Economic Nexus: Solving the Online Tax Dodge

By Tom Yamachika, President, Tax Foundation Hawaii

Recently there has been some confusion about a bill now in our legislature, SB 620, that would redefine how our general excise tax laws define “doing business.”

The bill concerns a U.S. Constitutional concept called “substantial nexus.” Some amount of connection between a potential taxpayer and a State is needed before the State has power to impose that tax. The Supreme Court held in Quill Corp v. North Dakota, 504 U.S. 298 (1992), that some physical presence is needed before substantial nexus can be found. Thus, online retailers such as Overstock, Land’s End, and Amazon made a good business of selling into states without withholding and paying those states’ sales taxes. This was all legal, they claimed, because they have no physical presence in those states.

Now, in Hawaii and in states that have sales taxes, the law says that if a person imports something from a retailer who doesn’t have to pay sales tax, then that person, the customer, becomes liable for the same amount of money. It’s called “Use Tax.” The purpose of Use Tax laws is to protect local businesses who must pay over state tax when they sell the same or similar products. If no tax is paid, the online retailer has a competitive advantage. Problem is, most consumers either aren’t aware of or don’t pay Use Tax, and although the Department of Taxation can and does force businesses to pay this tax, the Department hasn’t had the time or resources to beat up on ordinary consumers with a few online purchases. Thus, lots of tax goes uncollected – for Hawaii, one study by the University of Tennessee estimated the uncollected amount at $120 million just for the year 2012.

So, you might ask, what could SB 620 possibly do? Obviously, it is not changing the U.S. Constitution. SB 620 basically tells businesses, “If you make at least $100,000 in sales into our state, we don’t care if you have physical presence or not. We’re going to go after you to collect our tax on this business activity.” Will the Supreme Court stick to its physical presence rule and say that a business that is making zillions of dollars in sales into a state has no “substantial nexus” just because it has no boots on the ground?

Hawaii is not the only State to consider this type of legislation, which is sometimes called “economic nexus” or “factor presence nexus.” Others have passed it or are considering it. The Multistate Tax Commission, a nationwide network of State tax agencies, has an active “Sales & Use Tax Nexus Model Statute Project” that recommends that States adopt legislation with, among other things, economic nexus components. The legislation effectively raises the ante on the online retailers, who can look forward to court battles to invalidate the laws and huge tax bills if they lose. Some of the retailers are starting to knuckle under. Amazon recently announced that it reached agreement with our State to get a GET license and pay tax over to our State effective April 1, 2017. A January 2016 study estimated that Amazon by itself sold $255.6 million worth of retail goods statewide, avoiding $11.1 million in tax in 2015. With Amazon now collecting and paying, a good part of that $11.1 million will now come in the door every year.

If you buy from Amazon after April 1, you will, no doubt, see another line on the bill passing on the Hawaii tax. But don’t scowl at it too much. If you bought the same merchandise from any local business, you probably will see the same line. Which means that Amazon and businesses like it now need to compete the old-fashioned way – on price, selection, and quality, and not based on legally due but uncollected tax.

Moreover, that $11.1 million is only the tip of the iceberg. Another $110 million is potentially out there waiting to be collected. If we can collect more of the taxes that are due but unpaid, our government won’t have to squeeze law-abiding citizens even more to close the funding gap.