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States Beg Congress to Regulate Their Tax Systems

States seem to think that pressing Washington to pass the Marketplace Fairness Act, which requires medium-to-large businesses selling online to collect sales taxes from all buyers, will help swell their coffers—perhaps $11 billion a year. But their efforts could lead to major unintended consequences: federal intrusion, if not control, over state tax systems.

If a consumer buys something in a brick-and-mortar store, that consumer will have to pay all applicable state and local sales taxes. However, if that same consumer buys the same product online from an out-of-state vendor, he may avoid the sales tax—if the vendor does not have a significant presence, such as an office or distribution center, in the purchaser’s state.

Actually, avoiding that tax is illegal because all states have a “use tax,” which requires residents to pay their state the sales tax they escaped by purchasing from an out-of-state vendor. Of course, very few people ever pay the use tax; indeed, most don’t even know it exists.

Brick-and-mortar businesses have complained about this situation for years, claiming—reasonably—that they are disadvantaged by having to add on sales tax, raising the effective price of their products.

The Marketplace Fairness Act proposes to address this inequity by requiring businesses with more than $1 million in revenues to collect the sales tax based on where the online purchaser lives and remit it to that buyer’s state. In essence, forcing businesses in one state to collect the use taxes owed in other states, when those business have no vote in electing the politicians who control those states and their tax systems.

But even though the Act requires states to give their businesses software that will calculate these transactions, it is still a daunting task to comply with some 9,600 separate state and local tax jurisdictions, especially since taxable products and services vary significantly from state to state.

The Act apparently has enough support to pass the U.S. Senate, though it may face a more uncertain future in the House.

What has largely been ignored in the debate is the federalism-shattering precedent being set: States are urging Washington to impose federal regulations on their tax regimes. Historically, Washington has stayed out of state tax policy; it’s one of the legacies of the federal system created under the U.S. Constitution.

By asking Congress to come to their rescue, states are opening the door to a lot more interference and intervention in the future. And we know this because it happened in health care.

For decades the federal government stayed out of the business of regulating state health insurance; it was a state prerogative, sanctioned by the McCarran-Ferguson Act of 1945.

That all changed with President Bill Clinton’s effort to fundamentally restructure the health insurance system in 1993-4. The Clinton plan failed, but it got federal lawmakers to thinking.

There were complaints about people losing their health insurance coverage when they changed jobs, and about those with a pre-existing medical condition being unable to get coverage, among other issues. And so Congress stepped in with the Health Insurance Portability and Accountability Act (HIPAA) of 1996. On addition, Congress began imposing mandates on certain health insurance coverage.

Since that 1996 intrusion, Congress has felt zero qualms about regulating state health insurance. Fourteen years later, we got ObamaCare.

The quest to get Congress to mandate the gathering of state sales taxes for online purchases might encourage a similar takeover.

The next step might be federal harmonization of all state sales taxes. As it stands, the Act requires state sales tax simplification, with one option being to join with 24 states that have signed a specific agreement. But what happens if trying to comply with the tax rules of 9,600 different jurisdictions still proves too difficult?

If business compliance proves unworkable, will the default be to petition the federal government to make all state sales taxes the same? What does that do to the four states that don’t currently impose any sales taxes? The law already supersedes those states’ tax regimes by forcing their businesses selling online to collect sales taxes they do not currently collect at a brick-and-mortar site.

Another step might focus on business income taxes. Let’s say the Missouri-based Widget Company made 10 percent of its online sales to residents of Illinois. Could chronically cash-strapped Illinois eventually turn to the feds and demand that Widget pay Illinois 10 percent of its business income tax obligation?

While tax simplification is a good idea, several states take great pride in their tax system. Some boast that they have no state income tax—including Texas, where I live—others tout no state sales tax. And others like to say they have balanced their state income and sales taxes to keep both low. Of course, states like California can’t claim any of the above.

And state tax systems are used by some states as a competitive advantage over other states. Having the federal government intervene by mandating nationwide online sales tax collection could be the first—or more accurately, the next—step in undermining our legacy of constitutional federalism.