Governing: Internet taxation/March 2000

E-Conomics Problem

BY CHRISTOPHER SWOPE

Reproduced from Governing: The Magazine of States and Localities

March, 2000, pp. 20-23

As Michigan taxpayers sit down to fill out their tax forms this year, many are in for an unwelcome surprise. When they get to Line 30, they will see something they’ve never seen before: a space in which to tally their Internet taxes.

By now, a lot of folks in Michigan, as elsewhere around the country, have come to conclude that buying stuff online is tax-free. And with good reason. Most Internet retailers don’t bother to collect sales taxes, except in a very few states where they have to. That was OK for a while. In the early days of electronic commerce, the tax revenues that Michigan lost to Internet retail amounted to a pittance.

Not anymore. State revenue experts estimate that Michigan is losing $21 million a year in tax-free Internet sales &emdash; and growing fast.

On Line 30, Michigan is asking taxpayers to add up all of the tax-free purchases they made last year, both on the Internet and through mail order catalogs. Then multiply by 6 percent. For the most avid of online shoppers, this could come to hundreds, if not thousands, of dollars. It is likely, however, that most taxpayers will just skip Line 30. After all, there’s no way that Michigan can track what they bought.

The 6 percent tax that Michigan is asking residents to pay is not actually sales tax. It is something called “use tax,” which for decades residents have ostensibly owed when they buy things from out of state. But like the 44 other states that have use taxes in place, Michigan has never before made much effort to collect it. “We’ve never had broad compliance from consumers,” says Michigan Treasurer Mark Murray.

The point of Line 30 is not, however, to raise cash. It is to prepare taxpayers for a permanent response to the Internet tax problem. Michigan is gearing up to test new technology that would automatically collect sales and use taxes on Internet purchases. And that pilot, which could begin as early as this year in several other states as well, is itself a prelude to much bigger plans to come.

The “Big Seven” associations representing state and local officials, led by the National Governors’ Association, are sketching out a sweeping strategy to completely overhaul the way in which state and local governments collect sales and use taxes. The explosion in tax-free e-commerce sales, they say, is putting traditional retailers who do collect sales taxes &emdash; on America’s Main Streets and in its shopping malls &emdash; at a competitive disadvantage. It also threatens the budgets of 45 states and hundreds of cities, which count on sales and use taxes to pay for the essential government services. “Ten years from now, the typical person will be all wired,” Dallas Mayor Ron Kirk says, launching into a popular joke. “He’ll have his high-speed Internet link, buying everything online. His life will be dependent on computers and the Internet. Then one day, in all that electronic equipment, he’ll have a short, and it will start a fire in his house. And when he calls 911, we’ll fax him a picture of a fire truck.”

The irony, however, is that if technology, through the Internet, is bringing state and local budgeteers’ concerns to a crisis point, then it is technology that also may bail them out. State and local officials want Internet retailers to use software that would automatically calculate and charge sales and use taxes. The system would be run by a third party &emdash; meaning that collection of sales and use taxes would essentially be privatized. To make the system work, states would probably have to simplify the myriad complexities of their sales-tax codes. In essence, they would be creating a national sales tax, implemented on a state-by-state basis.

This idea is one of several to come out of a commission that Congress appointed in 1998 to study Internet taxes. With one meeting remaining, the Advisory Commission on Electronic Commerce is deadlocked. One faction on the commission, led by Utah Governor Michael Leavitt, generally supports the privatized software solution. On the other side is a group, led by Virginia Governor James Gilmore, that proposes making all online purchases tax-free for consumers. Gilmore disagrees with the notion that making the Internet tax-free would put traditional retailers at a disadvantage. “I just don’t start from the assumption that everything in America ought to be taxed,” he says. “And therefore, to not tax it is somehow implying some type of privilege.”

In Congress, there is a lot of support for Gilmore’s position &emdash; especially from anti-tax conservatives. But other members of Congress are pushing a national sales tax in which the federal government would pass the revenues back to the states and cities.

The good news for state and local officials, many of whom aren’t happy with either approach, is that Congress is likely to be as stalemated as the commission. That means many eyes will be watching the circle gathering around Governor Leavitt. Leavitt insists that the states can put their privatized tax regime in place without Congress’ blessing. The approach has the support of at least half of the nation’s governors, including high-profile Republicans such as John Engler from Michigan and Wisconsin’s Tommy Thompson. This year, perhaps a dozen legislatures will consider proposals to have their states’ top revenue officials meet to start pounding out details.

They are in for a monumental undertaking. The effort will require an unprecedented amount of interstate cooperation to keep all the states and cities moving in one direction &emdash; while fending off Congress in the meantime.

There is fair reason to doubt that the governors can pull off their gambit. Overhauling all the states’ tax codes on a state-by-state basis is bound to be a political mess. Along the way, they will have to do battle with the myth of the tax-free Internet, which is already ingrained in many people’s minds. Although the governors are only proposing to collect use taxes already on the books, people will inevitably interpret the move as a tax increase.

Then there is the question of whether this is something the governors should be pursuing. A privatized tax-collection system is enough to make even the most committed privatization advocates nervous. And anything the states try to do on this would likely be challenged in the courts. Critics make a strong argument that the states are wading too far into matters of interstate commerce. “Somebody has to lay down the law here,” says Robert Strauss, an economist at Carnegie Mellon University. “And that’s Congress.”

If this debate has a familiar ring, it is because it is essentially a replay of the feud that states have had for decades with mail-order companies. In both Congress and the courts, state and local governments have fought to make catalog retailers collect taxes for them. And for the most part, they’ve lost. “This is an old wound aggravated,” says David Hardesty, author the book “Electronic Commerce: Taxation and Planning.” “They used the debate surrounding e-commerce to reopen this argument.”

The main obstacle is a 1992 Supreme Court decision on taxing mail-order sales, known as Quill Corp. v. North Dakota. The Quill decision said that states cannot force catalog companies to collect taxes for them &emdash; unless the retailer has a physical presence, or “nexus” in that state. In other words, L.L. Bean, the Maine catalog company with stores in no-sales-tax states, must only collect sales taxes from its customers in Maine. It would be an “undue burden,” the court said, for L.L. Bean or any other seller to have to keep tabs on the sales-tax rates in each state and every city, as well as all the numerous exemptions and special rules those jurisdictions impose.

In the wake of Quill and a similar earlier ruling, state and local governments feared that they would lose a lot of revenue. They went to Congress and proposed a bargain: If Congress would make catalog companies collect taxes for them, they would simplify their tax codes to make collection easier. But nothing ever came of it.

So the states and cities learned to live with Quill. Instead of asking sellers to collect taxes, they tried to collect the tax themselves. It wasn’t hard on business-to-business purchases, because businesses are audited regularly. But collecting taxes from household consumers was a nightmare. By the mid-1990s, state and local governments were losing as much as $3 billion a year in revenue on tax-free mail-order sales.

Comparatively, electronic commerce is still small, but it is growing exponentially. According to Forrester Research, Internet sales topped $18 billion in 1999, and could reach $108 billion by 2003. Multiply those numbers by, say, a 6 percent sales tax, and the budgetary threat of e-commerce dwarfs the damage that mail order did.

Taxware, a small computer software company, is sitting in the right place at the right time. Since 1980, the company has been developing computer systems that help businesses comply with state sales- and use-tax laws. At Taxware’s Salem, Massachusetts, headquarters, a brigade of more than three dozen employees is dedicated to an unconscionably complex task: keeping track of how 7,600 different state and local jurisdictions tax some 1,500 different products.

The state and local strategy for taxing electronic commerce relies heavily on the research and technology produced by companies such as Taxware. A software solution would do more than create technological wizardry. It would help the states circumvent the Quill decision. After all, the court had said it would be too burdensome for remote sellers to keep track of all the different state and local tax rates &emdash; but technology could ease that burden for them.

The governors propose making banks or credit-card companies responsible for collecting sales taxes. These so-called “trusted third parties” would embed tax-collection software into the Web sites of e-commerce vendors. When a customer buys a product online, the third party would automatically calculate and charge the proper sales or use tax and then pass the revenue back to the right state or city.

State and local governments would pay for the system through a small fee on each transaction. A profit margin built into that fee would aim to attract private-sector partners.

Should governments be turning over one of their most basic functions &emdash; tax collection &emdash; to small private shops? Even the conservative Heritage Foundation, which has advocated privatization of everything from adoption services to airports, thinks the NGA plan goes too far. “How trustworthy are the trusted third parties?” asks Adam Thierer, a Heritage scholar who testified before the e-commerce commission. Thierer’s main concern is maintaining taxpayer privacy in a system where private parties know what people are buying, where they live, and what their credit-card number is.

Beyond the privacy factor, local-level sales-tax rates sometimes vary from neighborhood to neighborhood. In these places, pegging exactly which tax district a shopper and her computer are in would be no easy task. Spelling errors and other glitches could easily muck things up. “A computer can do a lot of things, but it can’t figure out what it is that you really meant to spell,” says David Sjoquist, an expert on state and local taxation at Georgia State University.

A bigger problem is that no two states share the same tax base, with different states exempting different products from the sales tax. Unique rules abound. For example, in Massachusetts, the first $175 of an article of clothing is tax-exempt. In Connecticut, only the first $50 is tax-exempt. In New Jersey, clothing is completely tax-exempt. Then there is the question of what constitutes clothing. “The real problem is the varying definitions,” says Tennessee state Representative Matt Kisber. “It’s difficult writing software that understands whether a scarf is for decorative purposes and is taxable, or if it’s clothing intended for warmth and is tax-free.”

A diligently programmed software package could handle this. But state and local officials are coming to understand that they need to simplify and harmonize their sales taxes. This year, revenue officials from a dozen or so states are expected to come together to start working out a plan to do just that. “If the system remains as complex and burdensome as it is today, the software will cost a whole hell of a lot of money,” says Frank Shafroth, chief architect of the plan at NGA. “The greater the simplicity, the cheaper it will be.”

As the simplification debate moves off of dry-erase boards and into state legislatures, it is likely to open a political Pandora’s box. Local governments, for one, are skeptical of simplification. Some ideas on the table, for instance, call for one tax rate per state. That would effectively lock cities and counties out of using sales taxes in the future. Given how much local governments rely on sales taxes to fund roads and arenas and to pay off bonds, they will be a powerful force in the debate.

Other special interests could get involved, just as they have whenever sales-tax-base issues have come up. For example, Georgia’s sales tax exempts the bait used by its lucrative shrimping industry. The simplification debate could end up a lobbyists’ free-for-all as lawmakers unpeel the shrimp exemption and hundreds of others like it.

Some critics fear that, given the complex politics involved, legislatures won’t confront the political challenge but will lean on the software solution as a golden crutch. “The NGA proposal leaves a lot of the complexity in place,” says Charles McLure, a tax expert at Stanford University’s Hoover Institution and a longtime simplification advocate. “It says we’ll transfer the costs of that complexity to the trusted third party.”

Illinois state Senator Steven Rauschenberger is more optimistic. “The biggest motivating factor for states is that they’ll recognize soon that if they don’t act to modernize their tax codes and make the system work, they may not have much of a system left to be concerned about.”

There is another way that the NGA plan tries to circumvent the Quill decision. The court said that states could not require remote sellers to collect sales or use taxes. But the NGA plan does not demand that merchants play in this elaborate system of trusted third parties. Participation is voluntary.

The big question is: Why in the world would any Internet retailer sign up if they don’t have to? “The problem with a voluntary system is that there is a reward for holding out,” says Richard Prem, the head of e-business services at Deloitte & Touche. “By joining, businesses would be giving up sales.”

The least likely to join would be the pure e-commerce sellers. Take ValueAmerica.com, a company that sells merchandise only over the Internet. Under the current rules, ValueAmerica has nexus only in Virginia, where its headquarters are located. For ValueAmerica to join the third-party system, it would be giving up a big competitive advantage over bricks-and-mortar retailers: tax-free shopping in 49 states.

There are some retailers, however, who would be likely participants, according to Leavitt. The most promising are big national chain stores. By now, nearly every major chain retailer, from big-box stores such as Staples to mall fixtures such as Crate & Barrel, has a virtual store online. But because they have physical stores &emdash; and thus nexus &emdash; in so many states, they already have to collect taxes for almost every state. Having a third party collect taxes for them would actually relieve a major hassle for these “bricks and clicks” retailers.

But there is a loophole in that logic, one that big chain stores are tearing through like running backs. Look at Wal-Mart. With 2,500 stores in all 50 states, Wal-Mart would be a natural fit for the NGA plan. But in January, Wal-Mart followed the example of its competitor K-mart and others: It created a separate company for its Internet business. Despite close ties to the mother company, the upstart Walmart.com bears more resemblance to ValueAmerica. It has nexus only in California, where its headquarters are, and Arkansas and Utah.

Aware of this problem, the states are planning a number of carrots to try to persuade even sellers such as Amazon.com or Walmart.com to participate. For example, the third parties might offer financial bonuses to retailers who play. In addition, participants would receive a sort of tax amnesty. And there might also be a bureaucratic advantage to joining: Sellers would have to answer to only one state audit, rather than 45 audits by the states that assess sales and use taxes.

There is also one big stick: the courts. The states could do some legal ganging up on Amazon and Wal-Mart in the same way that they went after tobacco companies. They might have a case. Does Amazon create additional nexus for itself when it posts its link on another vendor’s Web site? Perhaps not. But these types of questions are as yet largely unsettled, and it might be more expensive for dot-com companies to litigate than to go with the program.

Critics argue that the governors’ proposed tactics are too strong-armed. “How voluntary is a system when it offers financial incentives as carrots to get sellers to join?” asks Adam Thierer. “The whole system hinges on two things: Will the trusted-third-party idea mechanically work? And is it really voluntary? If the answer to either of those questions is no, then the NGA plan falls apart.”

Besides, the states may have trouble getting merchants to play, despite the incentives. The governors’ plan amounts to “fiscal hunting in the dark,” says Carnegie Mellon’s Robert Strauss. “There has to be federal legislation here,” he adds. “There need to be some rules of the game for states to collect use taxes.”

Then, again, the system might half work: Some retailers would play, while some wouldn’t. But if the result is replacing the current inconsistent patchwork of taxes with another, it wouldn’t much satisfy anyone. “If we go down the road of a voluntary system, and we’re only partially successful, we will have lost lots of time which we can’t replace,” says Wade Anderson, who used to be the top tax collector in Texas. “It will make it that much harder to go back and change this later. But I wish them luck.”

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