The Internet Tax Dodge

Henry J. Aaron
Henry J. Aaron The Bruce and Virginia MacLaury Chair, Senior Fellow Emeritus - Economic Studies

December 3, 1999

Suppose someone proposed the following retail sales tax: Customers who buy from a store with more than 10,000 square feet of floor space will pay a 5 percent tax, but customers who buy from a store with fewer than 10,000 square feet of floor space will pay no tax.
Yes, I know it’s a silly idea. But just to carry this absurdity a bit farther, assume that some state actually adopted the proposal. Then, sales in stores with fewer than 10,000 square feet grew more rapidly than did sales in larger stores. The organization representing small stores pointed to this fact and argued that they should remain tax-free because low taxes promote sales growth. No one would take them seriously, would he?

Well, it appears that Virginia Gov. James Gilmore and House Budget Committee Chairman John Kasich would—at least if you replaced “stores with fewer than 10,000 square feet” with “Internet commerce” and “stores with more than 10,000 square feet” with “ordinary retailers.” They claim that taxing Internet sales to consumers the same as ordinary retail sales would stifle Internet growth.

State sales taxes fall on goods sold by retailers in stores that you can walk into—but not on Internet sales. Partly because of this tax advantage, Internet sales are growing at double-digit rates. Mail-order sales enjoy a similar advantage, and they too are experiencing explosive growth. But potential Internet sales vastly exceed mail-order sales.

Both Internet and mail-order buyers are supposed to call their state tax authority, ask for a use-tax form and volunteer to pay tax on their purchases. Guess what—almost no one does. As a result, the sales tax base shrinks as Internet and mail-order sales increase.

Ordinarily, retailers in one state are not required to collect tax on sales made in other states. Few states bother to try to collect from sellers taxes that would have to be remitted to another jurisdiction. And state tax authorities lack information on goods purchased by residents through the mails or over the Internet. So each state, acting independently, looks the other way as these transactions cut into potential sales tax revenues.

One can understand why Internet and mail-order retailers would want to preserve this sweet deal. If you were a retailer and could make sure that your competitors had to pay a tax that you were spared, you might be tempted to invoke every imaginable argument to support this blatantly unfair practice. You might even claim—if you could manage to keep a straight face—that not taxing Internet sales promotes economic growth.

But it surpasses understanding why a governor, such as Gilmore, or a senior member of Congress, such as Kasich would endorse such claims. Govs. Michael Leavitt of Utah and Don Sundquist of Tennessee have both made clear that while they oppose taxes levied specifically on the Internet, they favor equitable taxation of retail sales from both ordinary stores and e-stores.

The same technology that makes Internet sales possible also enables taxation of those sales. Retail sales taxes are supposed to be levied in the jurisdiction where goods are used. Most Internet and mail-order sales are either delivered to or billed to identifiable Zip codes. It would be straightforward to write software identifying the tax rate applicable to each type of good or service in each Zip code. Internet and mail-order companies could be required to use the services of newly created firms licensed by the states to administer such software and to distribute revenues among the states. Leavitt and Sundquist have proposed a similar idea on a trial basis.

If it turned out that removing its unfair tax advantage killed Internet commerce, then the conclusion would be inescapable that e-commerce grew only because of taxes and could not prevail in a fair fight. But Internet commerce is flourishing not just because it enjoys tax advantages but also because it has other, more important, strengths: the convenience of permitting people to shop at home, the ease of comparison shopping and the real economies e-retailers can achieve through smaller inventories and smaller places of business.

Whatever its strengths, however, e-commerce has not eliminated the need for schools, fire departments, police forces, parks, libraries, health care and other government services, and for the revenue to pay for them. To maintain those revenues and to restore a genuinely level playing field for U.S. retailers, Congress and the states should cooperate to make sure that all retailers are treated fairly, whether they sell in shops or in cyberspace.