July | August 2017

By Joseph D. Henchman
Sometimes sales tax is charged on online purchases and sometimes it isn’t. The reason is a long-standing restriction on state tax power, preventing states from imposing their tax system on individuals or businesses with no physical presence in the state. Retailers currently are only required to collect sales taxes in states where they have a physical presence of property or employees.
This limitation has come under pressure due to the growing size of Internet retail and the resultant disparity in tax treatment between goods purchased online and goods purchased at brick-and-mortar stores. Americans spent about $263 billion in Internet retail purchases in 2013, a growth of 15 percent over the year before and comprising about 6 percent of the $4.5 trillion in all retail sales. State and local sales tax collections on online purchases could total as much as $4 billion nationwide, if they could be collected. The Council of State Governments in May 2012 approved a resolution supporting legislation to allow states to tax online sales and has joined a coalition of organizations supporting such legislation.
A growing number of states are defying constitutional restrictions and ordering retailers to collect sales and use taxes, sparking extensive litigation and economic uncertainty. Another group of states has adopted the Streamlined Sales Tax Agreement, which held promise as a potential solution but has struggled to win over most states.
A more constructive approach has been action on the Marketplace Fairness Act, a proposed federal bill that would allow a state to require sales and use tax collection by out-of-state retailers if the state adopts specified simplifications for its sales tax system. In May 2013, the U.S. Senate voted 69 to 27 to approve the act, but the U.S. House of Representatives has yet to consider the bill. Virginia Rep. Bob Goodlatte, chairman of the House Judiciary Committee, is floating an alternative “hybrid origin-sourcing” approach, which would significantly transform the structure of sales taxes.
Marketplace Fairness Bill
While it is important to allow states room to set tax policies in line with their interests, it is also vital that states be prevented from adopting policies that would excessively harm the free-flow of interstate commerce in the national economy.
The Marketplace Fairness Act tries to strike that balance with four main goals:
For example, the Marketplace Fairness Act requires states to provide a uniform sales tax base, stopping the practice of many of the 9,952 sales tax jurisdictions from choosing categories of what will and won’t be taxed that are different from their home state. States must give 90 days notice on rate changes, must provide tax rate lookup software keyed to ZIP codes, and must provide combined collection forms and mechanisms.
States, eager to see the bill passed, have offered other concessions. A revised version sponsored by Rep. Jason Chaffetz of Utah is rumored to limit multistate audits of online sellers and require states to integrate sales tax collection software with intracompany payment processing systems.
Hybrid-Origin Sourcing
To avoid double taxation, sales tax requires a consistent, uniform rule about where sales occur, known as a sourcing rule. Unless states adhere to such a rule, a transaction involving a consumer in California, a warehouse in Texas, a website server in Nebraska, an incorporation in New Jersey, a corporate headquarters in New York and trucks crossing many states could conceivably be taxed multiple times as each state jockeys for its asserted share.
Every state with a sales tax uses destination-sourcing—the location of the sale is considered the location where the customer receives it—for interstate sales and all but two states also use destination-sourcing for intrastate sales. The Marketplace Fairness Act also uses a default destination-sourcing rule, although if there is no delivery location specified, the tax applied would be the customer’s billing address, and if that’s not known, the seller’s address.
Goodlatte’s hybrid-origin sourcing model departs from these norms and has a more complicated approach. Under this approach, the sale would always be sourced as the taxing jurisdiction of the seller. A voluntary interstate compact would be established to send the revenue to the taxing jurisdiction of the buyer. The tax would thus be collected and then redistributed.
For example, assume a Rhode Island consumer purchases an item on the Internet from a seller located in Washington state. Under the current destination-sourcing rule, the sale is sourced to Rhode Island, and the state’s 7 percent tax is due. Under the hybrid-origin system, the sale is sourced to Washington state and that state’s 6.5 percent tax, plus the local sales tax, averaging 2.38 percent, is due, but the money is remitted to Rhode Island—if Rhode Island joins the compact.
The hybrid-origin approach has a number of insurmountable problems, including the difficulty of defining origin and consequent tax arbitrage opportunities, the economic and structural difficulties of transforming the sales tax into a business tax, the unlikelihood of an interstate compact structure to achieve uniformity, taxation without representation for many consumers, the retention of economically unjustifiable tax distinctions for similar items purchased in the same state, and the lack of needed simplifications to the sales tax system.
Most problematically, it likely violates the Due Process Clause of the U.S. Constitution because it imposes state tax authority on taxpayers who lack the minimum contacts required for a state to assert personal jurisdiction. Hybrid-origin also may exceed Congress’s power under the Interstate Commerce Clause by overly coercing states to alter internal tax policies unrelated to interstate commerce.
What’s Next?
Keeping the sales tax up to date with the modern economy is important for the states and brick-and-mortar retailers, just as making multistate sales tax collection as seamless and simple as possible is important for Internet retailers and the national economy as a whole. The Marketplace Fairness approach—giving states limited additional authority to collect existing taxes, as long as the state adopts meaningful simplifications to its sales tax system—is a better solution than constructing a brand new sales tax system based on hybrid origin-sourcing.
Congress, however, ultimately will decide what happens. Marketplace Fairness Act proponents have demonstrated they have the votes in the Senate, and they probably have them in the House, too. Getting a vote to occur is another matter. Supporters have tried to attach the bill’s language to nearly every “must-pass” piece of legislation in recent memory, without success.
Joseph D. Henchman is vice president of Legal & State Projects at the Tax Foundation. Since 1937, the Tax Foundation’s research, analysis and experts have informed tax policy at the federal, state and local levels.