Browsing through an Internet Sales Tax: Policy Analysis

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Washington has been abuzz lately over discussion of an internet sales tax law, called the Market Place Fairness Act, which specifically gives states the ability to force out of state online retailers to collect sales tax from instate consumers. Because online sales are technically interstate commerce, the federal government must pass such a law to abdicate its enumerated power over interstate commerce over to state governments. The issue is especially relevant for political and policy reasons, because it is not a clear cut issue. Although Speaker Boehner and House Republican Leadership has decided to halt the progress of the bill, which has made it through the Senate, there are many Republicans that support the idea. The division in the Republican Party’s ranks parallels my own division over the issue, and it shows that there are deeper arguments for and against the policy. In the end, I believe a careful cost benefit analysis reveals that an internet sales tax only is a bad idea, but comprehensive tax reform is not.

Before delving further, I think it is essential to point out that the law gives power to the states to enforce online sales tax collection, but does not establish any new taxes. It also identifies the location of the transaction as first the address for delivery, then the customer’s known address, then the billing address, in that order. Due to varying state laws and state taxes, the effects of the law will be different on each state government individually, ranging from no effect for those states that have no sales tax, to a large effect for those states with high sales taxes.

The surface argument against an internet sales tax is composed mainly of the following statement: paying more taxes are bad because it means we have less money, an internet sales tax represents more taxation, therefore an internet sales tax is bad. Likewise, the surface argument for the internet sales tax is simplistic: sales taxes make prices artificially higher, only brick and mortar shops are forced to levy sales taxes, therefore online retailers receive an unfair price advantage over brick and mortar shops.

These two points are important when considering any policy, because tax neutrality is important, as is limiting the amount that residents are taxed. But they are just the tip of the iceberg. Perhaps the biggest missed line of argument is in regards to compliance and privacy. Because the law allows interstate enforcement of sales tax obligations, it means online businesses will need to stay compliant with a complex system of 50 separate state tax codes, and nearly 9000 other local codes. If they are forced to collect, they will need to send owed taxes through the collection systems of dozens of states, which means becoming familiar with several dozen times more forms and regulations than a brick and mortar store would possibly have to deal with. These transaction costs are essentially deadweight losses: resources spent on things that do not make anyone better off.

In order to carry out this law, there is also the implication that governments will need to set up databases to track out of state transactions. Such databases are yet another vulnerability point for identity theft and further government privacy invasion. Given the government track record with the NSA and the management of the Affordable Care Act Exchange websites, this is no small concern.

In addition, the fact that out of state internet sales are effectively tax free serves to restrain state officials from enacting punitive state tax rates. State officials cannot make brick and mortar stores collect ridiculous sales tax rates if they do not want residents to flock to online out of state retailers for their goods. Further, state legislatures are forced to compete with other states when it comes to income tax, as an out of state online retailer in a lower income tax state will have a competitive advantage over in state businesses, if instate income tax rates are high. The fact that current internet sales tax policy has positive externalities for taxpayers in other parts of the code is an excellent reason to further oppose the bill.

To end off this analysis, I think it is only fair to address several of the very legitimate concerns that this tax debate has brought up. One such concern is that tax codes should be fair. In that sense, I agree with many people who support the Marketplace Fairness Act: tax policy should attempt to be as fair as possible. But this should also take into account if the entity bearing the tax is using state services, like road systems, local police enforcement, etc. In the case of out of state online businesses, the answer is by and large a resounding no. Even if this is left aside, there is also an inherent problem with advocating only for internet sales tax changes.

If it is to be argued that  the playing field should be leveled between internet and brick and mortar stores, it must also be achieved in all realms of sales taxation. In most states with sales taxes, services, foods, and many other types of items are exempted, for one reason or another, and this is done purposefully. How can policymakers cry out for fairness, if service industries, like hair salons, nail parlors, car repair shops, and others do not get taxed? Many of these services compete with physical goods for people’s money, especially when it comes to leisure. And in all these cases, the government is effectively giving unfair advantage to one type of good over another.

This all goes back to my opinion that it is easier and less transparent to put exemptions into sales taxation than income taxation. It is one of the reasons why I think that an ideal code for any state would use a flat income tax system. Income tax systems, according to some simple microeconomic models, maximize the welfare of the individual the most for the same amount of revenue vis-à-vis a sales tax, because they allow the individual to fully choose how to change consumption to meet the lost income. But that is a story for a different time.

The bottom line is that the Marketplace Fairness Act destroys interstate tax competition, presents a privacy problem, and will result in large dead weight losses. All of these reasons present a more nuanced argument as to why the internet sales tax is misguided fiscal policy.

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