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to Internet Commerce Estimates: A Reality CheckFrom Collecting Taxes in the Cyberage
p. 33-38, published 1999
A Kentucky resident decides to do her Christmas shopping through mail order; she reads a gift catalog she received in the mail from a company in Maryland and decides to buy some toys for her grandchildren. She has a few options. She fills out the order form accompanying the catalog and reaches the line that says, “MD and VA residents add sales tax,” and leaves it blank. She totals the bill, writes the check, and puts the envelope in the mailbox. Or, she gets out her credit card, calls the company, places the order, gives her mailing address and credit card number, and hangs up. Or, she goes to the company’s website, chooses the items she wants from an online catalog, enters her mailing address and credit card number, clicks on “Order,” and logs off. All three scenarios yield the same result: her merchandise will be delivered in a few days, her account will be charged or debited for the price of the items plus shipping and handling, and she will owe the Commonwealth of Kentucky use tax.
Kentucky and every other state with a sales tax impose a use tax. Generally, use taxes are levied on the “storage, use, or consumption of tangible personal property not subject to sales tax or exempt from tax that is brought into that state, or acquired under nontaxable presumption.”(2) The use tax “backstops” the sales tax and is designed to balance the burden between those purchasing tangible personal property inside the state and those who buy outside the state. It represents an attempt to ensure that the sales tax will not unfairly burden in-state retailers who must compete with retailers in other states who are not required to remit the sales tax. In recent years, the spectacular growth of online commerce has generated concerns about a declining sales tax base, and has thus accelerated the pace of states’ action regarding use tax policy. This chapter explores past and current experience with use tax administration, both nationally and in Kentucky, and describes some of the opportunities for improved administration in the future.
State imposition of use tax dates back to the mid-1930’s, when California and Washington imposed taxes on the use of goods purchased outside the state. The U.S. Supreme Court upheld Washington’s tax, finding that it was not a tax on interstate commerce, but on the privilege of using goods after the interstate commerce transaction was completed.(3) This decision provided the basis for use taxation in the states. The Interstate Commerce Clause of the Constitution necessitates the imposition of use taxation to ensure that interstate commerce transactions do not escape taxation. By the 1960’s, all states with sales taxes had passed some form of use tax.
While tax laws clearly established the tax liability upon the value of the goods being used within a state’s boundaries, case law worked to relieve out-of-state sellers of their responsibility to collect and remit the tax, unless they maintained some physical presence in the state. Thus, state tax agencies have had to rely heavily on voluntary and enforced compliance of individuals and businesses with a presence (nexus) in the state. The nexus issue remains a substantial source of controversy in use tax administration and consequent litigation. The courts have found that out-of-state companies with retail locations inside the state have sufficient nexus and must register and remit the tax.(4) They also have found that the presence of the seller’s employees, representatives, or agents within the state taking orders for delivery from out-of-state generates sufficient nexus.(5) However, occasional delivery activities of an out-of-state seller do not generate nexus.(6) In 1967, the Court found that a mail order company whose only presence in the state was to send catalogs to prospective customers and receive orders through the U.S. mail and ship goods to customers via common carrier did not have sufficient nexus for the state to require them to register, collect, and remit use tax.(7) More recently, the Court found that the Due Process Clause justification for the 1967 mail order decision was invalid, but upheld the decision based on the Interstate Commerce Clause.(8) This decision led to a flurry of activity among the states to craft nexus standards that would capture mail order activity, should the Congress exert its powers to regulate interstate commerce in this arena.
Kentucky statutes impose a 6 percent use tax on the purchase price of goods purchased for storage, use, or other consumption in the state, with credit given for tax paid in another state. Those persons first using, storing, or consuming the tangible property are liable for the tax. The responsibility for collection of the tax rests with every “retailer engaged in business in the state.” The statutory definition of a “retailer engaged in business in the state” (KRS 139.340) attempts to address the nexus issues raised by court decisions described above. The Revenue Cabinet provides various methods for taxpayers to report and remit the tax.
Individual Income Tax Return. Approximately 15 states and the District of Columbia link the collection of use tax with the individual income tax. About half of these states offer a consumer use tax form with instructions inside the packet of income tax forms. The others include a line on the income tax return where consumers can report their use tax liability. Kentucky uses the latter method and provides a worksheet for the consumer use tax line in the income tax instruction booklet. Compliance with this method of use tax reporting is spotty. Data from Kentucky’s income tax forms indicate that approximately 1 percent of Kentucky individual income tax filers report something on this line, with an average use tax liability of $37, for a total of approximately $700,000 for tax year 1998. These taxpayers have, on average, $63,000 in Federal AGI, $7,500 in itemized deductions, three dependents, and income tax liabilities of $2,600. The data also suggest that use tax reported increases slightly with income. It is interesting to note that more than 600 of the 18,000 taxpayers that filed this way reported $1 of use tax. Only 1,200 reported more than $100. Nevertheless, this low-cost means of reporting and remitting use tax represents nearly $12 million in taxable transactions. Individuals can also report their use tax liabilities on a Consumer Use Tax form, so these data underestimate individuals’ use tax compliance levels.
Collection via Consumer Use Tax and Sales and Use Tax Returns. In Kentucky, consumers should report and remit their use tax liability within 20 days following the month in which they made purchases subject to use tax. The Revenue Cabinet provides a Consumer Use Tax return on which taxpayers report the number, type, and purchase price of these items, and calculate their tax liability. The form is available at the Cabinet’s Website for downloading and at any of the Cabinet’s taxpayer service centers located throughout the state.
Most other states have similar forms for remitting use tax. Businesses can remit payments on the sales and use tax forms. Most use tax is paid in this fashion. Generally, use tax collections run between 7 and 9 percent of total sales and use taxes among the states.(9) Kentucky collects approximately $250 million in use tax via the sales and use tax returns, or about 12 percent of total sales and use tax collections.
Cooperative Agreements. States have entered into interstate agreements to enhance voluntary vendor compliance and to cooperate on enforcement activities. These agreements generally take the form of regional compacts to share information and pool resources to encourage voluntary compliance and share audit responsibilities. One of the earliest successful compacts was the New York-New Jersey Sales and Use Tax Agreement, established in 1986. This compact established joint administration responsibilities for the two states in which a vendor in either state registers in one state and must remit sales and use tax due in both states. Since then, the trend has been toward increasing cooperation among states on a regional basis. Kentucky is an associate member of the Multistate Tax Commission (MTC), which provides for information sharing and a multistate audit staff, and a member of the Southeastern Association of Tax Administrators (SEATA) and the Ohio/Indiana Exchange Agreement. Kentucky also participates in The Federation of Tax Administrators (FTA), an organization representing taxing jurisdictions throughout the U.S. The FTA has been progressive in expanding information-sharing among state tax agencies, recently providing electronic means of communicating and sharing data. In general, Kentucky’s experience with these agreements and organizations has been productive, leading to more efficient tax administration through exploration of best practices and adoption of more uniform administration among the states.
Voluntary Compliance Among Out-of-State Sellers. The Revenue Cabinet currently collects use tax from a large number of out-of-state firms that have voluntarily registered to report and remit the tax on sales to Kentucky residents. The Cabinet encourages such voluntary compliance and is investing in systems integration technology to reduce the costs of compliance.
Collection of Use Tax on Large-Ticket Items. Individuals who purchase large-ticket items (boats, planes, furniture, mobile homes, computers, etc.) out-of-state for use in Kentucky incur a use tax liability if a 6 percent sales tax was not paid. The use tax compliance on these purchases tends to be greater than for small items. In particular, those items that require registration have tended to pose less of a problem for tax agencies. However, enforcement efforts vary considerably from state to state. Kentucky is among the states that put significant effort into enforcing the tax on boats and planes. Other large ticket items, such as mobile homes and travel trailers, are also subject to varying levels of enforcement among states.
Expanding Awareness and Understanding of the Tax. States that have launched public relations programs to advertise the features of the tax and the responsibilities of citizens to report it have achieved varying degrees of success. Some states have used mailings to remind citizens of the use tax, asking them to review their records for any purchases subject to it. Indiana, for example, sent 86,000 letters to higher income individuals, which generated approximately 20,000 responses, half claiming no tax due and the others generating an average tax payment of $30.(10) Assuming full compliance among those that remitted tax based on the letter, the campaign revealed approximately $1.5 million dollars in taxable transactions not previously observed. However, it is not known how many of these taxpayers would have reported their liability on Indiana’s individual income tax return.
Most states have expanded taxpayer assistance, with easier access to agency employees, increased training and professional development, and improved availability of instructional materials through the Internet. Clearly, the Internet offers significant opportunities to target education to those consumers most likely to make on-line purchases.
Encouraging Validation of Taxpayer Reporting. Because of the timing lag between purchases and the due date of individual income tax returns, taxpayers may have little information upon which to base their use tax calculation. Some states have tried to provide taxpayers with a means of calculating their use tax based on income, which simplifies reporting and effectively validates the amount they report. Maine includes a line on the individual income tax return for reporting use tax. The taxpayer can choose to report actual use tax due, or elect to report .04 percent of Maine AGI. If the taxpayer purchased an item that cost $1,000 or more, they are required to report a use tax for that purchase in addition to the .04 percent of Maine AGI. Before tax year 1998, if the taxpayer left the use tax line blank, Maine assessed an amount equal to .04 percent of AGI. That provision was repealed beginning in 1999 (1998 tax year); under current law a blank line is now considered a reporting of zero tax liability.
Policymakers have tended to focus on the Internet’s threat to the revenue adequacy of sales and use tax base. But the effects on efficiency and equity of the tax have received consideration as well. Efficient taxes minimize the distortion of consumer and producer decisions and the cost of compliance and administration. A general sales tax economy-wide is relatively efficient, in that all prices are affected similarly. Thus, no reallocation of resources from one market to another would result. The efficiency of the sales tax diminishes as the tax base shrinks, diverting consumption and corresponding resources to exempt markets. In the context of Internet sales, current sales and use taxes impose different prices on the same goods depending on the location of the seller. The most obvious distortion is between local and interstate goods, as mail order through the Internet becomes more popular. The distortion, or excess burden, harms the public by diverting resources from their highest and best use. Excess burden increases with the sensitivity of consumers to price or elasticity of demand. The extent of the excess burden of consumer use tax is unknown, but will likely be large if consumers perceive little difference in the delivered price of the goods other than the 6 percent tax. In addition, compliance costs have been a concern among multi-jurisdictional sellers, given the patchwork of state and local rates, exemptions, and filing calendars.
The shrinking of the tax base also raises equity concerns. Horizontal equity requires equal treatment of equals. On the business side, current administration of the tax favors out-of-state retailers. As more transactions take place via the Internet, in-state retailers will be forced to bear an increasing portion of the burden of the sales and use tax, as they strive to compete with out-of-state sellers not remitting the tax. Horizontal equity among households is less of a concern, given the ease with which households can transact on-line.
Also of concern is the effect of Internet sales on the vertical equity of the tax. Vertical equity implies unequal treatment of “unequals” and is widely held to mean that households with higher incomes should bear a larger portion of taxes. A Kentucky Long-Term Policy Research Center survey and analysis found that “the people who use technology tend to be younger, better educated, wealthier, and urban.”(11) Estimates of sales tax incidence based on current income indicate the sales tax is regressive as it stands. Until access to Internet purchases is available to households regardless of income and wealth, the sales and use tax will become even more regressive.
The Quill decision opened the door for Congress to authorize state imposition of use tax collection on out-of-state vendors. In fact, in the wake of the Quill decision, several bills were proposed in Congress to expand states’ ability to collect use tax, including the Consumer and Main Street Protection Act of 1995, The Independence for Families Act, (1994), and Senate Bill 1825 (1994). None of these bills moved very far in the legislative process.(12)
Cooperation among the states has progressed and offers some hope. At its 1999 winter meeting, the National Governors’ Association adopted a policy on streamlining sales taxation. The policy recognizes the ramifications of the Quill decision in reaffirming the authority of Congress to address state tax issues that affect interstate commerce, the states’ responsibility to simplify sales and use taxes, and the opportunities provided by innovation in information technology. The following description appears on the National Governors’ Association (NGA) website:(13)
The policy calls for joint industry/government development of a simplified sales tax system, including one sales tax rate per state, streamlined administration and audit requirements, and uniform definitions of the goods and services that may be taxed. States retain the authority to determine what is taxed and at what rate. The policy establishes incentives for states to streamline and simplify their sales tax systems by calling on the federal government to restore fairness in the sales tax by requiring remote sellers to collect sales taxes for states that simplify their taxes. A minimum level of sales would be established; companies that made sales in the past year above that de minimus level would be required to collect and remit the sales tax to qualified states.
Improvements in technology offer opportunities for reducing compliance costs for taxpayers. In the past, sellers have argued that multi-jurisdictional taxation imposed significant costs of calculating sales tax on a transaction-by-transaction basis. This is no longer the case. State and local tax rates can be applied to transactions based on a key in the transaction record. The rate database would have to be continually updated, but several businesses already provide such updates at relatively low cost.
The availability of rate information raises the relative importance of obtaining clear interpretation of the sales tax base. Compliance costs among taxpayers can be greatly enhanced to the extent that state and local governments can clearly establish which transactions are exempt and which are taxable. Sales tax uniformity across states would increase the use of such software by businesses to remit sales and use tax.
The NGA policy on Streamlining Sales Taxation offers the following solution:
One potential approach to administration of sales taxes would be to encourage establishment of a system of independent third-party organizations that would be responsible for remitting taxes to the states. Remote sellers would use a software package preapproved by the states that would calculate the tax due on the purchase based on the state rate where the item is sent, and electronically remit that tax to the collection organization. Remote sellers that opt to use the third-party system would enjoy additional benefits of compliance, including not filing returns and not remitting funds to states.(14)
Successful implementation of such a proposal requires considerable cooperation among the states and retailers and a newfound dedication to simplifying the tax codes. Therein lie significant challenges. Nonetheless, the benefits of such a program and the concern over an unpalatable federal solution to the nexus issue may provide enough incentive to get the job done.
In the 1950’s and 1960’s, tremendous investment in interstate highways greatly reduced the cost of interstate commerce, bringing cheap delivery of out-of-state merchandise to our businesses and homes. In the 1990’s, the investment has been in the information highway, with similar effects. Now the marketing and accounting functions of out-of-state sellers have reached our doorsteps as well. As we would expect, both periods have generated their share of interstate commerce problems. Fortunately, the Internet brought with it expanded opportunities for communication among the states and the technology to reduce taxpayer compliance costs to address these problems. Kentucky is embracing the promise offered by these cooperative efforts, as well as the new technology of tax administration, and is participating in the national policy debate on efficient tax systems.
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Kentucky Revenue Cabinet, Division of Research and Development. The views expressed in this chapter are those of the author and not necessarily of the Revenue Cabinet. Any errors are the responsibility of the author. I wish to express great thanks to my associates at the Revenue Cabinet for their assistance in this project. Return to text.
Fields, Robert J., Understanding and Managing Sales and Use Tax, CCH Incorporated: Chicago IL, 1994, p. 47. Return to text.
Henneford v. Silas Mason Co., Inc., 300 US 577 (1937). Return to text.
Nelson v. Montgomery Ward, 312 US 373 (1941). Return to text.
General Trading Company v. State Tax Commissioner, 322 US 325 (1944) and Scripto v. Carson, 362 US 207 (1960). Return to text.
Miller Brothers v. Maryland, 347 US 340 (1954). Return to text.
National Bellas Hess v. Illinois Department of Revenue, 386 US 753 (1967). Return to text.
Quill Corporation v. North Dakota, 112 SCt. 1904 (1992). Return to text.
John F. Due and John L. Mikesell, Sales Taxation, 2nd ed., (Washington, D.C.: The Urban Institute Press, 1994): 246. Return to text.
Ibid., p. 264. Return to text.
Peter Schirmer and Stephen Goetz, The Circuits Come to Town (Frankfort, KY: Kentucky Long-Term Policy Research Center, 1997): chapter 2. Return to text.
For a comprehensive treatment of use tax in a legal context, see Saba Ashraf, Virtual Taxation: State Taxation of Internet And On-Line Sales, 1997 Florida State University Law Review, viewed at http://www.law.fsu.edu/journals/lawreview/issues/243/ashraf.html#FNT*, 1 Dec. 1999. Return to text.
http://www.nga.org/106Congress/SalesTax.asp, viewed 5 Nov. 1999. Return to text.
http://www.nga.org/Pubs/Policies/EC/ec12.asp, viewed 5 Nov. 1999. Return to text.