Live From New York

How Not to Tax the Internet

Gov. David Paterson wants tolls on the information superhighway

By 3.24.09

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Imagine having to pay taxes to a state you don't live in just because you do business with someone who does. If you're an Internet retailer, you don't have to imagine. You have to pay.

New York Governor David Paterson (D) signed legislation last year requiring non-New York companies like Amazon and Overstock.com to pay New York sales taxes. The legislation is now being challenged in court.

The polite term for this is taxation without representation.

Neither Amazon nor Overstock has any physical presence in New York State. But some of their "affiliate" websites do. An affiliate is a website that links to, say, Amazon products, and receives a small percentage of any sales resulting from those links. Call it a finder's fee.

Affiliates are not owned by Amazon. They are independent entities. Yet Governor Paterson and the New York legislature maintain that such tenuous connections to their state are enough to force Amazon and Overstock to collect and pay sales taxes on any products they ship to New York.

This is not good policy under any circumstances. During a recession, it's destructive. When the new law came into effect last June, Overstock severed ties with more than 3,400 New York-based affiliates.

Paying taxes to a government that provides you with services, and where you can vote for or against the politicians setting tax rates, is one thing. But to pay taxes when you get no benefits and no democratic say is simply unfair.

Nor is it feasible. The more states that join in, the more expensive it becomes for companies to do business across state lines.

Already, five states are jumping on the bandwagon. California, Connecticut, Hawaii, Minnesota, and Tennessee all have Internet tax proposals in the pipeline, relying on the presence-by-affiliate argument. More are sure to follow.

Add in cities and counties, and we have about 11,000 sales tax jurisdictions in the United States. Every single one of them could use New York's logic against outside Internet retailers.

As April 15 approaches, we need no reminder of the difficulties of complying with the tax code. State and federal returns are bad enough on their own. Imagine filling out 11,000 forms every year.

It is true that sales taxes are simpler than income taxes. But 11,000 forms are 11,000 forms. If New York's tax precedent becomes the norm, that's what companies across the country may have to go through.

New York's thirst for revenue is not surprising. The state is in poor fiscal shape. The budget deficit is estimated to reach $13.7 billion this year. Revenues are down and spending keeps going up, even after targeted budget cuts.

The real surprise is that courts haven't thrown out Gov. Paterson's sales tax scheme. According to Supreme Court precedent, it is unconstitutional. The 1992 Quill v. North Dakota decision confirmed that a state may only collect sales taxes from companies that are actually located in that state.

New York and other revenue-hungry state governments would like to do away with Quill. They prefer what policy wonks call destination-based taxation. That means that everything that New York consumers purchase would be subject to sales tax, no matter where the seller is.

A better approach is origin-based taxation. Companies only collect and pay sales taxes where they have a physical presence. Not only is it more fair, it is more feasible. Companies pay one sales tax, not anywhere from 50 to 11,000.

Origin-based taxation also allows for tax competition, which incentivizes states to rein in their worst impulses. If a state charges excessive rates, companies can leave for another state with more reasonable rates.

Internet retailing is one of the few sectors of the economy still growing during this recession. If destination-based taxation prevails, it will cost precious jobs. Consumers will end up paying more for the same goods; their hard-earned dollars won't go as far as they would under origin-based taxation.

Governor Paterson's Internet taxation proposal is unfair unworkable, and bad for consumers and businesses alike. Courts should throw it out.

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About the Author

Ryan Young is Fellow in Regulatory Studies at the Competitive Enterprise Institute.