Free Money Online!

States scrounge in the couch cushions for more revenue, and find the Internet


Unless you live in Alaska, Delaware, Montana, New Hampshire, or Oregon, if you regularly buy things online then you are probably a tax cheat. Technically speaking, if you buy something online and don't pay sales tax as part of the purchase, you are obliged to pay the tax yourself (unless you live in one of the five states with no sales tax). It's safe to say, however, that vanishingly few people tacked that extra form onto their state and local tax returns two weeks ago.

As state budgets start to feel a little too snug for comfort (lots more on bloated state budgets in our May print edition) states are scrounging around for the tax equivalent of free money. The lowest hanging fruit is money citizens are spending or earning outside the state, much of it currently untaxed.

And where better to turn than the largely untaxed wilds of the Internet? Music downloads have a special allure for the taxman, with Wisconsin, California, and several other states trying for an "iPod tax" to capture revenue from online music purchases. Wisconsin legislators even had the chutzpah to try to include the online sales tax in their so-called stimulus bill. But Wisconsin is also trying to extract taxes from businesses headquartered within their borders on money earned outside the state—they call it the Las Vegas loophole.

Superficially, capturing online sales tax money looks like win-win for a state. Taxing online purchases or out-of-state earnings seems like getting something for nothing—the state doesn't have to provide any additional services, since the relevant business is already happening outside the state. Plus, adding tax to online purchases eliminates some of the allure of buying online. If you're not going to avoid taxes when you buy that new TV, you might as well schlep out and buy it at a bricks-and-mortar store in your home state to save on shipping and enjoy the instant gratification of an in-person purchase. This keeps local businesses humming and the tax base strong.

But this is a classic case of stealing from Peter to pay Paul. Increasing taxes online will further slow consumption of online goods, which has already proven to be one of the more robust modes of business as the recession slows our economy. And if online tax collection becomes onerous, this will only encourage mobile online businesses, already only tenuously tied to U.S. soil, to finally make the decision to flee the country for lower tax, business-friendlier climes (which, according to today's Wall Street Journal, means pretty much everywhere.)

Right now, the biggest hurdle for new online taxes is a 1992 Supreme Court ruling which prohibited states from requiring mail-order (and thus online) retailers to collect sales tax. The reasoning goes like this: Since every state has its own convoluted tax code, the burden on businesses catering to many states is simply too high. The Court essentially told Congress that unless states standardize their tax laws, online and catalog retailers were off the sales tax hook.

Never ones to give up on the prospect of a new vein of tax revenue, though, the states formed a Streamlined Sales Tax Project. There are now 22 states involved, and after nearly a decade, they have just about managed to come to an agreement on which goods should be taxable. This is a tougher question than it originally appears. The quandary is known in tax streamlining circles (yes, there are such circles) as the "Twix dilemma." Is a Twix a cookie, and therefore food, and therefore not taxable? Or is it candy, and therefore a snack, and therefore potentially taxable? The states in the Streamlined Sales Tax Project may have managed to settle that particular age-old question. But a tougher problem lies ahead: What should the universal sales tax rate be?

Still, legislators can't resist the allure of what could be $13 billion in new revenue, so they're asking Congress to go ahead and loosen up the laws. They promise to work out that Court-mandated standardization stuff real soon, honest. "This could qualify as a son of stimulus," West Virginia state Del. John Doyle, (D-Jefferson County) told Congressional Quarterly. "This is something the federal government can do for the states that wouldn't cost the federal Treasury a penny." Doyle, unsurprisingly, heads up the streamlining project. On May 13, another big push will happen on the Hill, to beg Congress for a law that would authorize state sales tax collection online.

For every debate about relations between the states, there can be a macro version regarding the U.S. and its relationship with other nations. So, while states figure out how to extract tax money from businesses done on other states' territory, the United States is puzzling out how to grab cash from Americans earning abroad.

President Barack Obama is looking to force companies to "repatriate" more of the cash earned overseas, and to do it more quickly. Right now, companies have wide discretion about when to bring their earnings back to the U.S. and declare them for tax reasons, which means they can choose to do so whenever they will pay the least taxes. And if the money is "permanently reinvested" overseas, it is never gets taxed in the U.S. While this might sound reasonable, Obama sees it as a "loophole" that needs closing, just like those Wisconsin officials and their Los Vegas loophole. Like his state-level brethren, Obama is drawing the wrong lesson. Budgets are getting tight everywhere, but grabbing a little seemingly free money now could have bad long term consequences. Plus, everyone should know by now not to fall for those blinking "Win Free Money!" banner ads online. Those always end in heartbreak.

Katherine Mangu-Ward is an associate editor at Reason magazine.