Why there is no sales tax on out-of-state Internet purchases

The New York Times recently installed Mrr Prof. Paul Krugman as its resident economic guru. In his area of specialization, international economics, he has many informative things to say. But in other areas, he is sometimes prone to put his foot in his mouth rather than offer insightful ,commentary. A recent case of this involves Internet taxation.

On February 13, Krugman went on a tirade against Sen. John McCain's proposal to permanently ban new taxes on the Internet. Krugman excoriated Sen. McCain for knowing nothing about the principles of sound tax policy. He said it is wrong to make purchases at a local store bear state sales taxes, while the same purchase made over the Interet would be tax-free:

The only problem with Krugman's analysis is that he didn't know what he was talking about. The current temporary ban has nothing whatsoever to do with whether state sales taxes are due on Internet purchases. It applies only to new taxes on the Internet itself, such as on Internet Service Providers. The constraint on taxing Internet purchases is largely a practical one, compounded by a Supreme Court ruling.

Passage of the Internet Tax Freedom Act in 1998 did not in any way change taxation of Internet purchases. The rule for such purposes is the same as has been the case for decades on out-of-state and mail-order sales.

Sales taxes are not collected but, in theory, use taxes apply to all such purchases. However, in practice, states find it very difficult to collect use taxes because they are not withheld by the seller. Consumers must voluntarily remit most use taxes. But since the chances of being caught are virtually nonexistent, few people pay them. A study by the Federation of Tax Administrators found compliance with state use taxes to be very low even before Internet sales took off.

Furthermore, state laws already exempt most of what is sold over the Internet. State sales taxes generally apply only to tangible goods. Virtually all services are exempt, as well as such things commonly purchased over the Internet as airline tickets and stock trades.

Governors Would Love To Collect More Taxes

Of course, states would love to tax outof-state mail-order and Internet sales of books, CDs and other tangible goods. But the Supreme Court ruled in Quill Corp. v. North Dakota in 1992 that states could not compel a seller to withhold sales taxes unless the business had a physical presence in that state. This problem is exacerbated by the fact that some Internet sellers with operations in many states, such as Barnes and Noble, have set up their Internet sales operations as legally separate companies. Since BarnesandNoble.com has no physical presence outside of where its computers and warehouses are located, no sales taxes need be charged on most of its sales.

The Internet Tax Freedom Act has nothing to do with the constitutional or practical problems of taxing out-of-state sales. But governors have used the debate over imposing new taxes on the Internet as an excuse to revisit the longstanding problem of collecting use taxes.

In the end, they are likely to be unsuccessful in getting Congress to help because the Quill decision appears to bar it from enacting federal laws forcing businesses to collect use taxes on sales to states where they have no nexus.

Eventually, Prof. Krugman realized his error. On February 20, he published a very brief mea culpa. It reminded me of the character Gilda Radner used to play on "Saturday Night Live" who would complain hysterically about some perceived problem about which she was always completely wrong. When corrected, she would say simply, "Never mind."

Copyright Human Events Publishing, Inc. Mar 24, 2000
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