On May 5, 2018, the Iowa Legislature passed Senate File 2417.  It is the most significant Iowa income tax cut bill in recent memory and substantially lowers individual Iowa income tax rates.  It conforms to many provisions of the federal Tax Cuts and Jobs Act of 2017.  Iowa Governor Kim Reynolds has praised the bill and is expected to sign it.

Cutting taxes and balancing the budget

The question before the legislators this year was how to pay for tax cuts and still balance the state budget.  Although the federal government routinely goes into debt and has creative methods of balancing a budget (just print more money!), states don’t always have such luxuries - the legislators must find a way to balance income and expenditures. 

With incoming revenue already not meeting expectations, Iowa’s conservatively controlled legislature faced a challenge of how to reduce taxes when the costs of running the state were only increasing. They certainly did not want to borrow money to finance tax cuts.

Backloaded tax cuts

The legislative solution has two parts.  First, many of the tax cuts are backloaded to 2023, subject to certain income thresholds. In order to take effect, the state must collect $7.97 billion in revenues in 2021 and $8.3 billion in revenues in 2022. For comparison, the state collected about $7.1 billion in fiscal year 2017. 

Iowa e-commerce tax

Second, in true Russell B. Long form, the legislature elected to increase taxes upon neither you, nor me, but the guy behind the tree.  Senate File 2417 will tax the sale in Iowa of “specified digital products.” These products include, “electronically transferred digital audio-visual works, digital audio works, digital books, or other digital products.”  Iowa will now tax the internet effective January 1, 2019.

Despite this new law, as of this writing, in many cases, it is illegal for a state to tax internet sales.  To impose sales tax, current federal law requires a non-resident seller to have a substantial physical nexus within the state, which is not the case for many of your favorite digital products vendors, including Hulu, Netflix, and Spotify, among others.

The Quill interpretation of the Commerce Clause

In 1992, the U.S. Supreme Court settled on this interpretation in the case, Quill v. North Dakota.  In Quill, an office supply company sold computer software into North Dakota by use of catalogs and periodical advertisements.  Quill had no physical presence in North Dakota and filled orders by shipping from out-of-state.  North Dakota attempted to tax the sales. The Supreme Court found that the Commerce Clause of the US Constitution prohibited the imposition of sales tax, because of Quill’s lack of a physical presence in North Dakota.  It would take an act of Congress for North Dakota to collect sales tax from nonresident sellers.

However, time marches on and internet sales have become big business in the multi-state economy and many states are looking for their piece of the pie. With no income tax, South Dakota is aggressive in its search for sales tax revenue.  The state passed a bill in 2017 requiring companies to collect sales tax on purchases made online by South Dakotans. When it would not comply with the new law, the state sued Wayfair, a Massachusetts based retailer selling home furnishings and decorations into South Dakota and elsewhere through e-commerce. The Supreme Court took up the case on appeal and in April 2018, the justices heard oral arguments in South Dakota v. Wayfair, Inc.

The Supreme Court is expected to release its Wayfair decision in June. Some Supreme Court handicappers are guessing that Quill will die.  Others are saying that the Court will not overturn Quill, thereby encouraging Congress to act. 

What does a South Dakota law have to do with Iowa?

The Iowa legislature is betting on its ability to increase state tax receipts with the imposition of sales tax on e-commerce - the tax cuts (and a balanced budget) largely depend on it. If the Supreme Court does not allow South Dakota to tax Wayfair, then Iowa is going to have trouble meeting its revenue targets in 2022 and 2023, unless Congress steps in to legislatively repeal Quill. Congress has not done this during the twenty-six intervening years.  We are watching the Supreme Court decisions, because if Iowa cannot tax the internet, then Iowa residents may not get our income tax cuts.   Alternatively, non-resident internet retailers will face a new Iowa tax burden, and Iowa retailers likely will face new sales tax compliance requirements in every other state.