the Tax Foundation examines how Congress could act to preserve the physical presence standard and move towards a better system for taxing online sales.
Research & Commentary: Internet Sales Taxes
https://heartland.org/publications-resources/publications/research–commentary-internet-sales-taxes
This Heartland Institute Research & Commentary on internet sales taxes explains how taxing the internet hurts business and fails to bring in the revenues proponents hope for: “The new tax-remittance burden, however, would fall on online retailers. It would add to their costs and could demolish one of the last remaining redoubts of vibrant economic enterprise—the last thing any state needs during a deep recession.”
The Internet, Sales Taxes, and Tax Competition
https://heartland.org/publications-resources/publications/the-internet-sales-taxes-and-tax-competition
Veronique de Rugy and Adam Thierer discuss the Main Street Fairness Act in this study from the Mercatus Center. The new legislation would force retailers to collect sales taxes for states joining a formal tax compact. The authors examine alternatives to the tax, including an origin-based sales tax.
An “Original” Solution to Taxation of Online Sales
https://heartland.org/publications-resources/publications/an-original-solution-to-taxation-of-online-sales
Writing for the American Legislative Exchange Council, Andrew Moylan discusses the origin-based sourcing rule for internet sales taxes and explains how it solves many of the problems created by destination sourcing: “Perhaps the most important advantage of origin sourcing, however, would be the infusion of tax competition it could engender. Under such a system, businesses would have an incentive to invest in lower-tax jurisdictions so as to attract price-conscious customers.”
States Already Can Tax Out-of-State Purchases, but Rarely Enforce those Laws
http://www.aei.org/article/economics/fiscal-policy/taxes/states-already-can-tax-out-of-state-purchases-but-rarely-enforce-those-laws/
Michael S. Greve of the American Enterprise Institute considers an overlooked issue in the internet sales tax debate: the often-unenforced use tax. Currently, if a product is purchased from a “remote” seller with no contact with a consumer’s state, the sale is not “tax-free”—the consumer owes a “use tax” equivalent to the local sales tax. Many states do not enforce this tax.
Nothing in this Research & Commentary is intended to influence the passage of legislation, and it does not necessarily represent the views of The Heartland Institute. For further information on this and other topics, visit the Budget & Tax News website, The Heartland Institute’s website, and PolicyBot, Heartland’s free online research database.
The Heartland Institute can send an expert to your state to testify or brief your caucus, host an event in your state, or send you further information on a topic. Please don’t hesitate to contact us if we can be of assistance! If you have any questions or comments, contact John Nothdurft, Heartland’s director of government relations, at [email protected] or 312/377-4000.
Matthew Glans joined the staff of The Heartland Institute in November 2007 as legislative specialist for insurance and finance.
