The principle of “nexus” has for decades prevented state governments from taxing people and businesses without a physical presence in the taxing state. However, many states – including Alabama, South Dakota, Tennessee and, most recently, Hawaii – are challenging the physical presence standard as part of their attempt to collect sales tax on transactions made on the internet.
A new proposal in Hawaii, modeled after legislation passed in South Dakota in 2016, would require all online retailers to pay state sales taxes, regardless of whether the seller has a presence in the state. The tax is only applied to retailers who make more than $100,000 per year from Hawaiian customers or more than 200 transactions per year in the state.
After South Dakota’s law went into effect, the state quickly sued four major online retailers for failing to collect the state’s 4 percent sales tax on orders made to South Dakota residents. Like South Dakota’s law, Hawaii’s proposal faces significant legal hurdles, including the precedent set by the U.S. Supreme Court’s 1992 decision in Quill Corp. v. North Dakota. In that case, the Court determined a state must prove a company has a “substantial nexus” within a state before taxes can be imposed. Since this ruling was handed down, the nexus, or “physical presence,” standard has been an important taxpayer protection.
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. South Dakota’s 2016 law was struck down by lower courts, which determined the law violated the Quill decision. The Supreme Court agreed to hear the case in January 2018, their first sales tax authority case since 1992.
Hawaii’s effort to impose the expanded tax was completed with the hope the Wayfair case empowers states with the ability to tax online retailers.
Expanding the sales tax to internet sales comes with important consequences; the new rules would dramatically expand the power of state governments over retailers outside their borders, including the imposition of different auditing requirements. Further, not all states tax sales the same, which is problematic; different state tax definitions and rules are likely to lead to confusion for out-of-state buyers and sellers.
Removing the physical presence standard for sales taxes would reduce Hawaii’s accountability to taxpayers and enables a dramatic 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 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 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 truly level 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
Joseph Bishop-Henchman of the Tax Foundation examines the details of the South Dakota v. Wayfair case and speculates how the justices may rule based on previous cases.
Understanding an 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
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
In this Heartland Institute Policy Tip Sheet, John Nothdurft examines several myths and facts about Internet taxes.
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
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
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
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.
Marketplace Fairness: Leveling the Playing Field for Small Business
In written testimony before the U.S. Senate Commerce, Science, and Transportation Committee, Kelly Cobb of Americans for Tax Reform discusses remote-state sales tax collection and physical presence in light of the oft proposed Marketplace Fairness Act. “The effects on taxpayers of the Marketplace Fairness Act and similar legislation would be dramatic,” Cobb said. “From a taxpayer perspective, any bill that touches remote sales taxes must preserve the physical presence standard and protect consumers on net from a higher tax burden. Unfortunately, the federal online sales tax bills miss the mark widely on both fronts.”
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 Lindsey Stroud, Heartland’s government relations manager, at [email protected] or 312/377-4000.