The Supreme Court Didn’t See E-Commerce Coming

But it now has a chance to fix a mistake that costs states billions in sales taxes.

You should be paying sales tax on this.

Photo illustration by Slate. Imaves via Cebas/iStock; Overstock.

The Supreme Court held 25 years ago that a state can collect sales tax only from a retailer that has a physical presence in the state. At the time, the justices did not anticipate that the explosive growth of e-commerce would lead to a dramatic rise in cross-state sales, and their decision has had a devastating effect on state finances in recent years. Fortunately, a new case will give the Supreme Court a chance to correct its quarter century–old error. It should seize the opportunity.

The 1992 case, Quill Corp. v. North Dakota, involved a mail-order vendor that sold office supplies to thousands of North Dakota customers but had no warehouses or employees in the state. Quill argued that North Dakota’s attempt to collect sales taxes from the vendor violated the Supreme Court’s dormant commerce clause doctrine, which prohibits states from taking certain actions that interfere with interstate activity. North Dakota responded that, in light of the rapid growth of the mail-order and telemarketing industries, a rule barring states from collecting sales taxes on remote transactions was ill-suited to the modern age.

The Supreme Court sided with the vendor and against the state. Writing for the majority, Justice John Paul Stevens said that taxing out-of-state businesses would “unduly burden interstate commerce.” He added that a “bright line” rule—under which states can collect sales taxes only from retailers with a “physical presence” in the states—“encourages settled expectations and, in doing so, fosters investment by businesses and individuals.”

Stevens and his colleagues could not, of course, have anticipated the developments that would soon shake up the retail sector far more than the mail-order business ever had. A few years after the Quill decision, Jeff Bezos founded Amazon, Pierre Omidyar started eBay, and the rest is retail history. As internet sales skyrocketed, the costs of the Quill decision surged as well. In 2012, according to the National Conference of State Legislatures, states lost more than $23 billion in uncollected taxes on transactions between their residents and out-of-state vendors. Consumers are legally obligated to pay so-called use taxes when sellers do not collect sales taxes, but another 2012 study found that use-tax compliance rates are below 2 percent.

The costs of Quill go beyond the impact on state finances. Quill also disrupts distribution channels. The physical presence rule perversely incentivizes retailers to locate their warehouses in different states from the bulk of their customers. Amazon, for example, avoided having any fulfillment centers in California for 17 years so that it could sell goods in the Golden State without charging sales taxes. While Amazon now collects sales taxes in all 50 states and D.C., other online retailers—such as Overstock and Wayfair—limit their distribution centers to a handful of states so that they can skirt tax authorities.

In this respect, the physical presence rule actually undermines the goals of the dormant commerce clause doctrine. According to the Supreme Court, the doctrine was designed to “avoid the tendencies toward economic Balkanization that plagued the … States under the Articles of Confederation.” The idea was that by prohibiting states from discriminating against cross-border business, the doctrine would promote the development of a truly national economy. Yet the physical presence rule does the opposite: It discourages retailers from expanding their operations into places where their physical presence would trigger sales tax obligations. Far from “foster[ing] investment,” as Stevens had hoped, the physical presence rule often deters firms from building new facilities and hiring workers in additional states.

A further goal of the dormant commerce clause doctrine is to ensure a level playing field between in-state and out-of-state businesses. Again, Quill undermines that objective. It puts businesses with brick-and-mortar presences at a competitive disadvantage vis-à-vis online-only outfits. If the Framers could have foreseen the internet, it is hard to imagine that they would have wanted this result.

There are two ways out of this mess. One is for Congress to act. Unlike in other areas of constitutional law, Congress can override the Supreme Court on dormant commerce clause issues. The doctrine is derived from the provision in Article I authorizing Congress to “regulate Commerce … among the several States.” The Supreme Court has understood those words to mean that states can interfere with interstate commerce if and only if Congress approves.

In 2013, the Senate passed a bipartisan bill that would have allowed states and localities to collect sales taxes from retailers with at least $1 million per year in out-of-state sales. The bill had backing not only from brick-and-mortar retailers such as Walmart but also from Amazon, which anticipated that it would soon have a physical presence across the 50 states. But House Judiciary Committee Chairman Bob Goodlatte blocked the bill from reaching his chamber’s floor. With Goodlatte, a Virginia Republican, still in charge of the judiciary panel, the prospects for legislative action in the near future remain rather dim.

The other way out is for the Supreme Court to self-correct. In 2015, Justice Anthony Kennedy, who sided with the majority in Quill, said in a concurring opinion that “[t]he legal system should find an appropriate case for this Court to reexamine” the 1992 decision. Now it has.

Last March, South Dakota passed a law requiring businesses to collect state sales taxes if they sell more than $100,000 of goods inside South Dakota annually, even if they have no physical presence in the state. South Dakota lawmakers knew that the state courts, which are bound to follow Quill, would strike down the statute, but they moved forward anyway with the intention of setting up a Supreme Court test case.

On Thursday, as expected, South Dakota’s highest court held that the state law violates Quill. State officials will now seek Supreme Court review. If the justices take up the case, their decision could come as early as next June. While the states have labored under Quill for far too many years, relief may arrive in a matter of months. Let’s hope that the justices finally fix their mistake.