CAN THE SALES TAX SURVIVE CYBERSPACE?

THE EXPLOSION OF E-COMMERCE IS MAKING STATES VERY NERVOUS ABOUT THE FUTURE OF THEIR SALES TAXES.

It was a neighbor who first alerted Ohio Senate President Richard Finan that the Internet might pose a threat to the future of his state's sales tax. "A moving van pulled up to his house one day, so I asked if he was moving. He said, 'No, I just bought new furniture over the Internet--and I didn't have to pay any sales tax.'"

For years, the Supreme Court has prevented states from requiring out-of-state sellers to collect sales and use taxes legally due from buyers. But now, with many experts predicting that the Internet will revolutionize retailing, states are beginning to get very nervous about the viability of their sales taxes in the electronic commerce environment. Some experts are even questioning whether the sales tax is viable in a 21st century economy.

This is a high visibility issue not only in state capitals but in the nation's capital as well, and it has all the elements of high drama. The players are:

* A federal commission chaired by a governor who has questioned the viability of the state sales tax.

* Members of Congress who want to preempt state tax policy without regard for the impact on state finances.

* State legislators and governors who see electronic commerce as a powerful economic development tool, but who also understand that education and infrastructure (often funded by sales taxes) are key building blocks in high-technology growth.

* Consumers who see Internet buying as a way to "beat the system."

* CEOs who must balance the need for skilled workers with the desire for low taxes.

* A powerful telecommunications industry with the means to provide candidates with needed cash just as the 2000 election cycle is heating up.

What makes this such a daunting issue is that its ultimate resolution depends on so many interrelated factors: Will electronic commerce grow exponentially, as analysts are predicting? Will electronic commerce revolutionize marketing, distribution and retailing? What will the federal advisory commission studying this issue recommend to Congress? Will Congress act during a presidential election year? Where do the presidential candidates stand? Will governors and legislators pass legislation to reduce the administrative burdens imposed by the sales tax?

Ultimately, the states must live with the consequences of the decisions, many of which they have no control over. "This may be the most important issue that states have faced in a generation," says NCSL Executive Director William Pound. "How Congress and the states resolve it will influence the balance of power between the federal government and the states for decades to come."

AN OLD PROBLEM...

The origins of the current Internet tax debate can be traced back to another era of major economic change in the United States: the Depression. State and local governments, which relied primarily on property taxes, suddenly faced a collapse of property values across the country. Many states turned to sales taxes to replace the failing property tax. In 1930, Mississippi became the first state to levy a general sales tax. By the end of the decade, 23 other states had followed suit. Today, only Delaware, Montana, Oregon and New Hampshire lack a state or local general sales tax.

These "new" sales taxes were designed in an era when citizens bought goods at the local store. The local merchant could, without much trouble, collect a few pennies on the dollar and send the money to the state once a month. And because retailers were present in the state, there was no question that states had the authority to require them to collect taxes on their behalf.

Fast forward to the 1950s and 1960s. The improvement of our national highway system opened up many opportunities for multistate selling. Major national retail chains emerged; consumers became increasingly mobile and had the ability to shop across state lines.

To protect in-state retailers from competition from out-of-state vendors, states turned to "use" taxes. Use taxes require residents who purchase taxable goods in another state to pay the equivalent of a sales tax in their home state. The use tax preserves a key principle of the sales tax: that the tax is due in the state where the product is used or consumed, not necessarily where it is purchased.

States had a fundamental problem with the use tax, though. For many transactions, they could not collect the tax because they relied on out-of-state merchants--not the state tax department--to collect the money. These merchants balked at becoming tax collectors for hundreds of states and localities, arguing that other states had no jurisdiction over them.

State attempts to enforce this use tax--by requiring out-of-state firms to collect taxes from customers--led to the 1967 Supreme Court decision commonly known as Bellas Hess. In that case, the court ruled that states lack the authority to compel out-of-state firms to collect use taxes unless those firms have "nexus" in the state. Nexus was defined by physical presence--having an office or store, owning property or employing workers in a state.

The Court's decision was rooted in the Commerce Clause of the U.S. Constitution, which gives Congress jurisdiction over issues involving interstate commerce. The Court said that imposing a tax collection obligation on out-of-state sellers would impose an "undue burden" on interstate commerce. This burden stems from the incredible complexity of state and local sales and use taxes--complexity that persists to this day.

For decades, states tried to convince Congress to overturn the Bellas Hess decision, but with no success. Congress had little incentive since all the potential new revenue would flow to state and local governments. A prosperous and powerful mail-order industry made sure Congress knew that it would be blamed for a tax increase if members acted to overturn Bellas Hess.

States also tried to convince the Supreme Court to reverse its decision. But in the 1992 Quill decision, the Court reaffirmed the physical presence standard in Bellas Hess.

WITH NEW URGENCY

By the mid-1990s, mail-order retailing had become a mature, slow growth industry. A 1994 report by the federal Advisory Commission on Intergovernmental Relations estimated that states lost about $3.3 billion in uncollected use taxes in 1994 on about $58 billion in sales where no tax was collected. The report also pegged the growth in mail-order sales at about 5 percent per year.

Although states were concerned about the revenue loss from mail-order sales, $3.3 billion on a base of $120 billion in state sales taxes was a relatively small problem. And with mail-order sales growing at a slow, stable pace, there was little cause for alarm.

But the Internet has changed all that. Economists and market research firms have been continuously upgrading their projections of how quickly Internet sales will grow in the next five years. Economist Austan Goolsbee in May told members of the NCSL task force studying this issue that sales to consumers would top $8 billion in 1999--a fivefold increase from actual sales of $1.5 billion in 1998. At the time, Goolsbee's projections were at the high end of the forecasting range.

By October, firms using data for the first three quarters of 1999 projected that Internet sales would top $20 billion. The updated projections were based upon the rapid growth (and success) of "clicks and mortar" retailers--retailers like Gateway, Gap and others that have storefronts where consumers can test merchandise and then place orders on their Web sites right from the store.

What really ought to scare state policymakers are long-term projections of the growth of Internet sales. The midrange estimates predict sales of $150 billion by 2003. States paying the most attention are those that rely heavily on sales taxes because they do not have income taxes--Florida, Nevada, South Dakota, Tennessee, Texas, Washington and Wyoming.

Tennessee Representative Matthew Kisber, co-chair of the NCSL task force that is studying this issue, points to his home state as an example. "Our revenues are not keeping up with economic growth, so we face a budget shortfall while most other states enjoy surpluses. One reason is that the sales tax base just keeps shrinking. Electronic commerce will only make that problem worse.

But with states enjoying record surpluses right now, it is hard to convince policymakers that the sky is falling. In fact, an industry sponsored study, "The Sky is Not Falling," makes the case that there is very little state revenue loss from Internet commerce right now.

THE TANGLED WEB OF SALES AND USE TAXES

At the heart of this issue is the sales tax itself. Over the years, states have created a complex system that truly imposes an enormous burden on multistate sellers. Companies like Sears and JC Penney, which have nexus in most states, spend a lot of money to comply with it. Firms like L.L. Bean and Amazon.com go out of their way to avoid the burden.

Consider a small Vermont firm that decides it wants to sell maple syrup directly to customers through an Internet site. First of all, it must determine if the product is taxable in the purchaser's state. Twenty-eight states exempt food for home consumption from the sales tax. Missouri, North Carolina and Georgia exempt food from the state sales tax, but not local option taxes. Colorado lets cities decide whether or not to tax food--some do, some don't.

But wait--is maple syrup food? States define food differently. Depending upon the statute or administrative interpretation, maple syrup may be considered food in one state and not in another. Once the vendor determines that the maple syrup is taxable, it must determine the applicable state and local taxes based on the customer's address. Thirty-three states allow for local option taxes, so the vendor must either ask the customer what the rate is or use software to determine it.

What if the person ordering the syrup is buying it to use in the annual Boy Scouts fundraising breakfast? The Boy Scouts may qualify for an exemption from all sales taxes because it is a charitable organization. The out-of-state vendor must know whether or not to honor the exemption request based upon another state's laws.

And to top it all off, the vendor who collects the tax becomes subject to audits from each of the state revenue departments (and some local revenue departments, as well). If the vendor makes a mistake--for example, honoring an exemption request from a purchaser who is not entitled to one--it may be liable for payment of the uncollected tax.

This hypothetical example illustrates how burdensome complying with state and local sales and use taxes can be to out-of-state sellers. Every time legislatures pass an exemption, a new local sales tax for stadiums or transit, a one-week sales tax holiday or some other special provision, the burden on national retailers grows.

THE FAIRNESS ISSUES

There are two fairness issues wrapped up in this debate. The first is the disparity between the treatment of "Main Street" retailers and Internet sellers. In an era where retail margins can be very small, remote sellers can offer their products for 5 percent to 8 percent less than traditional merchants by not collecting the sales tax. Shipping costs may help minimize the price advantage somewhat, but for computers, electronics and other expensive items the tax savings overwhelm any shipping costs.

An important principle of good tax policy is competitive neutrality--that sellers of similar or identical products be treated the same under state tax laws. The disparity between traditional and remote sellers clearly violates this principle.

Not only sales taxes are at risk. Main Street merchants also pay property taxes and support local charities and civic organizations. If they cannot compete with remote sellers due to disparity in tax treatment, local communities suffer.

The second fairness issue concerns the administrative costs imposed on multistate sellers with nexus. Firms that decide to have storefronts--either traditional national chain stores or the emerging "clicks and mortar" model pioneered by Gateway computers--face a costly administrative compliance burden that their competitors without nexus can avoid. These administrative costs--keeping track of state sales and local sales tax law changes, filing forms, participating in audits and defending against legal actions from state revenue departments--come right off the bottom line.

SIMPLIFICATION

Can the sales tax be "saved" or is it structurally incompatible with the 21st century economy? That is the question that state and federal lawmakers, academics and business leaders are trying to come to grips with. There's no answer yet.

It is clear that if states are ever going to collect taxes from remote sales, they must minimize or eliminate the "undue burden" of collection by simplifying state and local sales taxes.

The dilemma for legislatures is that most simplification options require states to give up some measure of authority over their tax policies. For example, one option is for legislatures to adopt a single sales tax rate per state. Most local governments, although unhappy about the prospect, would probably go along with "one rate per state" if it applied only to remote sales.

But a single rate per state for remote sales means continuing the disparity between Main Street and remote sellers. Remote sales could be taxed at a lower rate in one location and at a higher rate in others. Higher rates for remote sales may run afoul of constitutional prohibitions against states interfering with interstate commerce. Also would companies that have both stores and Internet sales be subject to the "one rate" or the local option rate?

A single rate per state would overcome these problems only if it applied to all commerce. This means the end of all local option taxes as they exist today, a prospect likely to encounter stiff resistance from local governments. No more stadium taxes; no more local transportation or cultural facilities taxes; and no more local autonomy over a major source of local tax revenue in some states. Local governments would have to trust legislatures to make up for lost funds through revenue sharing programs.

Another likely requirement of a simplified system is that states adopt a common set of definitions of products and services subject to the sales and use tax. Right now, the same product may be defined differently depending upon the state. A common set of definitions would allow the development of a database that would tell retailers whether the product they are selling is taxable or exempt in each state.

States would also need to agree on standardized filing, treatment of exempt organizations, and simplified audit and record keeping procedures. Remote sellers are unlikely to agree to any system that subjects them to 50 different state audits.

A TECHNOLOGY SOLUTION?

In the last few months, another simplification option has emerged that would harness the power of technology and the Internet to simplify sales and use taxes. Called the "zero burden system" because it would remove the collection burden from retailers, this idea builds upon current technology that allows retailers to verify credit and debit card purchases in "real time."

The system would create a third-party financial clearinghouse that would maintain a national database of tax rates by jurisdiction and by which products are taxable in each state. When a transaction is processed, the company would supply retailers with the amount of tax to collect. Instead of the retailer collecting the tax and remitting it to the states, the tax would go directly to this third-party clearinghouse and then be remitted to the states.

Under this system, retailers would no longer be burdened with collecting the tax. Of course, states would have to pay for this service--much the same way that vendors pay VISA, American Express and other credit card companies through a small percentage of each transaction.

States would still need to take several steps to simplify their sales and use taxes. One of the biggest problems is the lack of uniformity in how they treat exemptions for nonprofits, charitable organizations, farmers, business purchases and others. A zero burden system would also require standardized exemptions and other steps to simplify the administrative side of sales taxes. But the major policy decisions--whether to tax certain goods and services and at what rate--would remain with the legislatures.

Will legislatures be willing to make such changes to their tax systems, especially at a time when states are boasting of record surpluses? Those segments of the e-commerce industry that are opposed to any taxes on Internet commerce are trying to convince Congress and state policymakers that any efforts to collect existing use taxes are tantamount to new taxes. At a time when states have been cutting taxes, no elected official wants the "tax and spend" label.

There may be ways to sell this issue to the public, however. The fairness to Main Street argument strikes a responsive chord with many citizens. It is also possible that a sales tax modernization effort could be coupled with a reduction in sales tax rates for all consumers. Although Internet shoppers would be forced to pay legally due taxes that previously went uncollected, all consumers would pay less on their Main Street purchases. This would help ensure that citizens at the wrong end of the "digital divide"--generally lower income citizens without computers and Internet access--would get a tax reduction.

THREE PATHS

There are three possible outcomes to this debate, at least in the short term: 1) Congress could make the Internet a "tax-free" zone and preempt state and local taxes, creating a major new tax loophole for firms that have both Internet sales and Main Street stores; 2) Congress and the states could maintain the status quo, with Main Street firms continuing to collect sales taxes, and remote sales escaping taxation; or 3) States could simplify the sales tax, perhaps leading to the collection of use taxes on remote sales.

The federal Advisory Commission on Electronic Commerce may play an important role in this debate. Members of the commission appear to be divided, with about a third favoring legislation to preempt state authority, a third favoring sales tax simplification in exchange for collection by out-of-state retailers and a third undecided.

The stakes for the states are enormous. Congressional legislation to codify the Quill decision--or go beyond it--could prevent states from ever resolving this issue on their own through cooperative efforts to simplify sales and use taxes. As University of Georgia at Athens Professor Walter Hellerstein recently commented, legislation to create tax- free Internet commerce, such as the bill proposed by U.S. Senator John McCain of Arizona, would "create a loophole through which not just the truck but the whole caravan could drive." Over time, the sales tax would become less and less important as a state revenue source--strengthening the hand of congressional advocates of a national consumption tax. States might lose the only revenue source fully under their control.

Even if Congress does not act to preempt state taxes, Quill remains the law of the land. State inaction on simplification would lead to the same result as federal preemption--a marginalized sales tax that continues to decline in importance as a state revenue source and imposes heavy administrative burdens on multistate firms with nexus.

The third option is for states to act. "We can no longer rely on a Depression-era sales tax system in a digital, 21st century economy," says Illinois Senator Steve Rauschenberger, co-chair of the NCSL task force. "And we can't expect Congress or the Supreme Court to bail us out of the mess we've created. Cooperative state action to simplify state and local sales taxes may be the only way to save them."

The strong economy may lead some state policymakers to question the need to act right away. But with Internet commerce growing exponentially, state inaction today may prevent states from ever coming to grips with the fundamental flaws in the current sales tax.

Scott Mackey is NCSL'S chief economist.

NCSL TASK FORCE DEVELOPS POLICY PRINCIPLES

NCSL's Task Force on State and Local Taxation of Telecommunications and Electronic Commerce is charged with the difficult duty of developing recommendations for NCSL policy on modernizing state and local sales and use taxes and how to tax telecommunications providers and services.

Established in November 1998 and headed by Co-Chairmen Tennessee Representative Matthew Kisber and Illinois Senator Steven Rauschenberger, the task force has already influenced NCSL policy. It developed seven principles that will guide lobbying efforts in Washington and with the federal Advisory Commission on Electronic Commerce. These principles were adopted unanimously by the delegates at the Indianapolis Annual Meeting in July. Next on the agenda: recommending state changes in sales and use taxes and telecommunications taxes to prepare tax systems for the 21st century.

These seven principles are:

1) State and local tax systems should treat transactions involving goods and services, including telecommunications and electronic commerce, in a competitively neutral manner.

2) A simplified sales and use tax system that treats all transactions in a competitively neutral manner will strengthen and preserve the sales and use tax as vital state and local revenue sources and preserve state fiscal sovereignty.

3) The Internet and Internet vendors should not receive preferential tax treatment at the expense of local "Main Street" merchants, nor should such vendors be burdened with special, discriminatory or multiple taxes.

4) States should recognize the need to undertake significant simplification of state and local sales and use taxes to reduce the administrative burden of collection.

5) Under such a simplified system, remote sellers, without regard to physical presence in the purchaser's state, should be required to collect sales and use taxes from the purchaser and remit such taxes to the purchaser's state.

6) NCSL should encourage current and future cooperative efforts by states to simplify the operation and administration of sales and use taxes.

7) NCSL will continue to oppose any federal action to preempt the sovereign and constitutional right of the states to determine their own tax policies in all areas, including telecommunications and electronic commerce.

STATES REPRESENTED ON FEDERAL BOARD

A state legislator and three governors serve on the federal Advisory Commission on Electronic Commerce, the group charged with advising Congress on whether and how to tax Internet transactions.

Among the 19 members are Delegate Paul Harris of Virginia, and Governors James Gilmore of Virginia (who serves as chair), Michael Leavitt of Utah and Gary Locke of Washington.

The commission, which includes representatives from the technology industry and government, must recommend a national Internet tax policy to Congress by April 2000. Other members are: Dean Andal, California Board of Equalization; Michael Armstrong, AT&T Joseph Guttentag, U.S. Treasury; Delna Jones, Washington County commissioner, Oregon; Ron Kirk, Dallas mayor; Gene Lebrun, National Conference of Commissioners of Uniform State Laws; Robert Novick, U.S. Department of Commerce; Grover Norquist, Americans for Tax Reform; Richard Parsons, Time Warner Inc.; Andrew Pincus, Department of Commerce; Robert Pittman, America Online; David Pottruck, Charles Schwab and Company; John Sidgmore, MCI Worldcom; Stan Sokul, Association for Interactive Media; and Theodore Waitt, Gateway Inc.