Taxation Without Representation

Tax-hungry states go after out-of-state retailers.

Amazon.com wants to make a deal with the state of Texas: no sales tax collection during the next four and a half years in exchange for 5,000 jobs and a $300 million investment to open distribution centers where those employees would work. South Carolina recently accepted a similar, smaller offer from the online retailer.

California this June, meanwhile, effectively closed down Amazon's "Affiliates" program, which pays a commission to websites that link to Amazon in the state, by insisting the bookseller pay sales taxes on any transaction referred from a California-based website. The move followed similar actions in Arkansas and Connecticut.

These are just the most recent skirmishes in a decade-long battle between Amazon and officials in various states over taxing online purchases. Now some in Congress, notably Sens. Dick Durbin (D-Ill.) and Mike Enzi (R-Wyo.), want to give the whip hand to state tax collectors with the so-called Main Street Fairness Act. The bill would allow states to impose taxes on interstate commerce, something usually blocked by the Commerce Clause of the U.S. Constitution.

Many policy makers and journalists view the debate over Internet taxes in narrow terms. They believe the fight is about whether or not federal, state, or local legislators should "tax the Internet." Consequently, the war of words has focused on competing bumper-sticker slogans such as "Don't Tax the Net" and "Level the Tax Playing Field." But framing the debate that way understates the complexity—and importance—of the issue.

The no-taxes side largely ignores the fact that the Internet isn't really a tax-free zone. It is true that, thanks to the 1992 Supreme Court decision Quill v. North Dakota, states can collect sales tax on online purchases only if the retailer has a physical presence in that state. If a Virginia resident buys a book from Amazon, which is based in Washington state, he pays no sales tax. But if he buys the same book from store in Virginia, the transaction is taxed. Likewise, Amazon consumers living in Washington have to pay in-state taxes.

Furthermore, many state governments technically oblige their residents to remit a "use" tax on any goods they purchase out of state. A California resident who buys a computer in sales-tax-free Oregon, for instance, is expected to send the Golden State's Board of Equalization a check for an amount effectively equal to 7.25 percent (California's sales tax rate) of the computer's price. But such levies are extremely unpopular and seldom enforced, leaving Internet users with the impression that their online purchases are tax-free.

On the other side, the arguments offered by people who would like to extend the sales tax to interstate Internet purchases are rarely valid. States claim such taxes will help them cover their cumulative $130 billion budget deficits. Yet a 2010 study for NetChoice—a coalition of trade associations, eCommerce businesses, and online consumers—by Jeffrey Eisenach and Robert Litan of the economic consulting firm Empiris LLC found that "total potential uncollected sales tax revenues in 2008 were approximately $3.9 billion, or less than three-tenths of one percent of state and local tax revenues."

To close their budget gaps, states should go to the source of their fiscal problem: overspending. According to a 2010 working paper by Matt Mitchell, an economist at George Mason University's Mercatus Center, from 2000 to 2009 state and local spending grew at nearly twice the average annual rate as the private sector. Since these governments depend entirely on the private sector for their resources, this level of spending growth is not sustainable.

States also argue that since online shoppers already owe the tax though the use tax obligation, retailers need to be pushed to collect what consumers won't otherwise cough up. But a tax that can't be enforced is a bad tax. And the states' inability to force consumers to pay use taxes is hardly a good reason to impose the collection burden on out-of-state retailers. A 2006 PricewaterhouseCoopers study found that sales tax compliance costs for small retailers (that is, retailers with less than $1 million in sales) equaled almost 17 cents of every dollar they collected for states. Expanded tax collection obligations could increase that deadweight economic burden and discourage marketplace innovation and new entry.

To the extent that sales taxes pose a real problem of unequal treatment, it's a problem of the states' own making. There are approximately 7,500 U.S. tax jurisdictions, each with different rates, each with different definitions and exemptions, most with a sales tax and a few without. Are marshmallows and granola bars a "food" or a "candy"? If they are labeled "candy," they are taxed in some states; if classified as "food," they are not.

The Supreme Court cited this dizzying complexity when it ruled that retailers should not have to collect a jurisdiction's sales tax unless they have a physical presence in that jurisdiction. But states are hoping they will soon be able to circumvent that decision through a tax simplification scheme called the Streamlined Sales and Use Tax Agreement. Twenty-four states already have signed on to the agreement, which they hope will allow them to force out-of-state retailers to become tax collectors. The scheme would tax retailers who don't consume public services. Some states, such as California, would even have the power to tax consumers who reside in other states, thus infringing on state sovereignty. And as my Mercatus Center colleague Adam Thierer noted in an April article for Forbes, the so-called simplification is a 200-page document that doesn't simplify rates or tax bases in any significant way and leaves thousands of loopholes and complexities in place.

While waiting to see whether Congress will come to their rescue, several states, including Rhode Island, North Carolina, and Illinois, have moved to extend collection mandates through an "affiliate" tax on state-based businesses that refer customers to online companies and then collect a commission. Such taxes are known as an "Amazon tax," since the online retailing giant has been the main target. But their main consequence has been to drive online vendors to cancel those commission arrangements, costing the states jobs and tax revenue. Both Amazon and Overstock.com have cut all ties with their Illinois-based partners.

After exiting several states, Amazon is promising jobs and investment in exchange for a tax exemption in some states where it has a physical presence. Such special pleading is the inevitable result of being targeted by tax collectors who are not satisfied with revenue from businesses within their own jurisdiction. However, if Amazon succeeds the results would be the equivalent of corporate welfare: One company will get special tax treatment unavailable to others. That could create a vicious cycle where only large companies can get a tax-free status in exchange for promises of jobs.

There are better ways to level the playing field. One solution is for states to cut taxes on in-state vendors. Another option is an "origin-based" tax regime, under which states would exercise their right to tax equally all sales inside their borders, regardless of the buyer's residence or the ultimate location of consumption. Under that model, all sales would be "sourced" to the seller's principal place of business and taxed accordingly. This approach is already fairly common. A Washington, D.C., resident who buys a car across the Potomac in Virginia, for instance, is taxed at the origin of sale in Virginia regardless of whether he brings the car back into the District. Each day in America, there are millions of cross-border transactions that are taxed only at the origin of the sale; no questions are asked about where the good will be consumed. We should extend the same principle to cross-border sales involving mail order and the Internet. Such an approach would be good for retailers, good for consumers, and good for federalism.

Contributing Editor Veronique de Rugy ([e-mail]), a senior research fellow at the Mercatus Center at George Mason University, writes a monthly economics column for reason.