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States Shouldn’t Tax Interstate Online Sales
In South Dakota v. Wayfair, Inc., to be argued before the Supreme Court next week, the Justices face the question of whether individual states are allowed to impose a sales tax on goods that are purchased from vendors, often online, that do not have some physical presence in the state to which the goods are shipped. This deceptively arcane question has sparked over forty Amicus Curiae briefs, including one in support of South Dakota—the state that wants to tax such sales—by the Solicitor General of the United States.
It’s a passionate issue. On balance, I would stick with the current law, as stated in the 1992 case of Quill v. North Dakota: the Constitution prevents any state from imposing that tax. The result is that many small companies that operate only in a single state are able to sell their goods across state lines tax-free, while larger retailers (including giants like Amazon) that have storage and office facilities in many states find themselves saddled by a tax that their competitors do not have to pay. Tax imbalances generally distort economic choices. The Supreme Court took the case to decide whether changed circumstances in the retail market since Quill justify overruling the earlier decision.
The problem is a classic illustration of second-best analysis. In my cautious view, the current uneasy status quo should be retained judicially as the lesser of two evils. Right now, sales taxes in the 45 states that impose them are largely concentrated in the 5 to 10 percent range, with added complications given that different states exempt different goods from taxation. The inherent complexity of this subject will in the end yield a tractable solution only if Congress organizes a taxing facility that can ease the enormous burdens that arise when, as Wayfair’s brief stresses, some 12,000 independent state and local taxing authorities unilaterally impose additional taxes against online retailers, both large and small.
Indeed, the best solution might just be the simplest one: Congress sets up a facility to tax all these transactions at around the median tax rate, say 7 percent, which it then can distribute pro rata to the various states, who in turn can divide them with local governments in whatever form they see fit. This solution imposes a tricky set of tradeoffs. In order to make the system easier to operate, it forces states to receive lower revenues per taxable transaction in exchange for reaching a larger tax place. Other possibilities will surely remain on the table.
To see why this solution is sensible, it is necessary to start with first principles. Constitutionally, there are two possible grounds to block the imposition of the tax. The first of these is an outgrowth of the Due Process Clause of the Fourteenth Amendment, which commands that no “State shall deprive any person of life, liberty or property, without due process of law.” That principle has proven powerful enough to shield any party from taxation by a jurisdiction with which it does not interact. But the effort of online sellers to reach customers across the country makes it hard for them, as Quill held, to steer clear of all interaction with such localities and thereby avoid local taxes.
Quill did offer the retailer relief under the oddly-named “dormant commerce clause,” which is said to derive from the text of the Commerce Clause giving Congress the power “to regulate Commerce with foreign Nations, and among the several States, and with the Indian Tribes.” On its face the Commerce Clause confers powers on Congress but does not appear to subtract any powers from the state. But as early as 1824, the concurring opinion of Justice William Johnson in the Supreme Court case of Gibbons v. Ogden suggested that in some instances the simple presence of the Commerce Clause in the Constitution precludes the states from regulating interstate commerce at all without, of course, Congressional intervention.
Notwithstanding its dubious textual pedigree, the dormant commerce clause is an essential element in the constitutional creation of a national market because it prevents individual states from using their powers of taxation and regulation to hinder or block the shipment of goods and services across state lines. At one point, that protection was so extreme that the Supreme Court, in Freeman v. Hewit (1946), shielded the interstate commerce in goods or services from all regulation and taxation, which gave those goods and services a systematic advantage over local goods that were subject to taxes. That result was overturned in the important 1977 decision Complete Auto Transit, Inc. v. Brady, which denounced Freeman “as a triumph of formalism over substance” that “has no relationship to economic realities.” In Freeman’s stead, Complete Auto Transit proposed a four-part test that states that the Court will sustain a tax against a Commerce Clause challenge so long as the “tax [1] is applied to an activity with a substantial nexus with the taxing State, [2] is fairly apportioned, [3] does not discriminate against interstate commerce, and [4] is fairly related to the services provided by the State.”
Complete Auto Transit was a well-established precedent when Quill came before the Supreme Court in 1992. Indeed, the state of North Dakota took up the same “changed circumstances” argument in 1992 that is put forward by South Dakota today. The original immunity from state taxation had been laid down some 25 years before Quill and 10 years before Complete Auto Transit, in National Bellas Hess v. Illinois, which had refused to impose a compensating “use” tax on goods “upon a seller whose only connection with customers in the State is by common carrier or the United States mail.” Faced with this precedent, Justice John Paul Stevens in Quill rejected the invitation to overturn Bellas Hess on the ground urged by the North Dakota Supreme Court that the sharp rise in direct mail deliveries constituted a “tremendous social, economic, commercial, and legal” innovation rendering Complete Auto Transit obsolete. More specifically, he held that the first and fourth requirements, dealing with “substantial nexus” and “fair relation” to services provided were unchanged notwithstanding the increased level of volume. Justice Stevens was not apologetic about this result, for he noted that although the rule “appears artificial at its edges,” that disability is “more than offset by the benefits of a clear rule.”
In my view, this statement is as applicable today as it was 26 years ago. The matter might appear to be relatively unproblematic if the South Dakota tax program is taken in isolation from the onslaught of other state and local taxes that will be imposed if Quill is undone in this case. The shipment of goods and services across state lines is a mass production operation, so that any uncertainty in the application of these many different rules will quickly spread throughout the entire system, which could result in inconsistent claims for taxation for entire classes of transactions in ways that we can only dimly foresee today. And lost in the justifiable claim for tax parity across different modes of the provision of goods and services is the simple point that the creation of this tax exemption has fueled an expansion of interstate transactions that has been a real boon to the economy.
Accordingly, the case for holding the line on Quill is that keeping the status quo is, now that the pressures on the old system are building up, more likely to lead to some form of Congressional action that could mend the current situation. If individual states and localities are allowed to impose their own sales taxes, they are likely to become a strong lobbying force to keep the status quo, from which they obtain short-term benefits. The resulting potential for opportunism could slow down the growth in online sales, which in turn will reduce the productive activities that generate, in addition to private income and wealth, other forms of tax revenue, most notably on labor and real property. But with Quill intact, these same states have much more incentive to push through Congress some proposal that would fix the situation.
A December 2017 GAO Study on sales taxes indicates remote sellers already have to pay between 75 and 80 percent of the total taxes that would be collected if sellers were required to pay local taxes on all transactions, which means that expanded taxing collection is estimated to produce somewhere between $8 billion and $13 billion in additional tax revenues. These amounts are large enough to worry about, but not so large as to justify an administrative nightmare. If the Supreme Court just overturned Quill, it would do nothing to stem the confusion. But introducing the single taxing facility would eliminate the game playing that now constantly ensues when buyers have goods shipped to some second address in a low-tax state where they are then picked up for actual use in a high-tax state. A single tax would ease collection, get rid of the fancy software for tax assessments and distribution that never quite works, and reduce the distortionary effects of higher state sales taxes. Clearly, much work has to be done. Keeping Quill in place is probably the best way to get Congress to complete its work. Tough case, all around.
© 2018 by the Board of Trustees of Leland Stanford Junior University
Published in Culture, Economics, Law
It wouldn’t really be a nightmare would it? It would probably become a feature patch of whatever PoS solution the website is using, probably with some kind of tax account management.
National online retailers already have the information and deal with the taxation because they have local presences.
For instance I pay sales tax for everything we buy through amazon.
I think the only real issue here is which address do you tax off of: the billing address or the shipping address?
A national VAT, some of which could automatically belong to the states ( without mandates) would enable states to reduce or eliminate sales taxes, reduce income taxes, make internet retailers voluntary tax collectors, would be a desirable tax on consumption and being a cash cow would enable things like eliminating the payroll tax. Simple is good and simple at the Federal or State level is essential
Just curious, but did the taxes in the period between Freeman (1946) and Complete Auto Transit (1977) just so happen to go up? And by how much? I’m less inclined to blame “innovation” for such problems than I am government’s insatiable greed.
I have no problem paying sales tax for online purchases. Just do two things.
Do both of these, and I have no problem.
The idea of a VAT in this country is intolerable. If you want to put a yoke on an economy like Europe, then by all means, enact a VAT.
The way I understand it, the seller isn’t taxed; it just collects the sales tax from the buyer. I think the buyers are still liable for the tax even if the seller doesn’t collect it.
I think you need to research the vat as used in New Zealand. Are you really saying that it is better to tax work, savings, investment and profit than to tax consumption when our current account deficit is an existential threat?
Here is how a VAT works which I’m gratuitously posting because many on our side don’t understand VAT and it is often confused with a turnover tax where every stage pays the tax and remits same to the government, which raises the total tax rate and creates incentives for vertical integration, a vey bad tax indeed.
I import 100$ worth of various materials. So, with a uniform 10%VAT I pay $110 because imported goods are taxed when they cross the border. I add $20 value and sell it for $120 plus $12 tax. I send 2$ to the government keep the $10 I’ve already paid. Amazon buys it from me when it gets an order adds $10 for its value added and sells it for $130 plus 13$ tax, and sends the government $1 and keeps $12 of the tax it has already paid on the product. The receipt says 130 plus 13$ VAT. The government has collected $13. Thus it is in every stages interest to collect all of the tax without probing from the government and without the government caring whether it was sold in a retail establishment or on line, or wether the retailer charged the tax and kept all of the money because the biggest part of the tax has already been paid. The fact that its’ uniform makes bookkeeping easy because every input, even government and shipping fees include the same %10 tax. New Zealand found that even though they cut income taxes by 50% income tax receipts went up the first year because of the vat. It is worth more to business to keep accurate records which they do anyway, than to cheat on income taxes which they all do even if just a little. In Europe and other countries different goods pay different VAT rates, so there is a corrupting log rolling to establish which good is essential to poor people and which a luxury good. Then every stage has to sort out which inputs went to luxury goods and which to essential goods at every stage, thus making a potentially transformative tax corrupting and burdensome . It’s transformative because it’s a cash cow and enables drastic cuts in income taxes and falls on consumption thus should stimulate savings and investment. Every dollar of our current account deficit is borrowed abroad to pay for an import. This is our balance of payments problem and our deficit problem.
Thanks for explaining it clearly. I never had the time/patience to write it out in another thread where we were comparing the VAT/Fair Tax.
Balance of payments is not a problem. We get cheap goods and they get useless paper. The deficit is a problem only insofar as it increases spending (on interest.)
Which type of VAT do you think the left will push for when they inevitably get control over it?
Mike H
the left wants a corrupting one they can demagogue of course. New Zealand threw an important bone to their Stalinist left, ANZUS. We’d have to go about it with a serious strategic thrust like replacing the payroll tax and privatizing ss for workers under 40, and maybe a tax credit for people who file income taxes for what a low income person would pay in their consumption to preempt the demagogues about regressive taxation which they’ll use to push tax rate variation. And we’ll need months of detailed informed PR which includes the down side of doing it wrong.
Every penny of the current account deficit adds to our external debt. At some point dollar holders abroad which includes every central bank, all private banks, and most of the worlds wealthy won’t want any more dollars. Shortly before we reach that point the George Soro’s of the world will borrow many billions of dollars ( he won’t be alone this time) and buy gold and attractive other currencies. At that point what? Our economy is destroyed dollar asset holders are wiped out, and the Chinese the Euro holders and George Soros et al own the difference.
Simple would be bad when it nullifies the states. I am not for simple when it destroys federalism.
States can choose to add a sales tax, or adopt an income tax. They’ve gained freedom because they also get their share of Federal revenue without mandates, no strings. Indeed a portion of the tax remittence could occur at the level of value added in each state. The Feds don’t get their hands on any of it in the first place and the money just roles in without the states having to do much but would not have the power to raise the rate as it works because it is uniform across the US on all goods.
This is an impossibility. There can be no federal funds without mandates and strings. The whole of human political history is about the strings that come with power and “presents”. It was true of the history of the Russian conquest of its empire (a topic I’m currently reading about) and it’s true of our history.
This sounds like nothing but a way for state politicians to avoid the blame for their running of the government by hiding their tax revenues under the federal taxation umbrella. “Money just roles in without the states having to do much” doesn’t sound like a good thing to me. If the state government wants to spend, make them levy the taxes and pay the political price.
That’s a judgement that starts with the premis that it’s not possible for s large country to do what a small country can do and that unlike Reagan or thatcher or John Paul we should’t try, I think this atttitude is baseball on a number of false sssumptions.
No, that’s an assumption based on the way humans behave in their relationships. It is not scale dependent. It doesn’t even apply just to politics.
Hank Morgan
thats my objection to any federal money to states. But if we decide to do it we should do it in the least damaging most economically favorable way possible that also solves a plethora of other problems while adding revenue stability. That is what Nee Zesland found and Im suggesting that we would to. I want people who know how corrupt and destructive our tax code is to try to think this through, very few have done so and my impression is that few understand it.
You’re right that people don’t understand the New Zealand system. I’ve found what you’ve written to be helpful in my understanding of it, some of which had been mistaken before you explained it. That doesn’t mean I would want it for us.