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Taxation of E-Commerce


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This the final draft of a research paper I completed my senior year of college for my Public Economics class.

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Taxation of E-Commerce

  1. 1. 1 Dominic Baldin Professor Aura Econ 4315 Paper 2 Final Draft April 27, 2010 Taxation of E-Commerce Rapid growth of online commerce has sparked a major debate regarding taxation of purchases made on the Internet. As of today, items sold over the Internet are not subject to state sales tax unless the seller has a physical nexus in the state where the purchaser resides. A physical nexus refers to the seller having a physical presence in a state, such as a store or a sales force. Existing sales tax law treats goods sold over the Internet exactly the same way it treats goods sold from catalog companies. States have realized the large amounts of tax revenue lost, and as a result have made the purchaser responsible for bearing this “use tax.” Due to current Constitutional Amendments and clauses, states must rely on self-reporting and payment by the customers. In turn, enforcement is almost nonexistent, with the exception of special cases such as high-priced goods like automobiles that must be registered. The Supreme Court has presided over cases similar to this and ruled in favor of the sellers. The decisions were based on the Commerce Clause in the Constitution, which clearly states that only Congress can impede interstate commerce. As a result, states have banded together to form the Streamlined Sales Tax Project in order to reduce the administrative burden on businesses. In doing so, the states hope Congress will require remote sellers to collect and remit the tax to the states. The United States Constitution contains two clauses that are significant to the issue of interstate commerce; these clauses are the Due Process Clause and the Commerce Clause
  2. 2. 2 (Sparks, 2). The Due Process Clause can be found in the Fifth and Fourteenth Amendments, which state that “persons shall not be deprived of life, liberty, or property, without due process of law (2).” While the Fifth Amendment restricts the federal government, the Fourteenth Amendment restricts the states (2). The Commerce Clause can be found in Article 1, Section 8 Clause 3 of the Constitution (2). This clause allows Congress to regulate interstate commerce. Therefore, Congress is allowed to regulate commerce so that goods can flow freely between states. While the Tenth Amendment does give the states the right to regulate domestic commerce, states are not permitted to exercise that power in a way that places a burden on or interferes with interstate commerce (2). The Supreme Court has used these clauses to issue rulings in two separate but similar cases. As a result, these two decisions would be applied to any cross-jurisdictional sellers, which include most Internet sales (3). The Supreme Court has ruled in favor of the remote sellers (catalog sellers with no physical presence in the state filing suit) and ruled that they could not be compelled to collect the use tax (Cornia, 1). For instance, in the National Bellas Hess, Inc. v. Illinois Department of Revenues case of 1965, the Supreme Court concluded that unless a firm has a physical presence in a state (nexus), violation of the due process protection and the Commerce Clause would result by forcing the firm to collect the use tax (1). In a more recent case, the 1992 court battle of the Quill Corporation v. North Dakota, the Supreme Court affirmed the nexus portion of the case, but also concluded that due process would not be violated if compliance requirements were imposed (1). Ultimately the decisions favored the remote sellers, and therefore can be used as a precedence to determine how the Supreme Court would rule on an Internet sales case.
  3. 3. 3 Congress has taken some action in the past to address this issue. On October 1, 1998, Congress passed the Internet Tax Freedom Act (ITFA) (Sparks, 5). The Act states, “no State or political subdivision thereof shall impose any of the following taxes during the period beginning October 1, 1998, and ending 3 years after the enactment of this Act—(1) taxes on Internet access, unless such tax was generally imposed and actually enforced prior to October 1, 1998; and (2) multiple or discriminatory taxes on e-commerce (Sparks, 6).” Effectively, this means that Internet providers are not allowed to charge a tax on access, and states are not permitted to require firms without physical nexus to collect use tax on e-commerce sales (6). The original Act also established the Advisory Commission on Electronic Commerce. The commission’s main purpose was to study federal, state, local, and international taxation and tariff treatment of transactions regarding the use of the Internet and Internet access (6). In April 2000, the commission came to the conclusion that states need to simplify the state and local sales tax system (6). This recommendation has given birth to a new strategy that many states are undertaking in order to try and persuade Congress to require remote sellers to collect taxes. In general, Congress has done very little regarding the taxation of Internet sales. Currently, the U.S. Supreme Court decisions remain the highest authority on Internet sales taxation (6). The moratorium expired in November 2003; still there is no guarantee that Congress will amend the Commerce Clause. The “use tax,” which is a close relative to the sales tax, is imposed on a good or service that is consumed within the state when the full sales tax on the item has not been collected (Cornia, 1). The major difference between the two taxes lies in who is responsible for collecting the tax. Although states can require in-state vendors to collect sales tax, they are not able to enforce compliance and collection requirements on out-of-state
  4. 4. 4 vendors (1). Therefore, the use tax is designed to be collected directly from consumers (1). This is where the problem lies in that it has been extremely difficult to collect due to the fact that most consumers really have no idea they owe the use tax (1). As a result, states have taken up an initiative to try and persuade Congress to require all sellers to collect taxes. Several states have banded together to form the Streamlined Sales Tax Project, or SSTP, in order to simplify their sales and use tax systems (1). In doing so, this would reduce the burden of collection for all sellers and create a collection system for out-of-state (remote) vendors (1). The states are engaged in these efforts in the hopes that a simplified tax system will result in remote vendors voluntarily collecting the sales tax (1). Currently, as of April 2004, 42 states along with the District of Columbia have joined in the effort to establish this project (Sparks, 6). There is one looming problem, and that is that states will still have to pass legislation in order to make actual changes to their sales and use tax systems (Cornia, 2). The fate of this project basically boils down to whether states will be willing to make these changes (2). The Streamlined Sales Tax Project has seven main goals: uniform tax definition within tax laws, rate simplification, state tax administration of all state and local taxes, uniform sourcing rules, simplified exemption administration for entity-based exemptions, uniform audit procedures, and state funding of the system (Sparks, 7). All seven will be discussed in brief. Upon joining the SSTP, each state will have to change its sales tax laws and definitions to match those of the SSTP (7). By changing the definition of products, this will ultimately affect state revenues, where states may receive more revenues by changing exempt items into taxable items (7). Of course the opposite could be true for others (7). The next goal is rate simplification. As of today, each state has one rate and each county and city have their own
  5. 5. 5 sales tax rate (7). But according to the SSTP, each state will be allowed one state tax rate and possibly a second rate in certain circumstances (7). This will make it easier for companies to file sales tax returns by reducing the number of rates as well as reduce the current 7,600 jurisdictions (7). The third goal of the project is state tax administration of all state and local taxes. This means that the states will be responsible for the administration of all state and local taxes, and will distribute local taxes to local governments (8). The next goal of the SSTP is to achieve uniform rules regarding how they will source transactions to state and local governments (8). These rules will be uniform for services, digital property, and tangible personal property (8). The rules will be destination/delivery based instead of sales based (8). The fifth goal is aimed at simplified exemption administration for use and entity-based exemptions. This deals with schools and other entities that are exempt from sales and use tax (8). These organizations must obtain an exemption from the state, and sellers will not be liable for uncollected taxes from these transactions (8). But if taxes are discovered later to be required, then the liability would now fall on the purchaser who must pay all the tax, interest, and penalties for claiming incorrect exemptions (8). The SSTP’s sixth goal is to obtain uniform audit procedures for sellers who participate in one of three certified technology models (8). By using one of the three models, the seller would be subject to less stringent sales and use tax audits (8). The final goal of the SSTP is to require states to aid in the funding of the three technology models. This would call for monetary allowances to be given for each model, and these allowances would come from tax collected by the three models and paid back to the seller from the states for a limited amount of time (8). Again, this would reduce the financial
  6. 6. 6 burdens on sellers. But just as anything in politics, it will be extremely difficult to convince all or even a few states to conform to all of these requirements. As more and more Americans begin to rely on the Internet for many of their shopping needs, this only adds fuel to the debate that has been taking place in Congress for decades now. Enacting legislation that would allow taxation on Internet sales will not only be very difficult, it would also remove one of the main attractions of a rapidly growing form of commerce. Even as states attempt to simplify their current sales and use tax systems, the United States is still a long ways away from establishing a sound system to capture tax revenues from Internet sales. Any legislation that is pushed through must be approved by Congress, who is not adamantly trying to amend Constitutional clauses to allow taxation on Internet sales. As a result, there does not seemto be any reason to think that Internet sales will be taxed or that laws enabling taxation will be enacted in the near future.
  7. 7. 7 Works Cited Cornia, Gary C., David L. Sjoquist, and Lawrence C. Walters. “Sales and Use Tax Simplification and Voluntary Compliance.” Public Budgeting and Finance 24.1 (2004): 1-31. EconLit, EBSCO. Web. 12 Apr. 2010. Goolsbee, Austan, and Jonathan Zittrain. “Evaluating the Costs and Benefits of Taxing Internet Commerce.” National Tax Journal 52.3 (1999): 413-428. EconLit. EBSCO. Web. 12 Apr. 2010. Sparks, C. Ryan, Melanie G. McCoskey, and John M. Alvis. “Can Internet Sales Be Taxed?.” Public Finance and Management 4.2 (2004): 109-137. EconLit. EBSCO. Web. 12 Apr. 2010.