Brian Anderson: Welcome back to the 10 Blocks Podcast. This is Brian Anderson, the editor of City Journal. Joining me on today’s show is Steve Malanga. Steve’s a senior fellow at The Manhattan Institute and the senior editor of City Journal. He writes about urban economies, business communities, public policy, and much else, and his work has been featured in the Wall Street Journal, LA Times, New York Post, and many other publications. He’s the author of several books including Shakedown: The Continuing Conspiracy Against the American Taxpayer. Today, though, we’re going to discuss his story, “The Tax Nexus Cometh,” which appears in our spring issue and details the complex and inefficient tax system that online retailers and businesses are now contending with. So Steve, thanks as always for joining us.
Steven Malanga: My pleasure.
Brian Anderson: So, businesses have been urging Congress to craft new laws that would define states’ proper application of sales and business taxes to the online economy. The rise of the digital economy, in which firms and customers and employees are frequently residing in different jurisdictions, has magnified the need for a simplified way of dealing with this kind of economic exchange. Yet, as you document, it in its 2018 South Dakota v. Wayfair decision, the Supreme Court overturned the doctrine that states may only tax firms physically present in their geography, which opens online retailers and other businesses to demands from states across the country. So, I wonder if you could briefly describe the Wayfair decision and what kind of problems it’s creating with regard to taxes and firms that operate in a digital space.
Steven Malanga: Yeah. So, the Wayfair decision was specifically about sales taxes, because there have been previous Supreme Court decisions that had prohibited catalog retailers for instance, and then later online retailers, from collecting sales tax for states when they didn’t have a physical presence in that state, merely because they sold merchandise to someone living in that state. The notion was that there had to be some physical presence or connection. Now that could include something like let’s say a warehouse, so Amazon, which has warehouses in many states, even before the Wayfair decision, was paying passing through sales tax to states because they had physical presence there.
What the states argued, and what the Supreme Court said in its decision, not only overturned this doctrine of physical presence for sales tax, but has created chaos, basically, because the new doctrine is being used for other kinds of taxes too. And here’s what I mean, rather than the physical presence qualification, now there’s what’s called economic nexus. What nexus means is that’s the connection that allows a state to tax a company that’s out of state. And the nexus used to be physical presence, meaning the company had some operations at least in the state. The new nexus is called an economic nexus, and what that means is the Supreme Court basically said that if a retailer, an online retailer from far away does a certain amount of business in a state, and the South Dakota law specifically said either $100,000 of sales to in-state residents or 200 transactions to in-state residents, if a state does a certain amount of business, that’s called an economic nexus.
And what the Supreme Court says is that you have to demonstrate a substantial nexus. Retailers had to start paying sales taxes to the state after just 200 transactions didn’t really seem very substantial. But so, what they did, the Supreme Court, was they essentially threw away the old idea of physical presence or some physical connection for this rather vague term called economic nexus. And in doing so in a way that applied to just one state and one state law, what they didn’t do, which Congress or legislature would do, would be they didn’t set out parameters that could apply to every state. So basically, by just overturning the old physical presence idea of nexus, they invited states to create all these new laws so that they could tax out-of-state businesses really however they please, because there’s nothing really to stop them except going back to the Supreme Court or getting Congress to pass some national law which clarifies how this should work.
Brian Anderson: You cite several business owners in the piece who attest to the kind of immense strain of this new post-Wayfair tax regime. So many of these business people fear that, absent the reform you just suggested, interstate taxation will become evermore onerous. And some firms have even announced plans to shut down, as you detail. So I wonder if you could describe a little bit more what sorts of compliance costs remote selling firms occur as they are grappling with myriad tax codes in multiple states.
Steven Malanga: Right. So first of all, in the decision authored by former Justice Kennedy, he essentially said that there was now the technology through software to easily allow compliance, and he urged states to band together, and some states did that, and they created a buyer-approved, state-approved software. But it hasn’t worked anywhere near as well as the Supreme Court justice said in his decision that it might work. Not surprising, he’s not a tech expert. And as a result, there have been a tremendous amount of headaches. I quote several businesses talking about buying the software, which costs several hundred thousand dollars, which for a small business is a big cost, and then compliance costs in terms of hours, employee hours, costing another $100,000 or so in the last several years. So, you’re talking about a half a million dollars some businesses are talking about. And these are relatively small businesses.
And in addition to that, the software not only hasn’t worked well, but the retailers have actually been held accountable for the mistakes that the state-approved software that they’re using makes, so that many of them are not only being hit with back taxes, but also fines for using essentially the software that doesn’t work that the states create. So it’s really the costs are extremely high. And in addition to that, a report by the Government Accountability Office said that the tax regime that’s emerged is economically inefficient because of that. Now what does that mean, economically inefficient?
Tax is economically inefficient when it starts changing your economy, when it forces businesses to do things that they wouldn’t otherwise do. And once you start doing that, you’re sort of undermining your own economy just for the sake of raising revenues. And in this case, the Government Accountability Office, which is a Washington DC nonpartisan group attached to Congress, they found examples of states getting ... I mean of retailers getting out of certain businesses, of changing their business practices, not doing business in certain states. And all of those things they said are not desirable for a tax regime. That is not what a tax regime should do, but that is one of the consequences of what ... It’s what’s happening now.
Brian Anderson: Now the underlying principle of Wayfair is that states have the right to charge anyone who participates in their economies. And as you document, that’s inspired states to assess all of these new levies. But several states are also using the standards for determining firms’ sales tax eligibility to impose income taxes, registration fees, and other fees on online sellers. And some are even considering a digital advertising tax. So what does this portend for online commerce?
Steven Malanga: Well, I think that’s probably one of the most troubling things for some of the businesses I quoted, including some who have testified before Congress. They’re now being hit with all kinds of taxes because basically what the ruling did, again, was by overturning this notion of a physical nexus for a vaguer term, a vaguer kind of economic nexus, they essentially said to states—the states have said, “Well, why can’t we also use this for instance to tax the income, the profits of out-of-state businesses?” Because again, if the idea of a physical presence, the reason that not only certain laws like the interstate income tax law of 1959 and the reason that these laws originally focused on physical presence was this idea that if you’re not in a state, you’re not using the state’s services. You’re not using their roads. You’re not using their police protection. And therefore, you shouldn’t be paying taxes to them because you’re not getting any services.
That whole idea has essentially been overthrown by the Wayfair decision. Instead now, what the Wayfair decision says is if you’re making use of money generated in a state, a state’s economy, well, the state is responsible for that economy and you have to pay for the privilege of accessing that. That’s a very different concept. And so now states are applying that not just through the idea of sales tax, but to income taxes, or business-registration taxes. Texas for instance doesn’t have an income tax, but in order to do business, you have to pay a state franchise tax, which is like a registration fee. Well, now, anybody who wants to even sell to somebody in Texas, they have to pay this registration fee, which could be several thousand dollars, depending on the firm.
So businesses are now being hit by all kinds of different taxes. And again, when you think of the fact that you have 50 states and with the online world, you can sell to everybody, I mean, some businesses are essentially saying, “We just can’t afford to sell to people in the most aggressive states anymore because it’s too expensive just to administer this whole regime.”
Brian Anderson: Right. The compliance costs alone must be significant if you’re needing to deal with differing tax codes and 50 different jurisdictions. Right?
Steven Malanga: Well, again, to take one of the examples, I talked about one firm which used that faulty software. They had to refile and redo 325, I think, tax returns. Think about that. Multiple years in multiple jurisdictions because you have not just states, but also many counties and cities have their own taxes, so they had to refile. When you have to update because you’ve made a mistake on your taxes, they had to refile 325 different tax returns in different jurisdictions, so that’s what businesses are facing right now.
Brian Anderson: You do propose reforms in this essay. You write that Congress’s response to the Wayfair ruling should be twofold. First, it should devise guidelines for a national remote sales-tax system. And second, that it really needs to provide a federal definition for this notion of economic nexus, the standard again for determining whether a person or business is subject to taxes in a particular jurisdiction. So what key provisions would an effective tax regime include? And is Congress even considering such legislation at this point? What challenges does Congress face in interpreting economic nexus for the digital age?
Steven Malanga: Well, in fairness to the Supreme Court, they have been calling for Congress to clear this up for years. And Congress has never seen this as being urgent. And there have been crafted over the years a number of pieces of legislation focusing on income taxes. There is a law, the 1959 law, that again is completely outdated because it doesn’t deal with this online world that we’re talking about. And that was the law that really cemented the idea that income tax, that states could only charge income taxes to businesses that have some kind of physical presence. So there are a series of laws, there are two things that are necessary, for state sales tax, there can’t be just one standard for every state because states are all different sizes and economies.
And the problem with the Wayfair decision, it was about South Dakota, and it basically said, “You can do this in your state at this level, the 200 transactions or $100,000 in sales,” and again, in a state like California, with 37 million people, that’s like a pin drop. Right? So there has to be some kind of national parameters that would apply that tells states what’s reasonable. In addition, the laws that have been proposed say things like retailers cannot be held accountable for flaws in government-approved software. You buy something that’s bad, and the people who sold it to you basically charge you anyway, and charge you penalties. I mean, it’s extraordinary. And then there are also questions about how this plays out in the world of telecommuting, which we haven’t talked about. But the whole remote world now that exists, which everybody sees as this great transformation of the economy, is also affected by this because what’s happening is there are many firms now that have employees in numerous states.
States are now saying, “Well, we can tax the income of any business if they have just one telecommuter working in our state.” And it’s gotten so bad that some accounting firms have said, “Don’t locate or don’t hire people in this state to work for you because it’s going to be too much of a headache.” So there’s also a mobile workforce bill before Congress which would also essentially stop states from taxing people just because they have a telecommuter. There would have to be some better definition of physical presence beyond just a single employee. So, these are some of the things, there’s not one piece of legislation that solves everything because you have everything from sales tax to income tax. You need different definitions, and you need definitions that apply, that can be used to apply for all the states with their different sizes and different kinds of economies.
Brian Anderson: The overall cost of this in terms of inefficiency must be staggering in dollar terms. Right?
Steven Malanga: Particularly when you think of the fact it’s now estimated that there are something like almost 2 million businesses that sell online. Now everybody sells online, of course, all the major businesses. I can’t think of many major businesses that don’t sell online. Even perishable products like food, they’re sold online and they’re shipped overnight. So every major business and many, many smaller businesses, everybody just sells online because it’s so easy and efficient to do that. So when you think of the extra hours that some of these businesses are talking about, small businesses that testified before Congress that have spent half a million dollars on compliance costs, and for some of them, for instance, some of them that sell everyday products that don’t have a very high profit margin.
So there’s this one New Jersey business I quote, where to reach the 200 sales threshold, now there was 200 transactions, at which point you’re subject to taxes, this one retailer was saying he basically has to spend $2.50 for every $1 in transaction costs. So his compliance costs are more than he’s actually bringing in, in sales. So it’s just deadly, it just undermines his profit margins completely. So again, you have many, many different kinds of businesses, including low-margin business, who thrive on doing many transactions at a low margin. And this is because of those compliance costs I’ve talked about. This is undermining that model.
Brian Anderson: Well, thanks very much, Steve. It’s a big problem, and hopefully we can get some legislative clarity on it going forward. Don’t forget to check out Steve Malanga’s work on the City Journal website. That’s www.city-journal.org. We’ll link to his author page in the description. You’ll be able to find this article we’ve been discussing there called “The Tax Nexus Cometh.” You can also find Steve on Twitter @cjstevem. You can also find City Journal on Twitter @CityJournal and on Instagram @cityjournal_mi. And as usual, if you like what you’ve heard on today’s podcast, please give us a five-star rating on iTunes. Steve Malanga, thanks very much.
Steven Malanga: Thank you.