The Scope of State Taxing Authority

5 min readBy: Joseph Bishop-Henchman

When a consumer buys something online, in many cases that consumer is not charged sales taxA sales tax is levied on retail sales of goods and services and, ideally, should apply to all final consumption with few exemptions. Many governments exempt goods like groceries; base broadening, such as including groceries, could keep rates lower. A sales tax should exempt business-to-business transactions which, when taxed, cause tax pyramiding. by the online retailer. The U.S. Supreme Court has ruled that, to prevent disruptions to interstate commerce, a state may force only those businesses with a “substantial connection” with the state (“nexus”) to collect its sales taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. . Otherwise, the Court held in its 1992 case Quill Corp. v. North Dakota, businesses would face an enormous burden of complying with over 8,000 separate sales tax jurisdictions, with ever-changing bases and rates. Thus, only businesses with employees or property in a state usually collect a state’s sales tax, even if the employees or offices are not directly involved in soliciting sales in the state.

The Quill decision expands on another important state tax case, Complete Auto Transit, in which the Supreme Court articulated a four-part test to determine if a state tax violates the Commerce Clause. (Prior to Complete Auto Transit, state taxation of interstate commerce was unconstitutional.) The Complete Auto Transit test requires (1) Nexus, a sufficient connection between the taxpayer and the state to warrant imposition of state taxes, (2) Fair ApportionmentApportionment is the determination of the percentage of a business’ profits subject to a given jurisdiction’s corporate income or other business taxes. U.S. states apportion business profits based on some combination of the percentage of company property, payroll, and sales located within their borders. , such that the state does not tax more than its fair share of the taxpayers’ income, (3) No Discrimination, in that the state cannot unduly burden out-of-state taxpayers in a similar line of commerce as local taxpayers or favor local taxpayers to out-of-state taxpayers’ detriment, and (4) Relatedness to Services, so that taxes are fairly related to services provided to the taxpayer by the state.

Simply put, the Supreme Court’s current position is that Commerce Clause requires a substantial level of contact between the state and the thing or person to be taxed.

Compliance Issues with Sales Taxes

These decisions have been premised both on the geographic limit of state powers and on the difficulty of complying with thousands of ever-changing state sales tax bases, rates, and exemptions, which are, contrary to popular belief, not aligned with 9-digit or even 5-digit zip codes. Getting sales taxes wrong can be costly: undercollecting risks serious tax penalties and fines, while overcollecting risks class action lawsuits from customers.

Simple and uniform taxes can create economic certainty, fostering investment by businesses and individuals. However, tax rates and exemptions vary widely among states and within states. The Streamlined Sales Tax Project (SSTP) is a recent effort to simplify and harmonize state sales taxes in the hope that Congress or the Supreme Court will permit states to impose use tax collection obligations on out-of-state companies.

While the SSTP has made notable progress on adopting uniform sales tax definitions and procedures, meaningful efforts to simplify sales taxes (such as by reducing the number of sales taxing jurisdictions or aligning them with zip codes) have been actively avoided in the hopes of attracting more members. States who have joined the SSTP can continue to tax types of clothing differently, to tax types of food differently, to add special taxes to various products and services, and so forth. Even the SSTP website’s compendium of state sales taxes has no web calculator for 10 states, and it includes the unhelpful disclaimer that the table “only reflects the general state sales tax rate. Some states have reduced rates on food and drugs. Please view their web sites to obtain the correct state rate for these products and other pertinent laws.”

Similarly, in recent years several new online software programs have appeared to help retailers with sales tax calculation and compliance. Like any other tax calculation service, these can be costly and prone to error in the details as they try to keep up with constantly changing rates and exemptions. Rather than fix underlying problems with state sales taxes, SSTP has instead immunized users of those services it certifies from compliance actions, preserving underlying complexity. It also tries to cement an inequity: local “brick and mortar” retailers need only collect one sales tax based on where they are, while online businesses must collect sales tax from thousands of jurisdictions, based on where their customers are.

Frustrated by revenue demands and the slow pace of progress at the SSTP, a few states have turned to more aggressive actions, like new expansions of nexus, “Amazon” taxes, or draconian disclosure requirements. A drop in state revenues has contributed to this pressure.

Cigarette Excise TaxAn excise tax is a tax imposed on a specific good or activity. Excise taxes are commonly levied on cigarettes, alcoholic beverages, soda, gasoline, insurance premiums, amusement activities, and betting, and typically make up a relatively small and volatile portion of state and local and, to a lesser extent, federal tax collections. Compliance

Cigarette retailers can be prone to confusing and costly compliance procedures. For example, Arkansas recently decided to control cross-border shopping for low-tax cigarettes with a border zone cigarette tax, which authorizes a state-wide cigarette tax rate but enforces a lower, variable rate for certain towns and even certain stores located near the state’s borders. Under this law, if an Arkansas consumer buys cigarettes across the border in Louisiana, Arkansas will collect a tax at Louisiana’s rate plus 3 cents if the resulting rate is lower than Arkansas’s standard rate for that area.

If Arkansas’s variable cigarette tax rate structure proves successful at limiting cigarette tax evasion, and it likely will be, I predict other states may follow suit. Thus, the future likely means more cigarette tax jurisdictions with disparate rates.

Conclusion

The physical presence rule of state taxation should not be compromised by federal or state laws that permit states to overreach and tax businesses without any substantial nexus. Destination/customer-based sales taxes risk multiple taxation and burdensome compliance costs that contribute to substantially diminished market shares, and adopting an ambiguous “economic nexus” standard would introduce substantial uncertainty for taxpayers, unsettle expectations, endanger economic investments, and distort business decisions.

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