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 United States, domestic policy debates have understandably receded into the background. Unity and bipartisanship are the order of the day on Capitol Hill. The good feelings won’t last forever, however, and so it’s vital not to neglect domestic policy disputes that, though less visible, remain important. In other words, as we focus on America’s enemies abroad, advocates of limited government must be more vigilant than ever here at home.

The debate over Internet taxation is a case in point. When the Internet Tax Freedom Act expires later this month, Congress will likely feel compelled to do something. But as the nation teeters on the brink of armed conflict, and the economy simultaneously flirts with recession, it’s crucial not to do the wrong thing. Proponents of taxing the Internet offer plenty of reasons to do wrong. Concerned about the quality of public schools? You should support Internet taxes. Interested in economic efficiency? Two words: Internet taxes. Digital divide got you down? How ’bout them Internet taxes! Crime out of control in your neighborhood? Rat infestation? War against terrorism? The solution-surprise!-is Internet taxes.

Of course, such shaky justifications don’t carry much weight with the general public or the business community, both of which rightly suspect that politicians already have plenty of money to carry on the legitimate functions of government. Consequently, the pro‐​taxers usually resort to the nuclear bomb of the Internet tax debate: the “level playing field” argument.

The logic runs like this: when Joe Shopper walks into a local store‐​one of those “old economy” edifices where they actually keep things that people buy‐​a sales tax will be collected at the point of sale. If, however, Mr. Shopper goes online, he can mail‐​order the same product from an out‐​of‐​state business that won’t collect the tax. Mr. Shopper is legally required to remit the money himself, but given the near total lack of both education and enforcement on that front, he probably won’t. The result is a de facto tax advantage for online shopping that, for expensive purchases, 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 local sellers, and so the tax advantage makes for bad policy. Economists worry that such favoritism leads some consumers to make purchases based on tax savings rather than price‐​a loss of efficiency that may leave society poorer overall. Brick‐​and‐​mortar businesses argue that the tax advantage is simply unfair.

Both groups have a point. In a perfect world, tax policy would be absolutely neutral and, while we’re musing about perfection, tax rates would only be high enough to fund essential government services. But in the real world, of course, all things aren’t equal.

First of all, the sales tax is not a neutral tax, so extending it to remote sales won’t necessarily lead to greater economic efficiency. Consider, for example, the fact that few sales taxes in the United States cover services, even though service purchases account for about 60 percent of consumer spending. In addition, states purposefully exempt items like food and clothing from the sales tax base. The result is a tax that arbitrarily favors producers of certain goods‐​and all services‐​over others. At best, extending that biased system to online purchases merely trades one inefficiency for another. [See: “Closing the Net Tax Debate (Part 2): Identifying the Real Sales Tax Drain,Cato TechKnowledge #23].

Second, the ability of consumers to shop online fosters healthy tax competition among the states. Because sales taxes collect only a few pennies at a time, it is difficult for taxpayers to know how much they have paid over the course of a year. Consequently, it is easier for states to hike sales tax rates than alternatives such as income or property taxes. When sales taxes were first introduced during the Great Depression, rates were extremely low; today, they average 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, consumers can take advantage of low tax rates elsewhere. Just like shoppers that drive from high‐ to low‐​tax states, the Internet will induce state and local governments to keep overall tax rates at a more reasonable level.

Third, requiring tax collection on mail‐​order sales wouldn’t just flatten the playing field, it would tilt it in the other direction. Consider the fact that local businesses are forced to collect sales taxes only for a single jurisdiction: the one where they are located. Local stores don’t ask where their customers live and then collect the tax for that jurisdiction. Thus, sales taxes are‐​rhetoric aside‐​actually based on where the seller, not the buyer, resides.

To truly level the playing field, states should instruct Internet‐​based businesses to collect the local sales tax regardless of where their customers reside. Under that system, a Maryland resident who buys a shirt from a store in Virginia would pay the Virginia tax. The administrative costs would be low because all retailers would have only one tax to collect and one revenue agency to deal with. And more importantly, the de facto tax advantage for online sellers would vanish, while healthy tax competition among the states would be strengthened. (The latter, of course, is why states immediately dismiss any origin‐​based proposal as unworkable.)

Finally, there are good non‐​economic reasons not to grant states new tax authority. Most obviously, out‐​of‐​state retailers don’t benefit from government spending in the same way that local businesses do, and worse, they have no way to influence the political process in distant jurisdictions. Forcible tax collection for distant governments is “taxation without representation,” and is manifestly unfair.

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

Additional Reading:
Tax Bytes: A Primer on the Taxation of Electronic Commerce,” by Aaron Lukas, Cato Trade Policy Analysis No. 9, December 17, 1999.