Sales and Use Taxes on Electronic Commerce: Legal, Economic, Administrative, and Political Issues

Charles E. McLure, Jr.*, Hoover Institution, Stanford University

*The author wishes to thank Harley Duncan for his comments on an earlier draft of this article. The author is solely responsible for any mistakes.

1. The definition of electronic commerce I like is "the use of computer networks to facilitate transactions involving the production, distribution, and sale and delivery of goods and services in the marketplace;" see Howard E. Abrams and Richard L. Doernberg, How Electronic Commerce Works, 13 State Tax Notes 121 (July 14, 1997). The Abrams-Doernberg definition is somewhat less precise than that in Organisation for Economic Co-operation and Development (OECD), The Economic and Social Impact of Electronic Commerce: Preliminary Findings and Research Agenda (Paris: OECD, 1999) at 28: "business occurring over networks which use non-proprietary protocols that are established through an open standard setting process such as the Internet." But it is more precise and more useful than that in U.S. Department of the Treasury, Office of Tax Policy, "Selected Policy Implications of Global Electronic Commerce" 1996 (the Treasury Department White Paper, available at http://www.ustreas.gov/taxpolicy/internet.html, visited January 7, 2001): "... the exchange of goods or services ... using electronic tools and techniques." This definition does not clearly differentiate what is commonly known as electronic commerce from such activities as telemarketing and television shopping, which are excluded by the Abrams-Doernberg definition.
2. Here and occasionally elsewhere, if meaning is clear from context, I use the term "sales tax" to refer generically to the combination of sales tax and use tax. More often I distinguish between sales tax and use tax. Much more has been written on the sales and use tax than on the state corporate income tax. On the latter, see Charles E. McLure, Jr. "Implementing State Corporate Income Taxes in the Digital Age" 53 Nat'l. Tax J. 1287 (December 2000), and Karl Frieden, Cybertaxation: The Taxation of E-Commerce (Chicago: CCH Inc., 2000), especially chapter 3.
3. For a more comprehensive description of state sales and use taxes, see John F. Due and John L. Mikesell, Sales Taxation: State and Local Structure and Administration, 2nd ed. (Washington, D. C. Urban Institute, 1994). Sales taxes are levied on an ad valorem basis (that is, as a percentage of the sales price) on a wide variety of items. They are to be distinguished from excises, which apply to relatively narrowly defined groups of goods and services (e.g., alcoholic beverages, tobacco products, and motor fuels), often on a specific (per unit) basis.
4. The Commerce Clause provides remote vendors complete immunity from duty to collect sales tax; see McLeod v. J.E. Dilworth Co., 322 U.S. 327 (1944).
5. See, generally, Due and Mikesell, supra, n. 3.
6. It has been estimated that as much as 40 percent of sales tax revenues are derived from taxation of business inputs; see Raymond J. Ring, Jr., Consumers' Share and Producers' Share in the General Sales, 52 Tax Nat'l. Tax J. 79 (March 1999). This reflects a range of 20 to 70 percent, depending on the state.
7. On some of the sources of complexity, see Robert J. Cline and Thomas S. Neubig, Masters of Complexity and Bearers of Great Burden: The Sales Tax System and Compliance Costs for Multistate Retailers, 18 State Tax Notes 297 (2000). For a summary of many of the complexities, see Walter Hellerstein and Charles E. McLure, Jr.,"Sales Taxation of Electronic Commerce: What John Due Knew All Along," 20 State Tax Notes 41 (January 1, 2001); also forthcoming in the proceedings of the 93rd annual conference of the National Tax Association, Santa Fe, November 11, 2000.
8. See Gary C. Cornia, et al., An Analysis of the Feasibility of Implementing a Single Rate Sales Tax, 53 Nat'l. Tax J. 1327 (December 2000).
9. See generally Walter Hellerstein, State Taxation of Electronic Commerce, 52 Tax L. Rev. 425 (1997) at 434. The Congress has exercised constitutional its power to change nexus rules for state income taxes, but has done so for sales and use taxes.
10. Quill Corp. V. North Dakota, 504 U.S. 298 (1992) at 306-307. For a general discussion of electronic commerce and due process nexus, see Hellerstein, Id., at 450-56.
11. Charles E. McLure, Jr., Taxation of Electronic Commerce: Economic Objectives, Technological Constraints, 52 Tax L. Rev. 269 (1997) (hereinafter Taxation of Electronic Commerce) at 323-26.
12. 386 U.S. 753 (1967).
13. 504 U.S. 298 (1992).
14. Whereas the Court failed to distinguish between Due Process and Commerce Clause standards for nexus in National Belas Hess, it drew this distinction in Quill; 504 U.S. 298 (1992) at 305. This distinction is crucial to the ability of the Congress to legislate a substitute for the physical presence standard of nexus. Whereas the Congress has the constitutional power to regulate commerce, it cannot make laws that deny due process.
15. See McLure, Taxation of Electronic Commerce, supra n. 11 at 332-34 and Hellerstein, supra n. 9 at 446-49.
16. For a description and critique of cases denying "nexus by affiliation," see Michael J. McIntyre,"Taxing Electronic Commerce Fairly and Efficiently," 52 Tax L. Rev. 625 (1997).
17. Hellerstein, supra n. 9, at 440, notes "[t]he implications of Quill for electronic commerce are neither as clear or as sanguine as they are for mail-order vendors."
18. 504 U.S. at 317.
19. The Court seemed almost apologetic in observing that "...contemporary Commerce Clause jurisprudence might not dictate the same result were the issue to arise for the first time today..." 504 U.S. 298 (1992) at 311.
20. This theme is developed further in Charles E. McLure, Jr., Electronic Commerce and the Tax Assignment Problem: Preserving State Sovereignty in a Digital World, 14 State Tax Notes 1169 (April 13, 1998); Charles E. McLure, Jr., Achieving a Level Playing Field for Electronic Commerce, 14 State Tax Notes 1767 (June 1, 1998); and Charles E. McLure, Jr., Rethinking State and Local Reliance on the Retail Sales Tax: Should We Fix the State Sales Tax or Discard It? 2000 Brigham Young Univ. L. Rev. 77 (2000).
21. It is also likely to be more favorable to saving than an income tax, but this is not necessarily the case.
22. Exemption of food is an extremely blunt instrument for effecting distributional objectives; it is far more efficient to tax all consumption and us family allowances to eliminate burdens on low-income households.
23. In the present context this refers to imports into, and exports from, the taxing state.
24. Thus arguments that tax should not be collected on sales by remote vendors, since they do not benefit from spending by the taxing state, miss the point. The appropriate question is whether the state where production occurs or the state where consumption occurs provides public services and thus should collect the tax. I believe the latter is more likely; if this is true, destination-based taxation is more consistent with benefit taxation. Commonplace application of the theory of tax incidence says that a destination-based tax is likely to be borne by the buyer, not the seller, which only acts as tax collector for the destination state.
25. Cross-border shopping constitutes a third deviation from destination-based taxation. It is more-or-less inevitable where cities straddle jurisdictional boundaries, and is more troublesome, the smaller the taxing jurisdiction; thus it is more problematic for local sales taxes than for state sales taxes.
26. I, at least, find it more difficult to explain to non-economists why sales to business should not be taxed and why all sales to consumers should be taxed. The need for simplicity and why the present system is overly complex is also easily explained.
27. For a partial catalog of unconvincing arguments for exempting interstate sales, with refutation, see Charles E. McLure, Jr., The Taxation of Electronic Commerce: Background and Proposal, in Nicholas Imparato, editor, Public Policy and the Internet: Privacy, Taxes and Contract (Stanford. Calif.: Hoover Institution Press) 49, at 77-82. The recent "cratering" of the dot.com world emphasizes the short-sightedness of using preferential tax treatment to favor activities that could not stand the market test.
28. I find it anomalous that states employ tax incentives in the attempt to attract economic activity, while continuing to apply sales tax to business purchases. The title of a paper I hope to write soon calls this, along with manipulation of the formula used to apportion corporate income among the states, "Looking for Love in All the Wrong Places." See also Peter D. Enrich, Business Tax Incentives: A Status Report, forthcoming in Urban Lawyer.
29. It is also probably desirable. If the Supreme Court had decided Quill in favor of the state, the states would have no incentive to reduce the complexity of the sales and use tax "system;" resort to Congress would have been essential. Had it decided National Belas Hess in favor of the state, even this remedy might not exist; see note 14. Because of the inexcusable failure of the states to act to simplify their taxes between 1967 and 1992, they now have the burden of proof to either the Congress or the Supreme Court that an expanded duty to collect sales tax would not be unreasonable.
30. See, for example, Cline and Neubig, supra, n. 7.
31. It is sometimes asserted that I favor a national sales tax. That is not accurate. I favor substantial uniformity of state (and local) taxes. Uniformity should not extend to tax rates, as the ability to set tax rates is crucial for state fiscal sovereignty and local fiscal autonomy.
32. Whether the de minimis rule should depend on the amount of sales a remote vendor makes to a particular state or the total amount of sales to all states where the vendor lacks a physical presence may depend on the technique used to implement the expanded duty to collect. Sales on which use tax is not collected because of the de minimis rule might be subject to the sales tax of the state of origin of sales or to a nation-wide tax imposed on behalf of all sales-tax states. The latter solution would be feasible only if there were a uniform sales and use tax law.
33. See, for example, William F. Fox and Matthew N. Murray, The Sales Tax and Electronic Commerce: So What's New?" 50 Nat'l. Tax J. 573 (September 1997). See McLure, supra, n. 27, for the author's proposal, the rationale for which is supported in other papers cited above.
34. The state sales tax has been called "road-kill on the information superhighway;" see Nathan Newman, "Prop 13 Meets the Internet: How State and Local Government Finances are Becoming Road Kill on the Information Superhighway," Economic Democracy Information Network Report, University of California, Berkeley: Center for Community Economic Research, August 1995. In fact, revenue loss are likely to be relatively small in the short run, if only remote sales made in electronic commerce are exempt, and future revenue losses are quite uncertain. It has been estimated that 80 percent of e-commerce sales are B2B transactions, many of which are either explicitly exempt or already effectively being subject to use tax. A substantial share of B2C electronic commerce sales are services (e.g., travel and financial services), intangibles, or goods (e.g., groceries and prescription drugs) that are legally exempt from tax; others involve sales diverted from other remote vendors that lack a duty to collect use tax. See Robert J. Cline and Thomas S. Neubig, The Sky Is Not Falling: Why State and Local Revenues Were Not Significantly Impacted by the Internet in 1998, Ernst & Young Economics Consulting and Quantitative Analysis, June 18, 1999, and Austan Goolsbee and Jonathan Zittrain, "Evaluating the Costs and Benefits of Taxing Internet Commerce, 52 Nat'l. Tax J. 413 (September 1999). For more recent estimates, including estimates of revenue loss for each state, see Donald Bruce and William F. Fox, E-Commerce in the Context of Declining State Sales Tax Bases, 53 Nat'l Tax J. 1373 (December 2000). On the uncertainly of future revenue loss, see U.S. General Accounting Office, Sales Taxes: Electronic Commerce Growth Presents Challenges; Revenue Losses Are Uncertain (2000).
35. More than autonomy over tax rates is at stake; many local governments have pledged sales tax revenues to debt service, for example, those issued to finance construction of stadiums; see Charles E. McLure, Jr., Electronic Commerce and the U.S. Sales Tax: A Challenge to American Federalism (hereinafter Electronic Commerce and the U.S. Sales Tax), 6 Int'l Tax and Pub. Fin. 193 (1999) at 210. The few states where the state and local tax bases are different or where local governments administer their own taxes would lose even more autonomy.
36. See McLure, Id., at 218, n. 9. It is ironic that the latter opponents of taxing electronic commerce, mostly economists employed by so-called "conservative" think tanks, favor both preferential treatment of electronic commerce, instead of a "level playing field," and federal restrictions on the taxing power of the states.
37. McLure "Taxation of Electronic Commerce," supra n. 11, at 404-406, discusses an abortive attempt to reach an agreement that would combine an expanded duty to collect use tax with greater certainty. Among the sources of uncertainty cited at the time were whether nexus would be created by temporary in-state possession of inventory manufactured for an out-of-state vendor with no other physical presence in the state and the number of days employees of a vendor could attend trade shows in a state without triggering nexus. These efforts at compromise, of interest primarily to a few large mail-order firms and companies engaged in sales to other businesses, did not entail comprehensive simplification of the sales and use tax.
38. Doug Sheppard, 2000: The Rise of the Streamlined Project and the Fall of the Advisory Commission, 20 State Tax Notes 34 (January 1, 2001), at 37 notes, regarding a bill by Senator Byron Dorgan (D-N.D.) that would authorize an interstate sales-tax collection compact, "organizations such as NCSL ... objected to SA.2775's federally mandated de minimis thresholds for retail sales, one rate per state for all remote commerce, use of NCCUSL to oversee state tax simplification, and extension of the ITFA moratorium prior to its expiration."
39. For speculation on why the European Community has adopted a system that approximates the ideal, while the American states have not, see Hellerstein and McLure, supra, n. 7.
40. The National Conference of Commissioners on Uniform State Laws (NCCUSL), which would probably be assigned the task of drafting a uniform law to be considered for adoption by the individual states, also lacks legislative power.
41. See Sheppard, supra, n. 38.
42. In United States Steel Corporation v. Multistate Tax Commission, 434 U.S. 452 (1978, sustaining the constitutionality of the Multistate Tax Compact in the absence of congressional consent) the Court found that congressional consent for an interstate compact is required only if the compact is "directed to the formation of any combination tending to the increase of political power in the States, which may encroach upon or interfere with the just supremacy of the United States." It appears that the agreement envisaged in the SSTP would not fail this test.
43. The SSTP Website is http://www.geocities.com/streamlined2000/.
44. Available at http://ntanet.org/, visited December 20, 2000.
45. See Kendall L. Houghton and Gary C. Cornia, The National Tax Association's Project on Electronic Commerce and Telecommunication Taxes, 53 Nat'l. Tax J. 1351.
46. For a play-by-play description of the deliberations of the ACEC and developments in the Congress during 1999, leading to the creation of the SSTP, see Sheppard, supra, n. 38.
47. The moratorium on "Internet taxes" provided by the ITFA has received substantially too much attention. This moratorium temporarily prohibits taxes on Internet access (which almost everyone agrees should not be imposed, though for reasons of dubious validity) and discriminatory taxes on electronic commerce (which no one was proposing). It would not prohibit non-discriminatory application of sales and use taxes to electronic commerce. Of course, Quill already did that for much of remote commerce, at least that in tangible goods.
48. Available at http://www.ecommercecommission.org/report.htm; visited December 20, 2000. The majority also endorsed application of the physical presence test of Quill, extended as described in the text, to nexus for business activities taxes, including income taxes.
49. These findings were, unfortunately, consistent with what I had predicted earlier, in McLure, Electronic Commerce and the U.S. Sales Tax, supra n. 35, at 208: "All-in-all, asking this Commission whether Internet access and electronic commerce should be subject to the same taxes imposed on local business is analogous entrusting a commission of foxes to guard the henhouse. The requirement of a two-third majority appears to be all that stands in the way of recommendations for legislation that could decimate traditional business." I explain there that, despite the appearance of balance in its composition, the Commission was, in fact, dominated by members (including those ostensibly representing state and local governments) opposed to all taxation of electronic commerce.
50. See Cline and Neubig, supra, n. 34 and Goolsbee and Zittrain, supra, n. 34.
51. From the Project Mission; see http://www.geocities.com/streamlined2000/index.html, visited December 14, 2000. For an early description and appraisal of the activities of the SSTP, see Susan K. Haffield and Arthur R. Rosen, "Star Wars" Meets the Sales and Use Tax: An Interim Objective Report of the Streamlined Sales Tax Project, * State Tax Notes 1457 (November 27, 2000).
52. See the press release dated December 26, 2000, available at http://www.geocities.com/streamlined2000/122200pr.pdf, visited January 2, 2001. A few amendments, most of which are of relatively little consequences for present purposes, were adopted on January 24, 2001; see http://208.237.129.206/sline/124amdedactandagrmt.pdf, visited January 29, 2001. Sheppard, supra, n. 38, at 38 notes that the NCSL contemplates quick action to thwart preemptive federal legislation.
53. I added the discussion of the January 27, 2001 action by the Executive Committee of the NCSL just before submitting the final draft of the article for publication. I apologize for the resulting roughness of exposition, as well as for any inadvertent errors.
54. This description covers only the most important provisions of the Agreement. Whereas the Agreement describes the requirements imposed on all members states, this section describes the system that would prevail in the member states once the agreement becomes effective. All references to "states" in the text are to "member states."
55. The resolution adopted by the Executive Committee of the NCSL on January 27, 2001 deleted this provision, reserving it for further study.
56. The resolution adopted by the Executive Committee of the NCSL on January 27, 2001 added the following wording to this provision: "except that for food, clothing, electricity, gas and other items specifically added to this Agreement, states may impose one additional lower rate, and that rate may be zero."
57. The resolution adopted by the Executive Committee of the NCSL on January 27, 2001 deleted this provision.
58. The resolution adopted by the Executive Committee of the NCSL on January 27, 2001 deleted this provision, reserving it for further study.
59. This limitation would be applicable only for purposes of sales and use taxation.
60. The state must apply the lowest tax rate imposed in a zip code area if the area includes more than one tax rate in any level of taxing jurisdiction. The seller would obtain the nine digit zip code of the buyer, which would be matched to tax rates provided by the state. If a nine digit zip code designation is not available for a street address or if a seller is unable to determine the nine digit zip code designation of a purchaser after exercising due diligence to determine the designation, the seller may apply the rate for the five digit zip code area. There is a rebuttable presumption that a seller has exercised due diligence if it has attempted to determine the nine digit zip code designation by utilizing software approved by the member states.
61. The resolution adopted by the Executive Committee of the NCSL on January 27, 2001 deleted this provision, reserving it for further study.
62. See Cline and Neubig supra, n. 7.
63. This hierarchy of sourcing rules is based on James Eads, Harley Duncan, Walter Hellerstein, Andrea Ireland, Paull Mines, and Bruce Reid, National Tax Association Communications and Electronic Commerce Tax Project Report No. 1 Of the Drafting Committee, 13 State Tax Notes 1255 (November 17, 1997).
64. A holder of a direct pay permit is not required to deliver an MPU Exemption Form to the seller.
65. The resolution adopted by the Executive Committee of the NCSL on January 27, 2001 deleted the provision of uniform definitions, reserving it for further study.
66. To deal with a problem peculiar to Ohio, the draft specifies that a state may deviate from the uniform rules regarding taxation of foods, provided the tax treatment was specified in the state's constitution on the effective date of the Agreement.
67. Clothing shall include: Aprons, household and shop; Athletic supporters; Baby receiving blankets; Bathing suits and caps; Beach capes and coats; Belts and suspenders; Boots; Coats and jackets: Costumes; Diapers (children and adults - including disposables); Ear muffs; Footlets; Formal wear; Garters and garter belts; Girdles; Gloves and mittens for general use; Hats and caps; Hosiery; Insoles for shoes; Lab coats; Neckties; Overshoes; Pantyhose; Rainwear; Rubber pants; Sandals; Scarves; Shoes and shoe laces; Slippers; Sneakers; Socks and stockings; Steel toed shoes; Underwear; Uniforms, athletic and non-athletic; Wedding apparel.
68. Clothing shall not include: Belt buckles sold separately; Costume masks sold separately; Patches and emblems sold separately; Sewing equipment and supplies (knitting needles, patterns, pins, scissors, sewing machines, sewing needles, tape measures, thimbles); Sewing materials that become part of clothing (buttons, fabric, lace, thread, yarn, zippers).
69. Clothing accessories shall include: Briefcases; cosmetics; Hair notions, including barrettes, hair bows, hair nets, etc.; Handbags; Handkerchiefs; Jewelry; Sun glasses, non-prescription; Umbrellas; Wallets; Watches; Wigs and hair pieces.
70. Sport or recreational equipment shall include: Ballet and tap shoes; Cleated or spiked athletic shoes; Gloves (baseball, bowling, boxing, hockey, golf, etc.); Goggles; Hand and elbow guards; Life preservers and vests; Mouth guards; Roller and ice skates; Shin guards; Shoulder pads; Ski boots; Waders; Wetsuits and fins.
71. Protective equipment shall include: Breathing masks; Clean room apparel and equipment Ear and hearing protectors; Face shields; Finger guards; Hard hats; Helmets; Paint or dust respirators; Protective gloves; Safety glasses and goggles; Safety belts; Tool belts; Welders gloves and masks.
72. The resolution adopted by the Executive Committee of the NCSL on January 27, 2001 deleted this provision, reserving it for further study.
73. Sellers not involved in Model 1 would receive whatever sellers' discounts are provided by law; for Model 2 sellers base rate payments would be in addition to such discounts.
74. For Model 2 sellers this payment would be made for only 24 months.

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