Closing the Net Tax Debate (Part 1): The Myth of the Level Playing Field

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In the wake of the recent terrorist attacks on the UnitedStates, domestic policy debates have understandably receded intothe background. Unity and bipartisanship are the order of the dayon Capitol Hill. The good feelings won't last forever, however, andso it's vital not to neglect domestic policy disputes that, thoughless visible, remain important. In other words, as we focus onAmerica's enemies abroad, advocates of limited government must bemore vigilant than ever here at home.

The debate over Internet taxation is a case in point. When theInternet Tax Freedom Act expires later this month, Congress willlikely feel compelled to do something. But as the nationteeters on the brink of armed conflict, and the economysimultaneously flirts with recession, it's crucial not to do thewrong thing. Proponents of taxing the Internet offer plenty ofreasons to do wrong. Concerned about the quality of public schools?You should support Internet taxes. Interested in economicefficiency? Two words: Internet taxes. Digital divide got you down?How 'bout them Internet taxes! Crime out of control in yourneighborhood? Rat infestation? War against terrorism? Thesolution-surprise!-is Internet taxes.

Of course, such shaky justifications don't carry much weightwith the general public or the business community, both of whichrightly suspect that politicians already have plenty of money tocarry on the legitimate functions of government. Consequently, thepro-taxers usually resort to the nuclear bomb of the Internet taxdebate: the "level playing field" argument.

The logic runs like this: when Joe Shopper walks into a localstore-one of those "old economy" edifices where they actually keepthings that people buy-a sales tax will be collected at the pointof sale. If, however, Mr. Shopper goes online, he can mail-orderthe same product from an out-of-state business that won't collectthe tax. Mr. Shopper is legally required to remit the moneyhimself, but given the near total lack of both education andenforcement on that front, he probably won't. The result is a defacto tax advantage for online shopping that, for expensivepurchases, may even outweigh shipping charges.

That's not an ideal state of affairs. All things being equal,there is no reason to purposefully favor out-of-state over localsellers, and so the tax advantage makes for bad policy. Economistsworry that such favoritism leads some consumers to make purchasesbased on tax savings rather than price-a loss of efficiency thatmay leave society poorer overall. Brick-and-mortar businesses arguethat the tax advantage is simply unfair.

Both groups have a point. In a perfect world, tax policy wouldbe absolutely neutral and, while we're musing about perfection, taxrates would only be high enough to fund essential governmentservices. But in the real world, of course, all thingsaren't equal.

First of all, the sales tax is not a neutral tax, so extendingit to remote sales won't necessarily lead to greater economicefficiency. Consider, for example, the fact that few sales taxes inthe United States cover services, even though service purchasesaccount for about 60 percent of consumer spending. In addition,states purposefully exempt items like food and clothing from thesales tax base. The result is a tax that arbitrarily favorsproducers of certain goods-and all services-over others. At best,extending that biased system to online purchases merely trades oneinefficiency for another. [See: "Closingthe Net Tax Debate (Part 2): Identifying the Real Sales TaxDrain," Cato TechKnowledge #23].

Second, the ability of consumers to shop online fosters healthytax competition among the states. Because sales taxes collect onlya few pennies at a time, it is difficult for taxpayers to know howmuch they have paid over the course of a year. Consequently, it iseasier for states to hike sales tax rates than alternatives such asincome or property taxes. When sales taxes were first introducedduring the Great Depression, rates were extremely low; today, theyaverage over six percent and run as high as ten percent.

While e-commerce is a minuscule component of consumer spending,its mere existence serves to inhibit excessive taxation.Politicians fear that if they raise tax rates too much, consumerscan take advantage of low tax rates elsewhere. Just like shoppersthat drive from high- to low-tax states, the Internet will inducestate and local governments to keep overall tax rates at a morereasonable level.

Third, requiring tax collection on mail-order sales wouldn'tjust flatten the playing field, it would tilt it in the otherdirection. Consider the fact that local businesses are forced tocollect sales taxes only for a single jurisdiction: the one wherethey are located. Local stores don't ask where their customers liveand then collect the tax for that jurisdiction. Thus, sales taxesare-rhetoric aside-actually based on where the seller, not thebuyer, resides.

To truly level the playing field, states should instructInternet-based businesses to collect the local sales tax regardlessof where their customers reside. Under that system, a Marylandresident who buys a shirt from a store in Virginia would pay theVirginia tax. The administrative costs would be low because allretailers would have only one tax to collect and one revenue agencyto deal with. And more importantly, the de facto tax advantage foronline sellers would vanish, while healthy tax competition amongthe states would be strengthened. (The latter, of course, is whystates immediately dismiss any origin-based proposal asunworkable.)

Finally, there are good non-economic reasons not to grant statesnew tax authority. Most obviously, out-of-state retailers don'tbenefit from government spending in the same way that localbusinesses do, and worse, they have no way to influence thepolitical process in distant jurisdictions. Forcible tax collectionfor distant governments is "taxation without representation," andis manifestly unfair.

The squabble over Internet taxes may seem irrelevant right now.Ultimately, however, such seemingly mundane domestic policyquestions deserve our attention. The United States will win the waron terrorism. That much is certain. What's less clear is theeconomic future of the nation we're fighting for. Granting statesnew authority to force tax collection beyond their borders is anassault on competition, fairness, and limited government.Distracted as we are, that battle is worth fighting.

Additional Reading:
"TaxBytes: A Primer on the Taxation of Electronic Commerce," byAaron Lukas, Cato Trade Policy Analysis No. 9, December 17,1999.