The History of Internet Sales Taxes from 1789 to the ...

The History of Internet Sales Taxes from 1789 to the Present Day: South Dakota v. Wayfair

Joseph Bishop-Henchman*

On June 21, 2018, the U.S. Supreme Court ruled that South Dakota can require collection of its sales tax on sales to its residents by out-of-state internet retailers.1 The 5-4 decision overruled two earlier precedents, National Bellas Hess, Inc. v. Illinois Department of Revenue (1967) and Quill Corp. v. North Dakota (1992), which had both held that only businesses with a physical presence in a state can be required to collect that state's sales tax.2 The new rule, articulated in Wayfair, is that a state sales tax can be constitutionally collected so long as it does not discriminate against or place excessive burdens on those engaging in interstate commerce. South Dakota's law, with built-in protections for taxpayers and limitations on its authority, passed constitutional muster.

In one sense, the Wayfair case is unremarkable. Most observers had predicted the outcome as inevitable. The four dissenting justices did not bother to defend the old physical presence rule, writing that "Bellas Hess was wrongly decided, for many of the reasons given by the Court," disagreeing only that Congress should fix the problem

* Executive vice president and general counsel at the Tax Foundation. The Tax Foundation brief in support of neither party that Bishop-Henchman authored in Wayfair was cited twice by the Court. He has also testified to Congress seven times and to states dozens of times on these issues since 2010.

1 South Dakota v. Wayfair, Inc., 138 S. Ct. 2080 (2018). Technically, the tax being collected is the state's use tax, a tax imposed at an identical rate as the sales tax on any purchase by a resident where sales tax has not otherwise been collected. Every state with a sales tax has a use tax, and their nondiscriminatory imposition was upheld in Henneford v. Silas Mason Co., Inc., 300 U.S. 577 (1937). To avoid pedantry I refer to them simply as sales taxes.

2 See National Bellas Hess, Inc. v. Department of Revenue of Ill., 386 U.S. 753 (1967); Quill Corp. v. North Dakota, 504 U.S. 298 (1992).

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rather than the Court.3 News coverage was an almost whimsical oh-well-it-was-good-while-it-lasted-but-now-we-have-to-pay-tax-onthe-stuff-we-buy-online.4 The largest online retailer, , had collected sales taxes nationwide since 2014, and shortly after the decision, rival said it would do so as well.5 In the weeks after the decision, states began preparing laws identical to South Dakota's, with several announcing plans to return any additional revenue in the form of cuts to other taxes.

But in another sense, Wayfair is the most significant case of this Supreme Court term. E-commerce now represents 11 percent of all retail sales, growing by 15 percent each year. Forty amicus briefs were filed in the case, with groups normally allied on other issues finding themselves on opposing sides.6 The attorney line to attend oral arguments in the case was the second longest of the term, behind only Janus.7 The lineup of the justices was unusual: Justices Anthony

3 Wayfair, 138 S. Ct. at 2101 (Roberts, C.J., dissenting).

4 A somewhat-related law still remains in force: the Internet Tax Freedom Act (ITFA), a two-sentence bill passed by Congress as a temporary three-year measure in 1998, extended several times, and ultimately made permanent in 2016. ITFA bans new state or local taxes on internet access, and multiple or discriminatory taxes on internet commerce. Accordingly it expressly bans taxes that apply to internet sales but not offline sales.

5 See, e.g., James Brumley, For Most Online Retailers, the Online Sales Tax Decision Is Non-Story, Investor Place, Jun. 23, 2018, -retailers-online-sales-201634136.html; Corinne Ruff, Overstock to Collect Sales Tax Following SCOTUS Decision, Retail Dive, Jun. 26, 2018, /news/overstock-to-collect-sales-tax-following-scotus-decision/526547.

6 Briefs supporting South Dakota included ones submitted by scholars Alex Brill and Alan Viard of the American Enterprise Institute; the city of Little Rock, Arkansas; trade associations for wholesalers, retailers, and shopping centers; 41 states and D.C., including many Republican-controlled states; Senators Heidi Heitkamp (D-ND), Lamar Alexander (R-TN), Richard Durbin (D-IL), and Mike Enzi (R-WY); and 60 tax and law professors of all ideological stripes. Briefs supporting Wayfair included ones submitted by New Hampshire and Montana; trade associations for catalog mailers and auctioneers; Etsy; practitioner group Tax Executives Institute; the National Taxpayers Union; the Competitive Enterprise Institute; and the Cato Institute. The Tax Foundation filed a brief in support of neither party, asking the Court to uphold South Dakota's law but to provide guidance stating that particular features of that law meant it did not burden interstate commerce.

7 Discussion between the author and the marshal of the Court Apr. 17, 2018. Tax counsels for L.L. Bean win the most tenacious award, having slept out overnight in freezing cold (in their employer's gear) to be first in the public line (not counting paid linestanders). Non-lawyers who arrived after 5 a.m. did not get to see the oral argument.

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Kennedy, Clarence Thomas, Ruth Bader Ginsburg, Samuel Alito, and Neil Gorsuch making up the majority, and Chief Justice John Roberts and Justices Stephen Breyer, Sonia Sotomayor, and Elena Kagan dissenting. It ended up being Justice Kennedy's final majority opinion, and his influence was felt on the decision. More than just about a South Dakota law, the case involved weighty and long unsettled questions such as due process limitations on jurisdiction, the proper roles of Congress and the courts in enforcing limitations on state actions taxing or regulating interstate commerce, the standard by which the Supreme Court should overrule prior decisions, the thorny question of state regulations that impact producers in other states, and how (or whether) to tax activities that happen everywhere and nowhere in the cloud or on the internet.

Wayfair may prove to be the first case where the Supreme Court truly confronted the need to pair, on one hand, constitutional and legal systems that define protections and obligations based on physical presence within geographic lines, and on the other, economic activities that are increasingly borderless, instantaneous, and nonphysical. As with all good constitutional stories, it starts in 1789.

Halting a Trade War, 1789 Edition

On September 17, 1787, the draft Constitution was approved by the Constitutional Convention, and it ultimately took effect on March 4, 1789, following state ratifications. The Convention had originally been called to consider amendments to the Articles of Confederation, which had governed, or more accurately failed to govern, the country since 1781.

The biggest shortcomings of the national government under the Articles of Confederation were its inability to raise revenue except through requests to the states and its requirement that all legislation be approved unanimously by each state.8 "Attempted requisitions were regarded by the sovereign states as voluntary contributions or alms and were generally ignored. The payment of taxes came finally to be regarded as a romantically honorable act, or even as a sort of amiable and

8 See Jared Walczak, How Failed Tax Policy Led to the Constitutional Convention, Tax Foundation, Sept. 16, 2016, -constitutional-convention.

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quixotic manifestation of eccentricity."9 Attempts from 1783 through 1786 to enact federal taxes failed to achieve unanimous support, and the United States government quickly started going broke.

Another major shortcoming was that the Articles of Confederation neither prohibited trade wars between the states nor empowered the national government to stop them. States with ports taxed commerce bound for interior states, tariff wars proliferated, and the national economy was imperiled. New York imposed special entrance and clearance fees on all vessels heading to or from New Jersey or Connecticut. New Jersey retaliated by imposing a tax of 30 shillings a month on a lighthouse that New York City had purchased in Sandy Hook, New Jersey. Fisher Ames wrote, "The king of New York levied imposts upon New Jersey and Connecticut, and the nobles of Virginia bore with impatience their tributary dependence upon Baltimore and Philadelphia. Our discontents were fermenting into civil war."10 Writing in 1824, U.S. Supreme Court Justice William Johnson described these actions as "destructive to the harmony of the states, and fatal to their commercial interests abroad. This was the immediate cause that led to the forming of a convention."11

James Madison orchestrated the Annapolis Convention in 1786 to attempt to halt this trade war, but only five states showed up. He then became determined to fix the issue in what became the Constitution by empowering the national government to restrain state actions that harm interstate commerce:

[T]he desire of the commercial States to collect, in any form, an indirect revenue from their uncommercial neighbors, must appear not less impolitic than it is unfair; since it would stimulate the injured party, by resentment as well as interest, to resort to less convenient channels for their foreign trade. But the mild voice of reason, pleading the cause of an enlarged and permanent interest, is but too often drowned,

9 Randolph Paul, Taxation in the United States 5 (1954). 10 Allan Nevins, The American States During and After the Revolution, 1775?1789 at 555?57 (1927). 11 Gibbons v. Ogden, 22 U.S. 1, 224 (Johnson, J., concurring). One biographer of Chief Justice John Marshall believes that Johnson's opinion was written in large part by Marshall himself, going "even further than the Court's opinion and express[ing] what was almost certainly Marshall's own view of the federal government's [exclusive] power." Joel Richard Paul, Without Precedent: Chief Justice John Marshall and His Times 370 (2018).

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before public bodies as well as individuals, by the clamors of an impatient avidity for immediate and immoderate gain. The necessity of a superintending authority over the reciprocal trade of confederated States has been illustrated.12

The Constitution thus contains several restrictions on states' ability to tax or burden interstate activity. Justice Joseph Story, praising these provisions in his Commentaries in 1833, wrote that "there is . . . wisdom and policy in restraining the states themselves from the exercise of [taxation] injuriously to the interests of each other. A petty warfare of regulation is thus prevented, which would rouse resentments, and create dissensions, to the ruin of the harmony and amity of the states."13 The Import-Export Clause prohibits states from imposing taxes on imports beyond what is needed for inspection duties.14 The Tonnage Clause prohibits state charges on shipping freight.15 The Privileges and Immunities Clause protects the right of citizens to cross state lines in pursuit of an honest living.16 And then there's the Commerce Clause.

12 The Federalist No. 42 (James Madison). 13 Joseph Story, Commentaries on the Constitution 2 (1833), at ? 1013. 14 U.S. Const. art. I, ? 10, cl. 2 ("No State shall, without the Consent of the Congress, lay any Imposts or Duties on Imports or Exports, except what may be absolutely necessary for executing its inspection Laws: and the net Produce of all Duties and Imposts, laid by any State on Imports or Exports, shall be for the Use of the Treasury of the United States; and all such Laws shall be subject to the Revision and Controul of the Congress."). See, e.g., Michelin Corp. v. Wages, 423 U.S. 276, 286 (1976) (stating that the Import-Export Clause prohibits import taxes that "create special protective tariffs or particular preferences for certain domestic goods."). Justice Clarence Thomas, a critic of dormant commerce clause jurisprudence, nonetheless argues that taxes that discriminate against nonresidents should be invalidated by the courts under the Import-Export Clause. See Camps Newfound/Owatanna, Inc. v. Town of Harrison, 520 U.S. 564, 610 (1997) (Thomas, J., dissenting) ("That the expansion effected by today's decision finds some support in the morass of our negative Commerce Clause case law only serves to highlight the need to abandon that failed jurisprudence and to consider restoring the original Import-Export Clause check on discriminatory state taxation to what appears to be its proper role."). 15 U.S. Const. art. I, ? 10, cl. 3 ("No State shall, without the Consent of Congress, lay any Duty of Tonnage . . ."). 16 U.S. Const. art. IV, ? 2, cl. 1 ("The Citizens of each State shall be entitled to all Privileges and Immunities of Citizens in the several States."). See, e.g., United Bldg. & Constr. Trades v. Mayor of Camden, 465 U.S. 208, 219 (1984) (identifying "pursuit of a common calling" as a privilege of citizenship protected by the Constitution); Saenz v. Roe, 526 U.S. 489 (1999) (invalidating a law that did not restrict state travel per se but discouraged the crossing of state lines with a punitive and discriminatory law);

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The Other Commerce Clause: From Complete Bar to Complete Auto

Readers of the Cato Supreme Court Review are familiar with the Commerce Clause. Over the course of cases from McCullough to Schechter Poultry to Jones & Laughlin to Darby Lumber to Wickard to Lopez to Raich, the Supreme Court transformed Congress's power to "regulate commerce . . . among the several States" into a federal power to regulate even non-commerce within one state, if it affects or could potentially affect interstate markets. Much of what the federal government does, for good or for ill, is thanks to this broad reading of the Commerce Clause.

Forget all that, for this is about a different Commerce Clause, sometimes called the dormant Commerce Clause or the negative Commerce Clause. The dormant Commerce Clause is a restriction on state laws that discriminate against interstate commerce, which is inferred by the grant of the power to regulate interstate commerce to the federal government. The "dormant" term comes from Chief Justice Marshall's majority opinion in Gibbons v. Ogden, where he explained that because the power to regulate interstate commerce was exclusively federal, it "must be placed in the hands of agents or lie dormant."17 States can pass laws that affect or even regulate interstate commerce, but they are invalid if they discriminate against interstate commerce or excessively burden it.

Gibbons involved a stereotypical application of this doctrine. In 1808, New York granted a 30-year monopoly to Robert Livingston and Robert Fulton, giving them exclusive navigation rights for all boats for all bodies of water in New York state, including approaches to neighboring states. Aaron Ogden began a ferry service between Elizabethtown, New Jersey, and New York City with a license from this monopoly, doing business with Thomas Gibbons. The partnership went sour. Gibbons then obtained a federal license under a 1793 coastal trade law and began running a rival ferry on the same

id. at 511?12 (Rehnquist, J., dissenting) ("The right to travel clearly embraces the right to go from one place to another, and prohibits States from impeding the free passage of citizens); Erwin Chemerinsky, Constitutional Law 450 (2d ed. 2002) ("The vast majority of cases under the [Article IV] privileges and immunities clause involve states discriminating against out-of-staters with regard to their ability to earn a livelihood.").

17 Gibbons, 22 U.S. at 189. See also Willson v. Black Bird Creek Marsh Co., 27 U.S. 245, 252 (1829) (describing "the power to regulate commerce in its dormant state").

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route, captained by Cornelius Vanderbilt. Ogden sued to enforce the monopoly, and New York state courts enjoined Gibbons from operating his ferry. In the U.S. Supreme Court, Gibbons's lawyer, Daniel Webster, argued that Congress had sole power of interstate commerce and the New York monopoly was void there.

The Supreme Court ruled in favor of Gibbons, finding that the ferry was interstate commerce and that the license granted under the federal 1793 law pre-empted any state license. That Congress had not specifically acted in this instance was to no avail; the Commerce Clause, the Court said, was written "to regulate commerce; to rescue it from the embarrassing and destructive consequences, resulting from the legislation of so many different States, and to place it under the protection of a uniform law."18 That Congress did not act did not mean that states could.

So strong was the concern over states' misuse of their power, that the rule for a century and a half was that states could not tax interstate commerce at all. Unimportant and noncontroversial U.S. Supreme Court opinions contained language that would be shocking to us today, such as "[a] State is . . . precluded from taking any action which may fairly be deemed to have the effect of impeding the free flow of trade between States" or "[n]o State has the right to lay a tax on interstate commerce in any form."19

This complete bar eroded as the rise of multistate corporations created concern that an out-of-state company could "exploit" instate markets without paying taxes to support in-state government services. The rule also became untenable as more and more economic activity became interstate. Few people today never buy or sell anything from someone in another state. These economic changes, together with the Supreme Court's defining the constitutional term "commerce among the several States" to encompass nearly all economic activity, and a federal government that has taken on many new areas of action and regulation, have led to a greatly expanded scope for the federal government and a narrowed exclusive scope for the states. A complete ban on taxation of anyone engaged in interstate commerce would greatly hobble state taxation.

18 Gibbons, 22 U.S. at 11 (emphasis in original). 19 Freeman v. Hewitt, 329 U.S. 249, 252-53 (1946); Leloup v. Port of Mobile, 127 U.S. 640, 648 (1888).

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That something had to change became apparent in the 1950s, when the Court treated economically identical taxes differently based on "magic words" in the statute. The Court invalidated a license tax imposed on the in-state gross receipts of an out-of-state company, but upheld a franchise tax on an out-of-state company's "going concern value," measured by in-state gross receipts.20 Justices and scholars became dissatisfied with a legal test that simply rewarded draftsmanship while missing the important question: "whether the challenged tax produced results forbidden by the commerce clause."21

Consequently, the Court abandoned its formal rule in the Complete Auto case of 1977, instead ruling that states may tax interstate commerce if the tax meets a four-part test: nexus, fair apportionment, nondiscrimination, and fairly related.22

Substantial Nexus

Substantial nexus is a sufficient connection between the state and the taxpayer. We'll come back to it.

Fair Apportionment

Fair apportionment means that the state cannot tax beyond its fair share of interstate commerce. It is determined by internal consistency: if every jurisdiction had the same tax, would it result in more than 100 percent of the business's income being subject to tax?23

What percent of a company's income can one state subject to its taxation? If all states can tax 100 percent of a company's income, that would lead to double taxation. Before the 20th century, most corporations were chartered by one state and therefore did not legally exist in other states. The rise of multistate corporations, and state corporate income taxes, gave rise to the need to apportion income among several states.

20 See Complete Auto Transit, Inc. v. Brady, 430 U.S. 274, 284 (1977) (comparing Ry. Express Agency v. Virginia, 347 U.S. 359 (1954) (Railway Express I) and Ry. Express Agency v. Virginia, 358 U.S. 434 (1959) (Railway Express II)).

21 Id. at 285. 22 Id. at 279. 23 See Container Corp. v. Franchise Tax Bd., 463 U.S. 159, 169 (1983) (applying the internal consistency test).

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