A Smarter Way to Tax Internet Sales

by on April 25, 2011 · 7 comments

Consumers are buying more and more stuff from online retailers located out-of-state, and state and local governments aren’t happy about it. States argue that this trend has shrunk their brick and mortar sales tax base, causing them to lose out on tax revenues. (While consumers in most states are required by law to annually remit sales taxes for goods and services purchased out of state, few comply with this practically unenforceable rule).

CNET’s Declan McCullagh recently reported that a couple of U.S. Senators are pushing for a bill that would require many Internet retailers to collect sales taxes on behalf of states in which they have no “nexus” (physical presence).

In his latest Forbes.com column, “The Internet Tax Man Cometh,” Adam Thierer argues against this proposed legislation. He points out that while cutting spending should be the top priority of state governments, the dwindling brick and mortar tax base presents a legitimate public policy concern. However, Thierer suggests an alternative to “deputizing” Internet retailers as interstate sales tax collectors:

The best fix might be for states to clarify tax sourcing rules and implement an “origin-based” tax system. Traditional sales taxes are already imposed at the point of sale, or origin. If you buy a book in a Seattle bookstore, the local sales tax rate applies, regardless of where you “consume” it. Why not tax Net sales the same way? Under an origin-based sourcing rule, all sales would be sourced to the principal place of business for the seller and taxed accordingly.

Origin-based taxation is a superb idea, as my CEI colleague Jessica Melugin explained earlier this month in the San Jose Mercury News in an op-ed critiquing California’s proposed affiliate nexus tax:

An origin-based tax regime, based on the vendor’s principal place of business instead of the buyer’s location, will address the problems of the current system and avoid the drawbacks of California’s plan. This keeps politicians accountable to those they tax. Low-tax states will likely enjoy job creation as businesses locate there. An origin-based regime will free all retailers from the accounting burden of reporting to multiple jurisdictions. Buyers will vote with their wallets, “choosing” the tax rate when making decisions about where to shop online and will benefit from downward pressure on sales taxes. Finally, brick-and-mortar retailers would have the “even playing field” they seek.

Congress should exercise its authority over interstate commerce and produce legislation to fundamentally reform sales taxes to an origin-based regime. In the meantime, California legislators should resist the temptation to tax those beyond their borders. Might we suggest an awards show tax?

Origin-based sourcing is not without its detractors, but the arguments against it are weak. R. David L. Campbell, for instance, responds to Thierer’s Forbes.com column by claiming that origin-based taxation amounts to “taxation without representation,” because it would result in some consumers paying sales taxes despite having no say over the elected officials who established such taxes.

That’s true, but so what? Consumers who buy from retailers located out-of-state are already impacted by laws in those states all the time. For instance, DC residents cannot buy wine and have it shipped to them from any Pennsylvania-based retailer due to that state’s laws, even though the District of Columbia has fairly permissive laws regarding direct-to-consumer wine shipments from out-of-state.

Cconsumers who buy online also pay all sorts of indirect taxes. Consider that major electronics retailer Newegg.com, which is incorporated in California, paid $22m in state corporate income taxes in 2008. A big chunk of that $22m was passed on to out-of-state consumers who have no say over California tax rates. While most Newegg.com customers can’t vote in California, many of the firm’s thousands of employees can. The company is also better positioned than thousands of dispersed citizens to lobby state legislators for a favorable business climate.

Campbell also brings up the SSTP (Streamlined Sales Tax Project), an effort launched back in 2000 by a group states to establish a cooperative sales tax regime. While the project’s objective to “streamline” sales taxes is laudable in theory, it turns out — unsurprisingly — that getting dozens of state governments to get behind a simple, uniform, reciprocal sales tax regime is quite challenging in practice.

Joseph Henchman, the Tax Foundation’s Vice President of Legal & State Projects, discussed the project’s massive shortcomings in his 2009 testimony before the Maryland Legislature [emphasis in original]:

The SSTP already abandoned the notion of taxing like transactions alike when they adopted “destination sourcing” for online sales, but permitted states to adopt “origin sourcing” for intrastate sales. This in effect requires Internet companies to collect sales taxes based on where their customer is located, but allows brick-and-mortar stores to collect sales taxes based on where the store is located. In this way, the SSTP prevents a level playing field between Internet business and brick-and-mortar businesses.

Coupled with the SSTP’s non-worry about reducing the number of jurisdictions . . . full implementation of the SSTP at this time, without serious reforms, could result in a serious and inequitable burden on e-commerce. . . . The SSTP has not accomplished its mission. The SSTP should look again at serious simplification efforts before declaring themselves a success and seeking to expand state taxing power. . . . Neither the wholesale adoption nationwide of uniform sales tax statutes, nor the development of a working alternative that provides the certainty needed for long-term investment, are likely in the foreseeable future.

While the SSTP has made some progress in the last couple of years, it continues to encounter resistance from state governments, and sales taxes remain exceedingly complex.

Congress could address the issue in a far simpler manner by enacting legislation that provides for origin-based taxation. Dr. Michael S. Greve, the John G. Searle Scholar at the American Enterprise Institute (and the Chairman of the Competitive Enterprise Institute) wrote a superb study in 2003, Sell Globally, Tax Locally, in which he articulates the case for origin-based taxation in painstaking detail. Greve discusses the importance of tax competition and dismisses the “race to the bottom” argument on pages 26 to 28:

By rendering sellers indifferent to the local tax, destination-based taxation minimizes tax competition. Under an origin-based regime, in contrast, sellers in a low-tax jurisdiction enjoy a competitive advantage. States and countries will seek to attract firms by offering a low tax rate. As jurisdictions attempt to stem the flight of business firms into lowtax jurisdictions, sales taxes will spiral downward. If sellers are perfectly mobile and transaction costs (such as shipping cost) are negligible, the equilibrium tax rate—all else equal—is zero. This “race to the bottom” argument is the sum and substance of the case for destination-based taxation and the true reason why governments consistently and vociferously oppose origin-based taxation. But the argument is unpersuasive.

First of all, all else is not in fact equal. We would probably see the zero-tax equilibrium if sellers were entirely free to designate their home state, or to designate their place of incorporation as their home state. The principal-place-of-business rule, in contrast, disciplines the sellers’ choices. As already suggested, sales taxes are one element in a bundle of services and obligations that are offered by each jurisdiction. A jurisdiction that provides an educated labor force, an excellent infrastructure, a favorable regulatory environment, a sensible and efficient judicial system, or sufficient “quality of life” benefits may be able to exact a sales tax or its economic equivalent. . . . An unattractive jurisdiction that drives up the cost of doing business, meanwhile, will be unable to compensate those selfinflicted disadvantages by becoming a “sales tax haven.”

More fundamentally, one cannot assume that the downward pressure on tax competition necessarily translates into a race to the bottom. Under certain (heroic) assumptions, tax competition may compromise local governments’ ability to finance public goods; in that event, the race is to the bottom. But . . . it is equally plausible . . . to welcome tax competition as a much-needed discipline and countervailing force to local rent-seeking and interest group exploitation. Under these more realistic assumptions, tax competition reduces the “political residuum” that is available to local politicians for purposes of redistribution—without, at the same time, compromising local governments’ abilities to levy taxes, akin to user fees, to finance public goods.

It is true that destination-based systems also curtail some tax competition. The local tax mix, including the sales tax, will be a factor in the citizens’ (though not firms’) locational decisions. . . . In many cases, though, firms may be more responsive to changes in the local tax structure—and to advantageous changes in “foreign” jurisdictions—than are individual citizens. A 2-percent local sales tax hike may not induce an individual to move. . . . That same increase, though, may have a rather dramatic effect on firms’ locational decisions.

States compete for citizens and firms on any number of margins—environmental regulation, labor regulation, business and income taxes. All elements of the regulatory and tax environment operate as factors for local firms. Countless government decisions provide firms with competitive advantages or disadvantages and, at the margin, shape business decisions to locate in a given state or locality.


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