by Jessica Melugin
June 9, 2008

Overstock.com announced on May 30 that it would file suit against New York State over expansive Internet sales tax legislation signed recently by Gov. David Paterson.This follows a similar suit filed by Amazon.com, the world’s largest online retailer, last month.If sales made over the Internet are to be taxed, there is a better policy solution than New York’s: an origin-based approach where taxation is determined by the location of the seller instead of the buyer. If you’re going to get taxed, it’s only fair that you get to vote—or not vote—for the politicians taxing you.

A 1992 Supreme Court decision, Quill v. North Dakota, currently governs how online sales are taxed. It prevents states from collecting sales tax from retailers with no physical presence, or “nexus,” in their state. So if a resident of California buys something from a retailer in Texas, unless the seller has a warehouse, store, or office in California, sales tax cannot be collected on the purchase. Technically, the California buyer is obligated to declare the purchase and remit a “use tax”—a tax for the consumption or use of an item in the resident’s state—but this is almost impossible to enforce and thus widely ignored.

New York’s legislation attempts to capture this lost revenue by expanding the definition of Quill’s nexus to encompass the affiliate programs of many Internet retailers. Affiliate programs are where smaller retailers are paid a commission for driving customers to larger retailers’ sites. Let’s say you’re visiting newbooksreviewed.com and notice it features a link to Amazon. You click through and go on to buy a book there. Amazon pays a sales commission to newbooksreviewed.com as compensation for directing you to Amazon. Under the New York Internet Sales Tax Provision, Amazon would have to pay sales tax on all goods sold to New York residents simply because some of Amazon’s affiliates are based in New York. This is a new and controversial interpretation of nexus and is the crux of the complaint by Amazon and Overstock.com.

Aside from affording consumers tax-free online purchases, the Quill regime is not a popular one. Traditional brick-and-mortar retailers don’t like Quill because it puts them at a disadvantage to online retailers whose transactions are often tax-free. Like tax jurisdictions all over the country, New York dislikes Quill because as more commerce moves to the Internet, more tax revenue goes uncollected.

Unfortunately, New York’s approach will only make things worse.

As messy as Quill is, it does keep politicians from reaching over state lines and imposing taxes on those to whom they have no accountability. New York’s plan does away with this safeguard, subjecting out-of-state businesses to New York’s tax regime. Taken to its logical conclusion, if every tax jurisdiction followed suit, companies with affiliate programs would be forced to remit sales taxes in a maze of over 7,500 different jurisdictions—each with different rates and exemptions—creating a costly accounting nightmare.

An origin-based tax regime would correct the problems of the current system and avoid the drawbacks of New York’s plan. Instead of the complications that accompany taxing purchases based on the location of the buyer, an origin-based approach would be based on the vendor’s principal place of business.

Taxing at the origin instead of the destination keeps politicians accountable to those they tax since businesses, not consumers, remit sales taxes. This preserves the principle of ‘no taxation without representation.’

Sellers will vote with their feet when deciding where to set up shop. State and local taxing authorities will have to balance attracting businesses to their jurisdictions with generating sufficient revenues. No matter where retailers locate, an origin-based regime will free them from the current accounting burden of reporting to multiple jurisdictions because they need only to report their gross receipts in their home jurisdiction.

Buyers will vote with their wallets; choosing the tax rate among other variables when making decisions about where to shop online. Every consumer will benefit from downward pressure on sales taxes.

Last, brick-and-mortar retailers would have the ‘even playing field’ they seek. An origin-based approach would apply even-handedly to traditional, Internet, mail-order, telemarketing and other yet-to-be-invented sales methods that might arise.

Ideally, online transactions will largely remain tax-free—the better way to level the playing field is to lower sales taxes for brick and mortar establishments. When it comes to taxation, leveling down is always a better solution than leveling up.

Hopefully the courts will rule against New York’s bad policy and Congress will act to fundamentally reform sales taxes. In the meantime, politicians in other states should resist the temptation to tax those beyond their borders.