To Help Main Street, Close the Internet Sales Tax Loophole

In 1992, when the U.S. Supreme Court heard the landmark interstate sales tax dispute of Quill Inc. vs. North Dakota, complying with the nation's 6,277 sales tax jurisdictions would have posed a major headache and expense for catalog merchants selling nationwide.

Internet retailing didn't exist, so it's unlikely the justices foresaw business owners punching a Zip Code into software that automatically calculates sales taxes or consumers instantly comparing product prices among shopping sites. The Quill ruling said Congress' constitutional authority to regulate interstate commerce precludes states from taxing sales by companies that lack nexus (a legal term for a company's physical presence) in the state unless Congress authorizes it.

Since then, the retailing world has been transformed by accelerating online sales, but the nearly 20-year-old ruling still governs. Until Congress acts, we're stuck with online retailers enjoying a privilege that grossly distorts market competition. The 45 states with statewide sales taxes face three major problems. First, their storefront businesses investing in local facilities and employees are severely handicapped when their remote competitors are effectively subsidized by 5 percent to 10 percent. Second, states will see substantial declines in sales tax revenue unless this imbalance is addressed. Lastly, Internet retailers are using the tax exemption to evade tax obligations even in states where they have obvious nexus.

Hidden Subsidies

It's time we force online retailers to face free market competition. Storefront merchants can't compete effectively when the government essentially subsidizes online retailers. As co-founder of community development group American Independent Business Alliance, I work regularly with retailers who report customers using their shop as a showroom to check out merchandise in the store and disclosing their plans to purchase online—often identifying sales tax as a decisive factor. Kevin Langdon, owner of Crywolf, an independent Apple (AAPL) dealer in San Diego, says customers often ask him to match deals from online giants. While he frequently can match remote competitors' actual prices, "on major items like computers and tablets purchased with credit cards, the sales tax exceeds my profit margin," says Langdon. "We provide assistance that goes far beyond delivering the product, but we're losing sales to that nine-percent subsidy." Countless brick-and-mortar retailers have cited the tax handicap as a factor in killing their business—and its contributions to their local and state economy with it.

While both chains and independents are affected, the loss is especially harmful when local entrepreneurs close up shop. Studies by another community development group, Institute for Local Self Reliance, and economic planning consultancy Civic Economics have shown independents' sales typically generate at least three times more local economic benefit per dollar than sales at chain outlets. A 2009 University of Tennessee study estimates that $11.4 billion will go uncollected on Internet sales next year, but the resulting loss of local retailers may outweigh the direct tax revenue lost to states and municipalities. Given their budget struggles, it's no surprise five states recently passed laws to narrow the sales tax exemption by defining nexus to include in-state affiliates. At least 10 more states have such affiliate bills pending.

The Internet exemption indirectly creates other problems, like allowing online mega-retailers to use corporate chains' long-standing scheme of pitting communities and states against each other to extract public subsidies. (AMZN) just announced it will abandon a partially built distribution center in South Carolina, after the state legislature declined to add a multi-year sales tax exemption to the free land, property tax waivers, and other subsidies, as reported by The State newspaper. Amazon is pushing for a similar deal in Tennessee.

Amazon's Angle

South Carolinians should note Amazon already has nexus via its CreateSpace digital media subsidiary and force the company to collect tax on in-state sales anyway. While Amazon attorneys would argue CreateSpace is a separate company, the state's Supreme Court already rejected that argument in 1993 when Toys "R" Us tried avoiding state taxes via a shell company. The U.S. Supreme Court declined Toys "R" Us's appeal later that year.

Overall, Amazon collects sales tax in just five of 19 states in which Amazon has a physical presence (two have no statewide tax). Amazon spokesperson Todd Fogerty declined to answer my questions for this column, instead referring me to the company's Feb. 24 letter to the California Board of Equalization, in which Amazon calls the state's pending affiliate bills unconstitutional and notes: "If any of these new tax collection schemes were adopted, Amazon would be compelled to end its advertising relationships with well over 10,000 California-based [affiliates]." In other words, it would eliminate its commissions for thousands of California residents. That bullying tactic, however, has lost its power since several tax-collecting national retailers now offer equivalent deals. Amazon also declined to comment on its subsidiaries in six California cities.

Although most online merchants will remain immune, state bills closing the Amazon loophole do help level the playing field for many businesses and build momentum for needed national reform such as that proposed by Senators Dick Durbin (D-Ill.) and Mike Enzi (R-Wyo.), who plan to reintroduce the "Main Street Fairness Act" during the current session. Their bill would ratify the Streamlined Sales and Use Tax Agreement, a compact developed by a coalition of state government representatives to harmonize sales tax policies. The bill also would give states the authority to collect tax on interstate sales under these simplified rules.

Although calculating tax rates is now relatively simple, managing payments to numerous states would still burden small businesses, so nearly every state and national reform exempts merchants that do minimal interstate sales. A simple alternative would be to apply a universal tax rate of, say, 5 percent for all interstate retail sales and divide the revenue proportionally among states—a measure that should discourage increases in local and state tax rates. Any national solution will carry drawbacks, but as states and municipalities seek to fill budget shortfalls, only a national solution will preclude dozens more state battles.

Our status quo is both unjust to business and self-destructive for states. All retailers depend on airports, roads, courts, and other state-supported services to do business, so it makes no sense for out-of-state or transnational corporations to benefit from privileges that handicap companies investing in local jobs and facilities. State and local governments should curtail their reliance on inefficient and regressive sales taxes, but as long as sales taxes exist, we should ensure they are implemented fairly.