Around the country, there is a growing effort amongst states to tax online purchases made by consumers. In addition to raising taxes, these efforts also seriously impede interstate commerce, put states at a competitive disadvantage with other states, encourage online black-markets and threaten property rights, and hamper the growing free-market that is the internet.

There are four primary eTax efforts: the Digital Goods Tax, the Amazon Tax, the Streamlined Sales Tax Project, and the Internet Access Tax.
 
Digital Goods Tax
The “digital goods” or “iTunes” tax allows states to collect taxes on music, movies, books, ringtones, and other digital goods that are purchased from an online retailer in the same state you live in. So, New York can tax residents who buy from a New York retailer, but cannot require a North Carolina retailer to collect a tax and send the money back to New York. Many of these states tax digital goods as part of their definition of “tangible personal property”.  Currently 18 states impose a tax on digital downloads.
 
Amazon Tax (or “affiliate nexus tax”)
The “Amazon Tax” allows states to reach well beyond their borders to collect taxes on residents who buy any good from virtually any online retailer around the country. The effort assumes that if an online retailer advertises through a company that is located in one state, say California, then that third-party advertising affiliation is strong enough for California to require the out-of-state retailer to collect taxes on California residents.
 
Streamlined Sales Tax Project (SSTP)
The Streamlined Sales Tax Project aims to extend tax collection to out-of-state online retailers just like the Amazon Tax; however, it does so by establishing a cartel of state legislators and tax administrators that can rewrite states’ tax codes under the guise of simplifying them.
 
Internet Access Tax
As the name suggests, some states have begun considering new taxes on connecting to the internet, even though federal law preempts such action under the Internet Tax Freedom Act that was recently reauthorized by Congress in 2007.
 
If all these efforts sound like complicated schemes to collect more taxes and circumvent the dormant commerce clause of the U.S. Constitution – that’s because they are.  Read the last section below for a brief legal overview of these taxes.
 
 
Why eTaxes are Bad Public Policy
  • Efforts to impose eTaxes across state lines violate the Dormant Commerce Clause, which restricts states from passing legislation that burdens or impedes interstate commerce. If the roundabout way the Amazon Tax and Streamlined Sales Tax Project work isn’t proof enough that this clearly hampers interstate trade, see the “Quick Legal Background” section below for a set of court cases that analyze the constitutionality of these efforts.
  • eTaxes put states at a competitive disadvantage. While many states are seeking to tax digital goods, some states are specifically exempting these products from taxation to entice digital vendors and other high tech companies to move to their state. Four States (North Dakota, Oklahoma, Ohio, and Minnesota) all exempt digital goods from taxation and California rejected similar legislation in 2008 for this very reason.
Additionally, the “Amazon Tax”, which establishes a nexus for taxation if retailers advertise through in-state advertisers, creates an incentive for retailers simply to terminate contracts with advertisers to avoid collecting what is likely an unconstitutional tax. This means costing small online businesses and bloggers a significant revenue source, while simultaneously failing to bring in the anticipated tax revenue. In fact, when Rhode Island passed legislation in June 2009, the bill’s fiscal report even projected it would not raise tax revenue for this very reason.
  • Wherever there’s a tax, there’s a black market. One of the largest black markets today is with music and film downloads. Studies show that nine out of ten music downloads are obtained illegally and that 40 percent of revenue lost by the film industry can be attributed to online piracy.  Increasing the cost of digital products through taxes will incentivize illegal downloading and subsequently reverse recent progress made in combating this problem.
 
A Quick Legal Background on eTaxes
 
In 1967, the U.S. Supreme Court determined in Bellas Hess v. Illinois that states could not require companies without either property or employees in the state to collect sales and use tax – in other words, companies needed a physical nexus.  The 1992 Supreme Court Case Quill v. North Dakota then reaffirmed the principle that a company must have a substantive nexus in order for the state to require the company to collect sales taxes.
 
These cases are primarily rooted in the Dormant Commerce Clause of the U.S. Constitution, which says that states are restricted from enacting laws that burden interstate commerce.  Amongst other reasons, Quill determined that forcing out-of-state companies to comply with over 8,000 tax jurisdictions across the country discriminated against specific businesses and significantly burdened interstate commerce.
 
As a result, states have pursued “use tax” collection, which requires citizens to voluntarily remit taxes to the state on purchases made out-of-state. Many states have also begun to pursue tax collection based on an economic nexus, merely taxation where the economic activity occurs. For example, in West Virginia v. MBNA, the state Court of Appeals determined that the physical nexus rule did not necessarily apply to state business franchise and corporate income taxes. This allowed the state to begin collecting taxes on businesses merely with customers in the state.
 
The “Amazon Tax” and “Streamlined Sales Tax Project” mentioned above reflect direct attempts to circumvent the Quill and Bellas Hess Supreme Court rulings and the U.S. Constitution. The Amazon Tax in particular is undergoing legal challenge in New York and was rejected in numerous other states in 2008 and 2009 due to likely constitutional hurdles.