The Internet Sales Tax Reveals Its Foolish Head Yet Again

They’re at it again: On Monday, the U.S. Senate voted 74-20 to proceed with debate on the “Marketplace Fairness Act.” The act would permit states to collect sales and use taxes from “remote” sellers, meaning sellers who have no nexus – no actual store or facility – in the taxing state except for the fact the purchaser of the goods or services lives in that state.

Bricks-and-mortar operations obviously like the idea, as do most state governments. Some Internet sellers are prepared to go along, provided state and local governments simplify and facilitate compliance with their nightmarishly complex tax regimes. There are nearly 10,000 U.S. taxing jurisdictions, all with their own tax rates, tax bases, tax holidays, etc. Other Internet sellers, such as eBay, oppose the Senate’s proposal, as do the states that have no sales tax.

The debate long predates the Internet – we had the same debate over catalogue sales. Good, bad and idiotic arguments on both sides have been rehearsed time and again. But the Senate’s impending consideration of the Marketplace Fairness Act provides occasion for a few reminders.

Many conventional tax experts favor tax “neutrality,” or the principle that taxes should avoid affecting firms’ and individuals’ economic decision-making. Under this principle, goods and services consumed in one state should be taxed at the same rate throughout that state, whether they’re purchased locally or ordered from sellers in other states. But if remote sales go untaxed, the destination state’s economy is distorted, as local buyers purchase goods and services from the remote sellers that offer the lowest prices.

Another popular tax concept is the “origin principle,“ whereby goods and services are taxed only once, in a single place: the seller’s home state. This would lead to fierce competition among jurisdictions to attract producers and downward pressure on sales taxes. I made the case for that principle a decade ago in an American Enterprise Institute book, “Sell Globally, Tax Locally”.

Our existing Internet sales tax regime honors neither tax neutrality nor the origin principle. This mix leaves no one happy. For example, out-of-state sellers are required to collect taxes only on sales to states in which they have a “nexus” (such as a warehouse). So states and merchants fight endlessly over what constitutes a sufficient “nexus,” and sellers configure their operations to avoid a nexus to high-tax states—as if some principle were at stake. There isn’t.

There is nothing wrong in principle with the neutrality argument, but it is really an argument for a uniform national sales tax, with a single rate and base: Collect the tax, send it to state and local governments where it belongs, and be done. But the United States has no uniform national sales tax. When the proposal was floated in the late 1990s by several members of Congress, state and local governments screamed bloody murder about losing tax sovereignty. So long as we live with state and local tax autonomy, neutrality is impossible. Any move in that direction—by means of destination taxation—will entail huge compliance costs.

We don’t follow a destination principle for in-state sales. Your local merchant won’t inquire about your home zip code—although the tax rate in your neighborhood may well differ from the store’s. No state wants in-state neutrality, because the compliance costs are too high. Imagine each supermarket or vending machine checking your driver’s license, or asking for your zip code, before giving you the total price. Why should we impose this burden on Internet retailers?

Even in interstate commerce, the Marketplace Fairness Act won’t result in neutrality. Delaware will remain a “tax-free” shopping haven for shoppers on buses from New York, New Jersey and Maryland. The Internet offers the same opportunity, at a lower cost, to folks who don’t happen to live near a “tax-free” state. If we make Internet sellers collect and remit the locally applicable tax, why shouldn’t we force shopping malls in Delaware to do likewise?

Finally, out-of-state Internet and catalogue sales already are subject to state and local taxation—typically, a “use tax” equal to the applicable sales tax. Residents of a state must pay this use tax on goods they buy remotely but consume at home. To be sure, few people pay use taxes, and states usually don’t bother to collect the tax from their own citizens. States would rather have sellers collect and remit the tax. Therefore, at the end of the day, this isn’t a tax problem; it is an enforcement problem.

The pro-tax states have attempted to expand their coalition by promising reduced compliance costs. Sophisticated computer software will be available, we are told, which will allow sellers to calculate, collect and remit the local tax cheaply and accurately. And when tax authorities from Bethesda, Md., suspect mistakes, they’ll show up at Gadgets ‘R’ Us in Montana and demand to audit the books. That does not sound like a sensible system.

I don’t mean to give state governments any ideas, but if we need snazzy computer programs anyhow, why not deploy technology to collect the tax from the people who actually owe it—the local citizens? Put the software online, and make taxpayers report and remit the use tax for all interstate purchases of, say, more than $100 (unless the seller already has collected the tax). The chore is inconvenient, but that is true of all tax reporting. And what price is too high for marketplace fairness?