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State governments rely on sales and use taxes for approximately half (48.2%) of their total tax revenue — or approximately $715.2 billion in FY2004.[1] Local governments derived 11.4% of their tax revenue or $44.6 billion from local sales and use taxes in FY2003.[2] Both state and local sales taxes are collected by vendors at the time of transaction and are levied at a percentage of a product’s retail price.

A state may tax a transaction if there is some connection (nexus) of the transaction to the state. Thus if the seller or the buyer is located in the state, the transaction may be subject to the sales tax. The important question in the out-of-state seller context is not the state’s power to tax the transaction, but rather whether the state can require the out-of-state seller to collect the tax from the purchaser.[3] While in such cases the buyer is required to remit a use tax to his or her state government, typically through the state income tax, in reality, consumer compliance with this requirement is quite low. Thus, contrary to what some commentators suggest, Internet purchases are essentially "tax-free" only in the sense that consumers are evading the use tax due on their online transactions.

Many observers suggest that the expansion of the Internet as a means of transacting business across state lines, both from business to consumer (B2C) and from business to business (B2B), threatens to diminish the ability of state and local governments to collect sales and use taxes.

The variation among the state and local governments in the administration of the sales tax is at the center of the Internet tax debate. The U.S. Supreme Court has ruled that the collection of sales taxes by remote vendors would be too burdensome; there are thousands of taxing jurisdictions, each with its own rates and base.

The Due Process[4] and Commerce clauses[5] of the U.S. Constitution limit a state from imposing tax liability or collection responsibilities on a business concern unless there is a substantial nexus or in-state contact established with the state. There is currently no statutory authority and scant case law on the subject of nexus and the Internet, but the U.S. Supreme Court has given considerable guidance in the analogous area of taxation of mail order sales.

The two major Supreme Court decisions in this area are National Bellas Hess, Inc. v. Illinois Department of Revenue,[6] and Quill Corp. v. North Dakota.[7]

National Bellas Hess Case[]

In the 1967 National Bellas Hess decision, the Supreme Court held that the state of Illinois could not require an out-of-state mail order sales company to collect a use tax from Illinois customers. Bellas Hess’s only contact with the state was via the mails or common carriers. This contact was found to be insufficient to establish nexus under either the Due Process or Commerce Clause. The Court utilized a physical presence standard for nexus for both of these clauses.[8]

Ten years after Bellas Hess, the Supreme Court set out a four part test in Complete Auto Transit, Inc. v. Brady[9] for determining whether a state tax is compatible with the Commerce Clause. For a state tax to be applied to an activity there must be substantial nexus with the taxing state. The tax must be fairly apportioned. It must not discriminate against interstate commerce. The tax must be fairly related to the services provided by the state.[10]

Quill Case[]

This clarification became more significant in the mail-order sales area after the 1992 Quill decision. In Quill, a case factually similar to Bellas Hess, the Supreme Court dropped the physical presence test for nexus under the Due Process Clause, requiring only that the seller’s efforts be “purposefully directed toward the residents of the taxing state.”[11]

Therefore, the Due Process Clause was no longer an impediment to requiring tax collection by the out-of-state seller. However, the physical presence standard or substantial nexus requirement of the Commerce Clause was reaffirmed.[12] Therefore the practical outcome of the case was the same as Bellas Hess. The state could not force the seller to collect the tax absent a substantial nexus.

The removal of the Due Process Clause as a road block did open a door for Congress, under its commerce powers, to legislatively empower the states to require the collection of these taxes. The Supreme Court, in Quill, specifically invited Congress to act in this area. To date, Congress has not enacted legislation in this area.

Two Components of the Sales and Use Tax[]

The revenue that a sales and use tax generates, assuming a given level of compliance, depends upon the chosen rate and the base to which the rate applies. The more narrow the base the higher the rate must be to raise an equivalent amount of revenue. States often have similar consumption items included in their tax base, but they are far from uniform. Tax rates can also vary considerably, depending on the state’s reliance on other revenue sources.

Tax Base[]

The sales tax, which is often considered a consumption tax, is perhaps better identified as a transaction tax on tangible personal property; expenditures on Internet access, legal, and medical services are often excluded from the state sales tax base.

Business-to-business transactions are often exempt from the retail sales tax, particularly in cases where the purchaser is using the good as an input to production. These transactions are exempt because including the transactions could lead to the “pyramiding” of the sales tax. For example, if a coffee shop were to pay a retail sales tax on the purchase of coffee, and then impose a retail sales tax on coffee brewed for the final consumer, the total sales tax paid for the cup of coffee would likely exceed the statutory rate.

Products that a business purchases for resale are typically not assessed a retail sales tax for a similar reason. If a coffee shop buys beans only for resale, levying a sales tax on the wholesale purchase of the beans and then on the retail sale would more than double the statutory rate. Tax treatment of business purchases is not uniform across states.

Many individuals and organizations are also exempt from state sales taxes. Entities wishing to claim the sales tax exemption are often issued a certificate indicating their tax-free status and are required to present this certification at the point of transaction. Non-profit organizations, such as those whose mission is religious, charitable, educational, or promoting public health, often hold sales tax-exempt status.

Tax Rate[]

The second component of a sales tax is the tax rate applied to the base described in the previous section. In 39 states, local governments piggy-back a local sales tax (which often varies among localities within the state) on the state sales tax; 11 states and the District of Columbia levy a single rate with no local taxes. Some states in the group of 39 may collect a uniform local tax along with the state tax and send the local revenue share back to the localities. This structure would look like a single rate to the consumer because vendors typically do not differentiate between the state and local share.

Generally, states with a broader base can collect the same amount of revenue at a lower rate than a state with a narrow base. Residents in high sales tax rate jurisdictions could gain from Internet purchases (and tax evasion) more than those in low tax rate states. Recognizing this potential revenue drain, many states have stepped up efforts to inform consumers of their responsibility to pay use taxes on Internet and mail-order catalog purchases. As suggested earlier, states with high rates — and whose residents have a greater incentive to evade taxes — are exposed to greater potential revenue losses from the growth of Internet commerce.

Because of the greater potential losses, these states are more likely to support reforms that help maintain their sales and use tax revenue base.

Streamlined Sales Tax Project[]

One of the objections to requiring out-of-state sellers to collect state sales tax is that there are many different sales tax rates (from state-to-state) as well as multiple sales tax rates within an individual state based on the type of good being sold or the locality where the tax is collected. The Streamlined Sales Tax Project (SSTP) is an effort now underway to address, at least in part, these concerns.

SSTP is comprised of thirty-nine states and the District of Columbia. According to the SSTP’s website, its goals are to establish uniform tax base definitions; simplify tax rates by allowing only one state rate (with limited exceptions); impose uniform sales and use tax exemptions; create uniform and limited audit procedures for sellers; and have states fund some of the required technology improvements. Many states currently employ a variety of sales tax rates, depending on what the type of purchase is (i.e. goods, food, prescription drugs, etc.). Local governments within states are also able to impose sales taxes, and often do so with a similar variety of rates. The SSTP would limit states to one sales tax rate per state, with the possibility of an exception (different rate) for food and drugs. Local jurisdictions would be allowed one local rate. Additionally, the SSTP would mandate that states and their local governments use a common tax base, and eliminate the widely imposed requirement that businesses file tax returns with local governments.

The coalition states working together are known as the Streamlined Sales Tax Implementing States (SSTIS). This group approved model legislation, the Streamlined Sales and Use Tax Agreement, on November 12, 2002. Ten states representing 20% of the population of sales tax states must conform for the agreement to come into effect (not clear whether states must actually be conforming in operation or just approve conforming). SSTP claims thirty-four states, and the District of Columbia, have approved the agreement and twenty have enacted some form of conforming legislation.

The next step is for the participating states would be to ask Congress for the permission to compel out-of-state vendors to collect sales and use taxes once the states have implemented the simplified system by approving the agreement and enacting conforming legislation. Successful implementation of the SSTP will rely largely on technology to simplify the administration of sales and use taxes. It envisions providing sellers (retailers) the opportunity to employ one of three technology models to ease and modernize administration.

Model 1 consists of a Certified Service Provider, paid for by the states, which performs all of the seller’s sales tax functions. Model 2 is a Certified Automated System which provides only the tax calculation function. The third option would be for the seller (typically a large nationwide retailer) to develop their own system and have it certified by the SSTP.


  1. U.S. Bureau of the Census, “State Government Tax Collections in 2009.”[1]
  2. U.S. Bureau of the Census, “State and Local Government Finances: 2001-02.”[2]
  3. Several states impose a duty on the in-state buyer to report the purchase from an out-of-state seller and remit the use tax.
  4. U.S. Const., amend. XIV § 1.
  5. U.S. Const., art. I §8, cl. 3.
  6. 386 U.S. 753 (1967).
  7. 504 U.S. 298 (1992).
  8. 386 U.S. 753 (1967). Generally, the Due Process Clause relates to the fairness of the tax burden and whether a business has minimum contacts with the taxing jurisdiction. The Commerce Clause is concerned with the effect of the tax on interstate commerce. Walter Hellerstein, "Supreme Court Says No State Use Tax Imposed on Mail-order Sellers . . . for Now," 77 J. Tax’n 120, 120 (Aug. 1992).
  9. 430 U.S. 274 (1977).
  10. Id. at 279.
  11. 504 U.S. 298, 312 (1992).
  12. Id. at 317.