Treasure Hunt

Budget trouble sparks renewed interest among states in taxing sales made via the Internet.

by / May 21, 2003
With their coffers running dry, state governments are eyeing billions of dollars in potential tax revenue on Internet sales. Laying aside traditional concerns over sovereignty and other issues, a growing number of states are joining an initiative to create uniform tax laws and codes, paving the way for collection of sales taxes on Internet purchases.

As of April 2003, seven states joined the Streamlined Sales Tax Project (SSTP) and adopted legislation to simplify the sales tax system. This was done by creating uniform definitions for taxable items from orange juice to clothing. In the past, orange juice was defined as a beverage in one state and a fruit in another state.

Studies estimate governments forfeit anywhere from $3.2 billion to $45 billion by not collecting sales taxes on various forms of e-commerce. Widespread state revenue shortfalls have rekindled the policy debate over whether states should have the power to require companies to collect taxes on remote sales made via the Internet.

Although SSTP is gaining momentum, states face a challenge in gaining congressional approval for their efforts. Congress, through the Interstate Commerce Clause of the U.S. Constitution, has the power to regulate interstate commerce, and it is up to federal lawmakers to ultimately pass legislation that compels retailers to collect and remit sales tax on remote purchases to states.

SSTP members hope to convince congress that it is possible to get states to agree to uniform definitions of taxable goods, and that retailers are not opposed to the idea of collecting sales taxes. The SSTP has set its first benchmark: enlisting 10 states that have a cumulative population amounting to 20 percent of the population of all states that collect sales taxes. Hitting that benchmark would prove to Congress that the states are serious.

When and if the SSTP hits this benchmark, member states plan to ask major online retailers in those 10 states to voluntarily collect and remit sales taxes on sales made to residents of those states. SSTP proponents hope this will convince Congress that collecting the taxes is not a burden on retailers and that retailers are willing to shoulder the responsibility.

If Congress refuses to support the plan, it is conceivable that a member state could serve as a guinea pig by requiring retailers to begin collecting and remitting the sales taxes. This could set in motion a lawsuit, which could force the Supreme Court to rule on the constitutionality of the state's requirement.

The Power to Tax
The number of states joining the SSTP is growing steadily. SSTP advocates hope to hit the 10-state benchmark this year, and ask Congress for the power to force remote vendors to collect sales taxes on member states' behalf.

But the remote sales tax issue has vexed state and local governments for decades. Before consumers used the Internet to buy goods, they shopped from mail order catalogs. States have long sought the power to require companies selling goods via mail order to collect taxes on those sales and remit those taxes to states.

Two key U.S. Supreme Court rulings -- National Bellas Hess, Inc. vs. Department of Revenue of the State of Illinois (1967) and Quill Corp. vs. North Dakota (1992) -- denied states that power.

As the Internet rapidly penetrated American consumers' homes, electronic commerce became the new mail order business, and states watched more buying occur in an environment beyond the long arm of their tax laws. Besides e-commerce, growing use of the Internet created other sticky challenges to tax laws.

Should online services, such as the electronic purchase of downloadable software or digital entertainment, be subjected to sales taxes? If a business Web site is hosted on a server located in a particular state, does that state have tax jurisdiction over that business?

In 1998, Congress enacted the Internet Tax Freedom Act to address some of these new problems, including moves by some state and local governments to impose "access taxes" on the Internet service fees that ISPs charged their customers.

The ITFA put a three-year moratorium on states and political subdivisions of states imposing taxes on Internet access (unless such a tax was already imposed and enforced before Oct. 1, 1998) and "multiple or discriminatory taxes on electronic commerce." That moratorium was extended by two years to 2003, setting the stage for another fight on Capitol Hill over Internet taxation.

Congress heard testimony on the matter in April -- the House Judiciary Subcommittee on Commercial and Administrative Law convened April 1 to consider H.R. 49, which would make permanent the existing ban on Internet access taxes as well as new, multiple and discriminatory taxes on e-commerce.

Though the SSTP itself and the power that member states seek is not part of the battle over the extension of the ITFA, observers say debate on the two issues in Congress will likely happen simultaneously because the two issues have become at least loosely linked in lawmakers' minds. The sentiment is that as long as lawmakers are discussing the merits of taxing certain aspects of the Internet, such as Internet access, they might as well consider the merits of the SSTP.

Pot of Gold?
At the heart of the SSTP is the pot of gold government sees at the end of the e-commerce rainbow.

Currently state and local governments can't force remote vendors to collect taxes on sales made to residents of a particular jurisdiction. This is because of the burden placed on remote vendors by widely differing tax laws in states and municipalities, and because those vendors don't have a physical presence in that particular jurisdiction.

The SSTP removes much of that burden, according to proponents, by creating a uniform set of sales tax laws.

Once that hurdle is removed, however, there's a debate over how much potential tax revenue is available. Some research puts the figure quite high; other research produces a low figure.

On the high end is a much-publicized study released in 2000 by University of Tennessee (UT) professors William F. Fox and Donald Bruce. The study, performed for UT's Center for Business and Economic Research, estimated that uncollected sales taxes from e-commerce would reach $45 billion by 2006.

Another study, released in March 2003, puts uncollected revenue at just $3.2 billion by 2006. That research comes from the Direct Marketing Association (DMA), a trade organization representing businesses involved in direct, database and interactive global marketing.

According to the DMA, the difference in the two studies stems from UT projections of Internet growth rates -- 38 percent annually -- that turned out to be too high, and the fact that UT's estimate includes business-to-business purchases made through electronic data interchange (EDI) and other proprietary networks.

Fox, director of the UT's Center for Business and Economic Research, defended the UT study. Fox said the study he and Bruce authored defines two types of tax losses -- the estimated total sales tax revenue loss and the estimated new sales tax revenue loss.

In a 2001 update to their original study, the professors define total e-commerce loss as "the sales tax loss on all sales over the Internet," and new e-commerce loss as coming "from sales made through the Internet both on goods that would have otherwise been purchased over the counter and projected new goods that will be purchased over the Internet."

Fox said part of the discrepancy between the DMA and UT findings stems from the DMA not comparing apples to apples. "They're describing their number as an 'additional loss' number [or new e-commerce loss number], but they're comparing it with our total loss number," he said. "That explains some of the difference between their number and our number, although it's still a big difference."

Fox also described issues such as whether to include EDI transactions in the definition of e-commerce as a red herring.

"We didn't define e-commerce. We let Forrester do that," Fox said. "Forrester are the e-commerce people, and we're the tax people ... Nonetheless, whether it's mail order or e-commerce or EDI -- if it's a remote transaction on which the sales tax is not getting captured, then lost revenue is lost revenue. If you use a different set of definitions, it doesn't necessarily change the revenue loss, it just changes a little bit what you say is the cause of that revenue loss."

Recent numbers from the U.S. Department of Commerce show that e-commerce is growing. U.S. retail e-commerce sales reached $34 billion in 2001 -- an increase of 22 percent over revised 2000 e-sales of $28 billion -- according to the Commerce Department's March 19, 2003, edition of E-Stats.

Still retail e-commerce sales accounted for only 1.1 percent of total retail sales in 2001 -- up from 0.9 percent in 2000, according to the Commerce Department -- though its research offers a preliminary estimate of total e-sales for 2002 of $46 billion, accounting for 1.4 percent of total retail sales for 2002.

States Steaming Ahead
States must go through a two-step process to comply with the tax simplification measures proposed by the SSTP. First, a state passes a law that essentially says the state wants to join the SSTP and will participate in interstate discussions to develop a simplified sales and use tax system.

Once the state becomes a participating or "implementing" state, the state's legislature must begin making the necessary tax law changes to conform to the SSTP model legislation. When those changes are made, the state can say it has simplified its sales tax system to match other states, and should be allowed to require remote vendors to collect sales taxes on remote sales and remit them to the state.

Organizers of the SSTP are pleased with the measure's progress, said Scott Peterson, co-chair of the SSTP and director of the South Dakota Department of Revenue's Business Tax Division.

"We were never really sure how successful we would be," he said. "Everything is going according to what we optimistically thought would be a best-case situation. We have a bunch of states introducing legislation, and it seems to be going along quite well everywhere it's introduced."

Though the SSTP has made significant progress, simply reaching the benchmark doesn't automatically start new tax revenues flowing, Peterson said. Collection of sales tax on remote sales by remote sellers remains voluntary until either Congress or the U.S. Supreme Court makes the collection mandatory.

"We hope that what we develop will provide enough simplicity and that with all the states supporting this project, Congress will agree that it is the right thing to support," Peterson said, adding that he's not sure the SSTP will hit its participation target by the end of this year.

In some states, such as South Dakota, the legislation has been passed but won't go into effect until Jan. 1, 2004. In other states the legislation won't take effect until July 2004.

Politics of the SSTP
Over the last few years, the SSTP successfully brought diverse factions of government to the same table to dissect the details of a common goal. Although everyone agreed the goal was worth attaining, those dissections still were uncomfortable.

Participants said one problem was that early on, much of the work done by the SSTP occurred behind closed doors, which generated apprehension among those who were left out of the process. One bone of contention was uniform definitions of taxable goods that came from the SSTP's early work -- work that was primarily done by state tax administrators representing the executive branch of state government.

Those definitions received much attention at a December 2000 meeting of the National Conference of State Legislatures (NCSL) Executive Committee Task Force on State and Local Taxation of Telecommunications and Electronic Commerce. The private sector voiced concerns to the NCSL that the process was moving too fast and wasn't giving industry the opportunity to articulate its point of view.

In January 2001, NCSL legislators and national officers asked SSTP leadership not vote on uniform definitions until private-sector concerns were addressed. That request was declined.

The NCSL request was based on the notion that private-sector buy in would be key to the SSTP's success, said Neal Osten, NCSL's director of telecommunications and interstate commerce.

"The members of the NCSL Task Force knew that if the agreement was to be adopted in the states, private-sector support would be essential," Osten said.

"It was decided that since the NCSL Task Force drafted the model legislation creating the Streamlined Sales Tax Project in the first place, we could add an additional step that called for a second round of model legislation that would allow for enlarged state delegations, including elected policy-makers and the private sector, to finalize a Streamlined Sales and Use Tax Agreement."

That second round of legislation created the Streamlined Sales Tax Implementing States (SSTIS), which was a forum for a wider range of perspectives on the various committees and subcommittees that cast votes at meetings to define policy and debate uniform definitions for taxable items. States that didn't adopt this legislation were classified as "observer" states -- they can watch what's happening but can't cast any votes.

"Politically, [the SSTIS] was a wonderful opportunity to include more people," Peterson said. "I can't tell you right off hand how many legislators are involved from implementing states, but it certainly added validity to this process and created a whole bunch of new converts to the value of this project."

The SSTIS mechanism also helped relieve tension between tax administrators and state legislators.

"Both [groups] wanted a simplified system, however, differences occurred over what was politically feasible in state legislatures," Osten said. "After the implementing states ratified the agreement last November, most tax administrators agreed that the participation of the elected policy-makers, legislators and private-sector representatives in the second round added a certain legitimacy to the agreement that did not exist previously."

In some states, the SSTP faces an additional hurdle: resistance from local governments. In jurisdictions known as "home rule states," local governments can create and administer their own local sales tax systems separate from the state. This is the case in Alabama, Alaska, Arizona, Colorado and Louisiana -- where state constitutions provide sales tax authority to local jurisdictions.

If these five states want to join the SSTP, they must amend their state constitutions -- a potentially cumbersome process.

In Colorado, for instance, an amendment to the state constitution must be approved by a two-thirds vote in each house of the Legislature. Then at the next general election for members of the general assembly, the amendment must be submitted to the state's registered voters, who have the ultimate power to approve or reject the amendment.

Technical details aside, a bigger problem for local governments is giving up the ability to collect their own taxes, said Susann Stubbs, director of tax compliance in the Treasury Division for the city/county of Denver.

"Over the years, we have relied more and more on sales and use taxes rather than property taxes for the local budgets," Stubbs said. "Many municipalities in Colorado have 60 percent or higher of their general fund budget coming from sales and use tax. The tax bases are very different between the state and the cities because frankly the lobbyists only have to go one place to lobby the state."

Colorado has granted approximately 100 exemptions to the state sales tax over the last 20 years, she said, while home rule cities are much more protective of their revenue. Stubbs said it's highly unlikely Colorado will join the SSTP.

"More and more cities are becoming home rule and deciding to collect their own tax because we have demonstrated repeatedly that we get more income when we self-administer," she said. "Denver is very aggressive in its pursuit of sales tax. We have almost as many auditors for the city as the state does for the entire state."

Battle on the Hill?
Though the SSTP won its share of fights in advancing this far, it's not clear what will happen during the current legislative session in Washington, D.C. The SSTP certainly has supporters and opponents on Capitol Hill, observers say, but a GOP-controlled House and Senate may hurt the SSTP's chances of securing the blessing of federal lawmakers, given the generally anti-tax attitude of the Republican Party.

"The jury is still out in Congress," said Lee Goodman, an attorney with the Washington, D.C.-based law firm Wiley Rein & Fielding, who works in the firm's government affairs, Internet and e-commerce, and election law practice areas. "Congress understands the issues. Congress is sensitive to state budget problems but is also mindful that states increased spending almost 100 percent over a fairly short period of time in the late 1990s."

Goodman served as chief of staff to the Congressional Advisory Commission on Electronic Commerce from 1999 to 2000.

At the April hearing on H.R. 49 (the permanent extension of the provisions of 1998's ITFA), the measure's author, U.S. Rep. Chris Cox, said Congress would not tie the extension of the ITFA and the SSTP together, according to NCSL's Osten.

"Congressman Cox made it clear during the hearing that the SSTP is a stand-alone issue," Osten said. "He said the states have made some real progress, and they deserve to be heard on their own issue."

SSTP supporters won't be orchestrating a lobbying blitz in Washington this spring, though, because they are waiting for state legislatures to wrap up their sessions.

"There are 23 states now, including those seven that enacted the legislation already, that are considering SSTP legislation or have passed the legislation in one or two state houses," Osten said. "We're confident that by the end of most states' legislative sessions, we will have over 10 to 12 states that have enacted the legislation. We will be very close to triggering the agreement as a voluntary instrument, and we'll have a better track record to go to Congress with our friends in the private sector."

"My guess is that Congress may want another year to look at the SSTP," said Goodman. "This is the first year that the SSTP has been taken to state legislatures for substantive adoption. Congress is going to want to see how many states have really moved to uniformity. Congress will want some assurances that uniformity isn't partial uniformity, that it's absolute uniformity, because without absolute uniformity, you're right back to the pre-SSTP morass."
Shane Peterson Associate Editor