U.S. News & World Report: States Shouldn't Collect Online Sales Tax

December 10, 2012

The debate about whether states should be able to tax out-of-state sellers is not new: It actually dates back to our country's founding. After independence, in the 1780s, states engaged in a trade war with each other. Coastal states imposed hefty taxes on goods going to interior states, and vice versa. This rivalry threatened to strangle the economy, so leaders called the Constitutional Convention.

The document they produced—the U.S. Constitution we still use today—stopped this trade war and ushered in decades of prosperity. It did so by giving the federal government the power to stop any state government that reaches beyond its borders to harm interstate commerce. For a century and a half, the rule was a simple one: States cannot tax interstate commerce. At all.

That complete ban gave way in the 1950s, as states complained that in-state businesses engaged in interstate commerce still used services like schools and police. The Supreme Court thus allowed states to start taxing businesses engaged in interstate commerce, on the condition that the business has to have a physical presence in the state.

It's a sensible rule. State services are based on physical presence and geographic lines, so state taxes ought to be as well. It's the same rule states have to follow with taxing income. They only can tax someone if he or she is actually in the state.

States are not happy with this physical presence limitation since it prevents them from imposing most taxes on non-residents (non-voters). That's the real motivation. I notice that legislators who complain about lost Internet sales tax revenue never mention that their state fails to tax sales of services by politically powerful residents like lawyers, accountants, and real estate agents, even though they involve hundreds of times more "lost revenue."

Proponents have one strong argument: It's not fair that a brick-and-mortar business has to collect sales tax on an item, while its online competitor does not. They're right. But their solution is equally unfair. The brick-and-mortar business would continue to collect one sales tax, but the online business would have to collect most or all of the 9,600 sales taxes in the United States.

Many of these local taxes have their own definitions, unique rules about what is taxed and what is exempt, their own tax filing system, their own audit rules, and varying interpretations of vague rules. Proponents like to woo state legislators with visions of all the money they'll collect from out-of-state businesses. But the same bill would force their in-state businesses that sell online to comply with thousands of sales tax rules.

Congress does need to act, since the states have no incentive to solve this problem. But before Congress gives to the states the power to literally tax any transaction anywhere, it should insist on meaningful sales tax simplification. This should include standardized definitions, rates that align with ZIP codes, no more vague interpretations of what is taxed, one tax form per state, unified audits, and immunity if the state provides wrong information. The current bills in Congress don't do these things.

Our economy has indeed changed, and technological progress is amazing. But the best computer can't make up for archaic state tax systems, just as computers haven't reduced to zero the cost of complying with the federal income tax. No matter how much technology advances, the principle that states should have limited powers should remain timeless.

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