A Sensible Constraint on State Sales Tax

A Sensible Constraint on State Sales Tax
AP Photo/Matt Dunham

This past legislative season, South Dakota, Louisiana, Rhode Island, among other states, intended to raise revenue from online sales. While this may seem like just another mundane tax issue, it represents a remarkable development in the relationship between government and the Internet. In fact, according to Supreme Court precedent, these new taxes are illegal.

In the early 1990s, the Internet was growing as a retail marketplace. Consumers could instantly search hundreds of companies so long as they had the patience for a dial-up connection. From the perspective of the states, these sales were problematic. Why? When a consumer buys from a brick-and-mortar retailer, the consumer is charged sales tax and the retailer remits the tax to the state government. Internet retailers, by contrast, often do not hold assets within a state’s jurisdiction. Therefore, the sales generated by these retailers may be non-taxable by the state in which the consumers live.

In response, North Dakota decided to capture forgone revenue and tax the activity of online retailers by forcing them to remit taxes owed to the state. In 1991, Quill Corporation sued North Dakota, arguing that the state lacked jurisdiction. The next year, the Supreme Court overturned North Dakota’s tax on grounds of the Interstate Commerce clause. The Court relied upon a past case, Complete Auto Transit Inc. v. Brady, in determining that certain factors must be satisfied in order for a state to tax a company. Specifically, according to Complete Auto, states are allowed to tax activities within the realm of interstate commerce through a four-part test: the tax must be applied to an entity with a substantial nexus (brick-and-mortar location) in the state; the tax must be fairly apportioned; the tax cannot discriminate against interstate commerce versus intrastate commerce; and the entity in question must be “fairly related” to services provided by the state.

It is easy to understand why the Quill decision irks state governments. Estimates in 2012 place the lost potential tax revenue at $23.3 billion. Overturning Quill may seem like sound economic policy to some analysts and legislators, but it is rife with unseen miscalculations. There are three main arguments rooted in the widely accepted economic theory that rejects the value of states levying online sales taxes.

First, enabling states to tax online retailers without a physical presence in the state reorganizes political incentives faced by legislators when deciding who to tax. The lack of physical presence means online retailers lack political power compared to constituent brick-and-mortar retailers. Taxing online retail is less politically costly relative to taxing constituent retailers, since online retailers matter less when it comes to reelection. If legislators repeatedly lean on taxing online sales versus brick-and-mortar retail, it could be disastrous for online retailers.

Second, taxing online retailers removes funding for investment in research and development. Logically speaking, as profits fall due to taxation of sales, firms will have fewer funds with which to develop innovations. The American Legislative Exchange Council finds that firms who operate solely online have great innovative value to American consumers by creating new technologies and new markets. Curtailing this progress may have implications that outweigh state revenues raised through higher taxes.

Finally, levying taxes for online sales would result in a transfer of wealth from private citizens to state governments. When a government levies a tax, the price of goods is artificially raised, reducing the quantity of goods purchased. Consequently, sellers and buyers who would normally do business no longer participate in the market. This deadweight loss is a disappearance of well-being from both firms and citizens. Sure, the state government will collect revenue, but the tax will result in less value for the state and for society as a whole. It is important to recall why consumers began shopping online in the first place: Online retailers typically offer consumers lower prices than brick-and-mortar stores, due in part to the absence of taxes.  By taxing online sales, state governments will destroy newfound wealth for many of their constituents.

Through its protective legal authority, Quill shields innovative online markets from taxes that reduce research and development investment and protects society’s economic surplus in online markets. Of course, states must collect revenue in order to finance fundamental government functions. With this in mind, states should look internally for budget solutions rather than pass challenging legislation intended to tear down Quill. Reducing spending, taking measures to grow the economy, and re-prioritizing government programs are all better solutions for consumers than burdening the most dynamic and generative sector of the economy.

States may see online sales as a potential cash cow, but taxing online retailers will result in decreased innovation and higher prices, leaving state constituents worse off than they would be otherwise.

Skip Estes is a Tax Fellow with the American Legislative Exchange Council and a Master’s of Public Policy student at The College of William and Mary.

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