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The taxing issue of e-commerce

District states are in the middle of the debate on Internet sales taxes

November 1, 2003


Frank Jossi Contributing Writer
The taxing issue of e-commerce

Following a well-worn path blazed by many small Internet entrepreneurs, Lee Kaplan discovered a niche market a few years ago and figured a Web site would help him reach customers. A cabin owner himself, he watched as thousands of cabins were bought or built throughout Minnesota and the rest of the country in the 1990s. He started supplying products through to cabin owners who wanted to monitor their second homes and automate tasks, such as keeping their indoor plants watered.

Not long after, he developed another Web business developed for selling, as he dubs it, "leading-edge pet supplies." Since he created both sites and found an inexpensive e-commerce vendor to handle financial transactions on the sites, he spent little money on the businesses yet discovered a devoted following. "Both sites sell things that you're not likely to find in big-box stores," says the suburban St. Paul businessman. "They're not the kind of products many places carry."

With sales hitting more than $80,000 annually, Kaplan's been happy with the businesses, but he worries about a collective effort under way by more than 40 states to tax products sold on the Internet. His current sites automatically charge Minnesota customers, but he wonders if they will be able to charge 40 or more different tax rates and, if so, how much that will cost and how much time will he have to devote to paperwork. Ultimately, Kaplan questions whether maintaining his burgeoning businesses will be worth it.

The proposal to tax Internet purchases remains contentious. Cash-strapped states are looking for new sources of revenue, and while taxes on resident purchases from e-commerce vendors might not be the mother lode, every little bit helps. Critics contend a tax hurts an emerging industry that still needs a small boost to continue expanding and developing new products and new technology. They charge it's also unconstitutional and unfair.

But "unfair" is also what land-based retailers might cry, as they claim that Internet retailers have an undue advantage. The South Dakota Retailers Association has seen Internet taxation as its most important issue "for the past number of years," says Jerry Wheeler, executive director. Remote retailers have a 6 percent advantage over his members and "that's a big disadvantage to us."

Worldwide web of taxes

In fact, this general debate has been going on for decades in the form of catalog sales, historically made by phone. But the explosion of e-commerce has pushed this tax matter to the fore, augmented by budget deficits in most states. For both catalog and Internet sales, states want to be able to tax those purchasers who live in their state.

Currently, if a resident of, say, Eau Claire, Wis., buys a Dell computer via the Internet, she pays no Wisconsin sales tax on the purchase. If she's a good citizen, she reports the purchase to the state and pays a "use" tax on it, as well as everything else she buys off the Internet and from catalogs. Good citizens are hard to come by, apparently, as state revenue officials say few taxpayers pay use taxes, in part because many do not even know they're supposed to.

To establish standards for Internet and catalog taxation, more than 40 states have created an organization called the Streamlined Sales Tax Project (SSTP). Initially backed by the National Governors Association, the organization seeks to create uniform rules to delineate what constitutes clothing, food and other items nebulously and differently defined by states and the country's 7,500 taxing jurisdictions.

The Ninth District is well represented in SSTP, with its co-chairs Diane Hardt of Wisconsin and Scott Peterson of South Dakota, revenue executives in their respective states. Once the group has completed the project, Congress will be left with the difficult choice of going against the will of deficit-heavy states and disallowing e-commerce taxation or agreeing to expand taxes against the wishes of industry groups and political constituencies.

Capitol Hill observers such as Adam Thierer, director of telecommunications studies for the Cato Institute, a libertarian-leaning think tank in Washington, D.C., predict the debate will heat up later this and next year. The number of governors jumping on the Streamlined bandwagon continues to grow, he says, noting Florida Republican Gov. Jeb Bush recently added his state to the proInternet tax ledger. (In late September legislation was introduced in Congress that addresses the Streamlined Sales Tax Project's plan.)

The Ninth District plays into the debate in other ways. The Internet taxation question grew out of a 1992 Supreme Court case dealing with North Dakota's desire to tax a Delaware company, Quill Corp., which sold $1 million annually worth of office supplies through mail and phone solicitations to 3,000 businesses in the state. Quill had no presence in North Dakota, but the state's law required the company (and other mail order firms) to charge North Dakota sales tax on all transactions if it advertised more than three times annually in the state.

The Supreme Court ruled against North Dakota because Quill had no "nexus," or physical presence in the state, and therefore did not have to pay taxes on products the company sold there. The court also suggested that if states simplified their tax codes Congress could give states the ability to tax Internet and catalog transactions.

North Dakota's interest in taxing Internet transactions has not waned, however, as U.S. Sen. Byron Dorgan has introduced bills to encourage states to simplify their tax rates to make Internet taxation easier in the future. South Dakota's federal legislators, too, have aggressively sought to expand states' rights to tax catalog and Internet sales. Wisconsin and Minnesota strongly favor taxing mail and cyber-commerce, while Montana sits on the sidelines since it has no sales tax.

When the Supreme Court made its decision, the explosive force of e-commerce could hardly be imagined. The decision mainly dealt with growing catalog sales. But as technology in the 1990s became more sophisticated, the Internet and an older technology, electronic data interchange (EDI), came to play an important role in the nation's economy. By 2001 e-commerce had exploded into a trillion-dollar business, led by manufacturing ($725 billion), wholesalers ($270 billion), retail trade ($34 billion) and selected services such as travel and media ($37 billion), according to the U.S. Department of Commerce.

And some brick-and-mortar companies cleverly circumvented the "nexus" problem by establishing separate online firms selling virtually the same product lines. The point? If a mass retailer had a nexus in several states, it would have to charge sales taxes in each of those localities. If a business was an online subsidiary with just one office, however, it could avoid charging a sales tax to all but those customers in the state with the physical storefront.

Big retailers like Target, Wal-Mart and Toys "R" Us have agreed to begin charging sales taxes for online purchases because they have a nexus in nearly every state and because it facilitates consumers' ability to return merchandise to stores without associated tax headaches. And big names like Sears, Roebuck and Co. and Circuit City always have charged customers a sales tax for online transactions.

Forrester Research Inc. suggests such a move is the future of retail, and the struggle against online sales taxes is probably not worth the effort since studies show consumers are not opposed to paying them. Still,, Dell Computers and other catalog and Internet-only merchandisers continue the opposition.

Lost and found?

The loss of tax revenue to e-commerce gained traction as research began to show significant and growing tax leakage from Internet sales. The most-cited study estimating revenue loss from e-commerce comes from the Center for Business and Economic Research at the University of Tennessee at Knoxville.

Donald Bruce and William Fox, Center faculty, used Forrester data to conclude states lost $13.3 billion in tax revenue in 2001, an amount that would triple to $45.2 billion by 2011, enough to pay off more than a few state deficits. In the Ninth District, projected revenue losses ranged from an estimated $897 million in Minnesota to $76 million in North Dakota in 2006, for example. State officials in the district say Bruce may be on the high side, but they do not dispute the point they're losing money on digital transactions, and they'd all like a piece of the action.

Given the differing sizes of state economies in the district, it also pays to take a look at the relative size of uncollected e-commerce taxes. The professors suggest South Dakota takes the biggest hit, seeing a potential loss of sales tax revenue to e-commerce of more than 8 percent in 2006. North Dakota was next in line with a 5.7 percent loss to e-commerce, while Minnesota could see a 5.6 percent loss and Wisconsin a 4.2 percent loss. (These percentages do not include local revenue losses where city or county sales taxes apply, which can add to a state's total e-commerce deficit, particularly in states like the Dakotas where local sales taxes are common. But given that local sales taxes are low—usually 0.5 percent to 2 percent—the cumulative local loss is believed to be a fraction of that experienced at the state level.)

Figures from the Bruce-Fox study also have been disputed by the Direct Marketing Association (DMA) in Washington, D.C. Peter Johnson, senior economist at the trade group, argues that the Tennessee study failed to distinguish between transactions achieved through EDI—digital networks of mainframe computers that operate on gateways separate from the Net—and the Internet itself. Sales taxes are voluntary in EDI transactions, but he contends most merchants do pay the sales tax on purchases.

Using the data presented earlier from the Commerce Department, Johnson argues that Bruce-Fox overstate the size of the future Internet economy and understate how many businesses voluntarily pay a use tax on electronic purchases. Under the DMA's scenario, states lost only $1.9 billion in 2001 and would suffer only a $4.5 billion loss by 2011, says Johnson.

Within the Ninth District, two states have done their own research. Larry Wilkie, director of corporate and sales tax at the Minnesota Department of Revenue, says a study by an independent consultant showed Minnesota lost $451 million in 2000 from businesses and individuals who either underreported sales and use taxes on their tax returns or who did not file returns at all. Of this amount, out-of-state, Internet and catalog sales comprised $125 million of the total gap, says Wilkie. Because of rapid growth of Internet and catalog sales, the revenue loss from these types of purchases will reach $334 million by 2007 and become nearly half the gap, he says.

Minnesota residents (businesses do not receive this exemption) who buy from catalogs and Web sites pay no taxes on the first $770 of purchases. But after that each should pay a use tax based on the 6.5 percent state tax plus any municipal taxes, he explains. Few residents and businesses bother to do so, and the state has no firm data on the issue.

"There's a lot of noncompliance on these kinds of transactions, and if we have 60 percent compliance I'd be surprised," Wilkie says. "Compliance rates are anywhere between 30 percent and 70 percent for businesses and probably are close to 1 percent for individuals."

Wisconsin revenue officials, meanwhile, believe mail order and Internet purchases will cost the state $97.8 million in 2003 and $145.9 million in 2006. Even using Johnson's method of figuring lost revenue, Wisconsin still loses $40 million a year—"a lot of money to a state with a big deficit," says Diane Hardt, administrator of the Revenue Department's Division of Income, Sales and Excise Tax and a leader in the streamlining movement.

Perhaps the district state fighting the hardest for a sales tax on remote sellers is South Dakota. Alison Jares, revenue supervisor at the South Dakota Department of Revenue and Regulations, says 70 percent of the state's income derives from the sales tax. "To us this is a big deal. We live and die by the sales tax in part because our residents do not want an income tax," she says.

North Dakota has not done any research but points to the Bruce report and to federal studies showing the tax loss could be as high as $76 million in 2006, says Gary Anderson, state revenue commissioner. Anderson says the state provides a voluntary payment form for those who purchase from remote sellers, but few residents bother to pay the tax. Now the state actively supports the SSTP and works with its local communities (all of whom have varying municipal tax rates) to help them understand how the system would work in the future.

Give me tax liberty

Outside of the numbers lies a philosophical debate. The DMA's Johnson simply believes too many taxing jurisdictions exist and too many states tax things in different ways, even from county to county, for a software program to ever be entirely accurate. A country that sent a man to the moon and developed the space shuttle should be able to create a software tax program, Johnson concedes, while suggesting it will never work.

Johnson paints a grim picture of a small business person in Maine—or a Lee Kaplan in Minnesota—faced with the daunting task of charging appropriate taxes. He also argues that Internet taxes symbolize taxation without representation, something the Founding Fathers fought against and a bulwark of the Constitution. But that's a fairly dubious claim since vendors simply collect the tax for states and do not have to pay taxes to any state but the ones in which they have physical locations.

Thierer of the Cato Institute emphasizes taxing businesses over which a state has no authority is antithetical to the country's commerce laws and in opposition to 30 years of Supreme Court decisions calling such taxes a burden on interstate commerce—a burden in particular on sellers. He tosses into his argument the 14th Amendment to the U.S. Constitution, famous for requiring that states give the "due process" of a trial to those allegedly in violation of laws. If an e-commerce firm wants to protest having to apply sales taxes to goods purchased by buyers, how can it demand "due process" in states where it has no nexus?

Both arguments, he admits, are long shots since technology will likely make the burden of applying Internet sales taxes much easier in the near future. And the 14th Amendment contention—"taxation without representation"—may not pass the Supreme Court's smell test to get a hearing.

Thierer prefers to oppose e-commerce taxation on economic terms. He calls the application of interstate taxes "destination-based" since the buyers, wherever they live, will pay the tax. Instead, Thierer prefers an "origin-based" system where states and municipalities tax only the businesses and products made within their borders. In his scenario a big Internet and catalog retailer like, say, Land's End, would pay a producer tax to Wisconsin.

Is that going to happen? He doesn't believe so, not in a New York minute. But making producers pay the tax, rather than consumers, would provoke "intensive tax competition between states ... which we don't have enough of," he argues. Moreover, he thinks the difficulty of taxing digital goods will only grow—for example, who gets taxed for a song created by an Indian pop group, distributed by a Los Angeles label and downloaded by a New Yorker from a server in London? Producer, or origin-based, taxing is the simplest to apply, comply with and monitor.

Of course, tax agencies and retail associations see the world in a starkly different way than the anti-tax crowd. Bruce, the Tennessee professor, says little evidence exists that businesses routinely pay taxes on EDI-transmitted expenditures. He sees Internet businesses that do not pay taxes as having an unfair tax advantage, and forcing them to charge a tax will not clip their wings. "I'm a small business researcher and the e-commerce study was a side project. But I'm sensitive to these issues, and what I would say [is] that if you're in business based on having an unfair tax preference, you shouldn't be in business," he says. Johnson retorts by pointing out that the no-tax cost advantage enjoyed by Internet vendors dissipates once shipping fees are tacked onto transactions.

But an echo chamber for Bruce's arguments can be heard across the district. Buzz Anderson, president of the Minnesota Retailers Association, says furniture stores in particular have been hard hit by customers looking at their wares but then making purchases from North Carolina merchants who do not have to charge Minnesota sales tax. His association, which includes some retail establishments with an Internet presence, wants to force Internet establishments to charge a sales tax to "level the playing field."

A streamlined, killer app

In the computer world a "killer app" is an application that changes the nature of business, like Microsoft's Powerpoint or Adobe's Photoshop. The killer app in the Internet tax world might just be the streamlined tax project. It promises to create uniform definitions and source codes of key items, to simplify rates, to provide a central point within a state for collection of all state and local taxes and to produce a uniform audit procedure. States would pay for technology models and volunteer to initially test them.

The system would be largely voluntary until Congress takes action. The District of Columbia and 40 states—including those in the Ninth District except Montana—have participated in the project, says Hardt, as well as many businesses in a variety of sectors ranging from telecommunications to accounting firms. The project proposes a system where purchasers would be charged a sales tax based on their zip codes, and each state would have one state tax, as well as the option to add one standard local tax. In South Dakota, for example, where municipalities have different rates, they would all agree to just one municipal rate.

The tax project anticipates some problems. If a business has under $5 million in gross receipts, it would be exempt from collecting taxes, says Hardt. The tax charged will "be the lowest possible" within a given zip code. If tax rates change, states must give sellers 60 days to comply.
The project began in 2000 but picked up steam this year and should be completed by next July. The economic decline of states has "helped us move this thing along," she concedes. "When we started, states were flush with money and they weren't as concerned about this. Now the situation has changed substantially."

Thierer calls the streamlined project a "screw your buddy system" where the states gang up on catalog and Internet merchants for a slice of revenue which does not amount to much of the total retail pie. Internet sales barely reached 1.1 percent of all retail transactions; catalogs hover around 5 percent. Taxing the remote sellers will not be a mother lode of cash for states.

And Thierer wonders how willing the states will be to abide by the rules, pointing out that Texas agreed to the streamlined tax proposal but asked to exempt one jurisdiction, Round Rock. Why? Because Round Rock is the headquarters of Dell Computers, the largest mail-order computer manufacturer in the country.

For now legislators are lined up with bills allowing states to begin taxing e-commerce and catalog interstate commerce. The SSTP is moving along nicely with a pilot project under way and with the states coming to agreements relatively quickly on most issues. Bruce dubs the states' effort "remarkable." Lee Kaplan is not so sure. He just hopes his small clientele understands they may not have to pay a sales tax since he potentially falls under the $5 million threshold. If an e-commerce tax does become a reality, he firmly believes it "won't be good for business."

Toll roads to the Internet

One element of confusion in the whole Internet debate is the probable agreement between Congress and President George W. Bush to continue a moratorium on Internet access taxes. Bush will reportedly renew the moratorium this year without opposition from Congress, prohibiting states, municipalities and the federal government from taxing Internet access provided by AOL and hundreds of other Internet service providers.

Opponents question why the federal government allows itself and states to tax phone lines but not Internet access. Most Internet users ride the same telecommunications backbone to surf the Internet as they do to make a phone call.

Still, the ban looks to become a reality. The move by Bush and Congress, however, does not ban the taxation of goods bought and sold on the Internet. It only eliminates taxes on providers, a crucial distinction in the ongoing debate.