Is There A Fair Way to Do Internet Sales Tax?

The “Marketplace Fairness Act” is clearing hurdles in the Senate, and there’s a good chance it might pass next week. The bill finally brings sales tax to the Internet.

Thanks to a Supreme Court case involving mail-order catalogs in 1992, businesses do not have to charge sales tax to customers who live in other states. There are two “unfairnesses” of this status quo that supporters of the Marketplace Fairness Act hope to correct.

The Status Quo

The first is the tax code being tilted in favor of online businesses. Customers often check out goods in local stores and then buy them online with no sales tax; this “showrooming” is arguably unfair and unsustainable, like a variant of the free rider problem.

The second is the loss of state tax revenue when customers act on this tilted tax code; if a state is taxing goods to fund its budget, there’s no obvious reason why the method of purchase should allow people in the state to opt out. (Indeed, many states require customers to report their missing sales tax every year, but it’s an unenforceable provision many people don’t even know about.)

This Bill

This particular bill gets local governments their revenue, but it doesn’t so much “level the playing field” for businesses as tilt it the other way. The bill requires all online merchants above a threshold to charge each customer’s local sales tax rate and pay it to each local government – over 9,600 jurisdictions by some counts. The bill simplifies things by requiring each state to be a sort of middleman, providing software for determining rates and single points for tax filing. But I’m not convinced it will be that simple.

Tax rates can vary within zip codes due to TIFs or “tourist districts” or whatever other creative ways local municipalities come up with to extract revenue from their citizens or entice businesses to move in. This means you cannot simply fill a database table of zip codes and rates and update it once a quarter; I think you’re going to need to query the exact rate for every individual customer’s address. With fifty different systems, there’s a good chance one of them will be slow or down sometimes, hurting your ability to serve customers.

How is this a level playing field? Physical retailers do not have to take the address of every customer and compute each individual tax rate; they simply charge their location’s rate to everyone. Is it even right to subject businesses to local governments all over the country?

Many supporters assume technology will automate the tax rate calculation; maybe it will. But they often ignore the issue of filing those taxes, and we’re all reminded every April that the government hasn’t done much automating on that side. Megan McArdle notes that businesses may have to file taxes 40+ times every month. And the $1 million threshold does not exempt as many “small businesses” as supporters claim; that’s not a difficult level to reach in revenue for an online business with small enough profit margins that it’s hard to afford three extra accountants to do all this new tax filing.

A Third Way?

If neither the status quo nor the proposed solution is “fair,” what about a Third Way? Wouldn’t it be simpler and fairer to just have each online business charge its local rate to all customers, just like physical retailers?

Local governments would still lose revenue when their citizens bought iPods on eBay instead of at Walmart. Of course, another local government would be gaining revenue, and it might be a wash except that it might encourage more businesses to move to states with no sales tax, where we would still have the status quo.

In theory, this might encourage states to lower their sales taxes, but the status quo doesn’t seem to be encouraging that too much. Besides, states might only replace it with other taxes, and I’m not sure we want to strongly favor property taxes over consumption taxes. The current bill might encourage locales to raise sales taxes because they would have less competition with lower-tax locales farther away (though they would still be competing to keep their citizens).

Nothing Is Fair

Perhaps the issue is that large numbers of people are now easily able to purchase things across geographical lines, and this means there is no totally fair way to tax based on geographical lines! Somebody is going to be getting “special treatment” no matter what.

Either online businesses get the benefit of not charging sales tax to customers in other districts, or physical businesses get the benefit of not collecting different sales taxes for customers in other districts and paying those taxes to other districts. Either businesses suffer “taxation without representation,” or customers suffer “taxation without representation,” depending on a meaningless distinction about who “really” pays the tax. (I’m not sure if the bill affects catalog businesses, who represent a small enough share of the economy that they might still get away with sales-tax-less special treatment. Surely they wouldn’t get the anti-treatment of requiring customers to accurately calculate how much sales tax to include on their mailed checks!)

If there’s no way to eliminate special treatment, we could try to pick the unfair option that is the least unfair option. Supporters of the Marketplace Fairness Act may believe this bill to be that option, although I’m not convinced it is that easy to order them by fairness.

We could also try to pick the unfair option that is the least infringing on individual freedoms. This would clearly not be the Marketplace Fairness Act, which adds a myriad of accounting regulations to businesses and opens them up to potential auditing from outside jurisdictions.

Finally, we could try to pick the unfair option that creates the best economic incentives for growth or good government policy or whatever our biases prefer. Between the two least-infringing options, I think the Third Way is at least better than the status quo, as it forces jurisdictions to compete more for businesses to get their sales tax revenue. (Of course, maybe local governments would just create more complex webs of special-treatment tax credit schemes to lure businesses into their districts instead of lowering the sales tax rate for the whole zip code.) The Third Way would at least help with the level playing field and lost revenue problems without complicating life and freedoms for small businesses, and I think I like the simplicity of literally giving all businesses, physical and otherwise, the same taxing rules.

Ultimately there are no easy answers. I should also probably note that I’m biased against the bill because it would affect my work. But I do think the Third Way is superior to both the bill and the status quo, and I’m hoping it will be amended in that direction before becoming law. I have made my congressional representatives aware of this, and maybe you should too.