But those tax breaks are starting to erode. With the U.S. recession pummeling states' budgets, their governments increasingly want to fill the gaps by collecting taxes on Internet sales, which are growing even as the economy shudders.
And that is sparking conflict with companies that do business online only and have enjoyed being able to offer sales-tax free shopping.
One of the most aggressive states, New York, is being sued by Amazon.com Inc. over a new requirement that online companies must collect taxes on shipments to New York residents, even if the companies are located elsewhere. New York's governor also wants to tax "Taxman" covers and other songs downloaded from Internet services like iTunes.
The amount of money at stake nationwide is unclear; online sales were expected to make up about 8 percent of all retail sales in 2008 and total $204 billion, according to Forrester Research. This is up from $175 billion in 2007.
Based on that 2008 figure, Forrester analyst Sucharita Mulpuru says her rough estimate is that if Web retailers had to collect taxes on all sales to consumers, it could generate $3 billion in new revenue for governments.
It's unclear how much more could come as well from unpaid sales taxes on Internet transactions between businesses. But even with both kinds of taxes available, state budgets would need more help. The Center on Budget and Policy Priorities estimates that the states' budget gaps in the current fiscal year will total $89 billion.
Collecting online sales taxes is not as simple as it might sound. A nationwide Internet business faces thousands of tax-collecting jurisdictions — states, counties and cities — and tangled rules about how various products are taxed.
And a 1992 U.S. Supreme Court ruling said that states can't force businesses to collect sales taxes unless the businesses have operations in that state. The court also said Congress could lift the ban, which remains in place — for now.
As a result, generally only businesses with a "physical presence" in a state — such as a store or office building — collect sales tax on products sent to buyers in the same state. For instance, a Californian buying something from Barnes & Noble Inc.'s Web site pays sales tax because the bookseller has stores in the Golden State. Buying the same thing directly from Amazon would not ring up sales tax.
That doesn't mean products purchased online from out-of-state companies are necessarily tax-free. Consumers are usually supposed to self-report taxes on these items. This is called a use tax, but not surprisingly, it tends to go unreported.
In hopes of unraveling the complex tax rules — and bringing states more money — 22 states and many brick-and-mortar retailers support the efforts of a group called the Streamlined Sales Tax Governing Board. The group is getting states to simplify and make uniform their numerous tax rates and rules, in exchange for a crack at taxing online sales.
Among other things, participating states need to change how they define things such as "food" and "clothing." For example, one state might now consider a T-shirt clothing and tax it as such, while another might consider it a sporting good and tax it differently.
In response, more than 1,100 retailers have registered with the streamlining group and are collecting sales taxes on items shipped to states that are part of the agreement — even if they are not legally obligated to.
The streamlining board also is lobbying Congress to let the participating states do what the Supreme Court ruling banned: They could force businesses to collect taxes on sales made to in-state customers, even if the businesses don't have a physical presence there.
New Jersey, Michigan and North Carolina are among the largest of the 19 states that have adjusted their tax laws to fully comply with the group's streamlined setup. Washington was the only state to join in 2008, but three more states are close to becoming full members of the group. And Scott Peterson, the group's executive director, expects another seven states — including Texas, Florida and Illinois — to introduce legislation in January that would make them eligible to join.
Undoing the patchwork can be difficult, even if the weak economy increases states' motivation to go after online sales taxes. Similar bills have been introduced in several states and failed, sometimes because of the cost of changing tax laws. New York, for example, decided against joining the streamlining board because it would require extensive revisions to its tax rules.
Besides various states and retailers such as Wal-Mart Stores Inc., Borders Group Inc. and J.C. Penney Co., the National Retail Federation, the industry's biggest trade group, also supports the Streamlined Sales Tax group.
Companies that handle Web sales only have organized as well. NetChoice, whose members include eBay Inc. and online discount retailer Overstock.com Inc., supports the states' tax simplification efforts, but its executive director, Steve DelBianco, says online retailers should have to collect taxes only in states where they have a physical presence.
But what if the meaning of "physical presence" is changed? New York essentially did that in April when its budget included a provision requiring online retailers like Amazon to collect taxes on purchases made by New Yorkers.
The new rule requires retailers to collect sales tax if they solicit business in New York by paying anyone within the state for leading customers to them. Since some Web site operators within New York are compensated for posting ads that link to sites like Amazon, the online retailers would have to collect taxes.
Matt Anderson, spokesman for the New York State Division of the Budget, said the state expects to reap $23 million during the current fiscal year, which ends March 31, from newly collected online sales taxes.
That's a sliver of the overall state budget for the same period, which is $119.7 billion. The state faces a revenue gap of $1.7 billion.
Yet Anderson said the state wants "to level the playing field and end the "unfair competitive advantage" Web-only companies have over brick-and-mortar stores that can't avoid collecting sales taxes.
Amazon complies, and collects sales taxes on shipments to New York. However, Amazon is still fighting the rule. It sued New York in April, alleging its provision is unconstitutional. Amazon also said it is being specifically targeted by the law. The case is pending.
Amazon declined further comment.
Salt Lake City-based Overstock is also suing New York over the law. Unlike Amazon, Overstock is not collecting sales tax in New York, because it ended agreements with about 3,400 affiliates in the state that were being paid for directing traffic to Overstock.com.
The Streamlined Sales Tax group hopes Congress takes up its uniform-tax idea in 2009. Peterson thinks the dismal economy boosts the chances of passage.
But Congress also will be occupied with economic stimulus plans involving bigger pools of money. And Mulpuru, the Forrester Research analyst, notes that for years there has been talk of taxing online retailers.
"It's a legal morass," she said. "In a best-case scenario, it's going to take a while to sort everything out."
