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Federalism.com

by Ramesh Ponnuru

An Internet sales tax should foster competition among states

The debate over Internet sales taxes, when all distractions are stripped away, isn’t about the Internet or taxes. It is about federalism. Confusion over what federalism means explains the conservative division the debate has created.

The immediate question is whether to support or oppose a bill to make it easier for states to tax sales made over the Internet. A lot of conservatives just need to hear the word “tax” to know they’re against it. Others say that fairness and federalism both counsel in favor of letting states tax Internet sales the same way they tax sales in stores. Many conservative economists who support the bill add that taxing Internet sales would make the economy more efficient.

Those economists, and the other proponents of the Internet-tax bill, are not wrong about fairness or efficiency. They’re wrong about federalism, though, and that’s enough to invalidate their case.

State governments, in theory, already tax sales over the Internet. In most places, people who buy products online are supposed to pay their state’s sales taxes. Very few people do so, though, unless the online seller collects the taxes and sends them to the state government where the buyer lives. Many people don’t even know they’re supposed to pay a tax.

The Supreme Court has held that a state may not force a company to collect and remit the sales taxes unless it has a physical presence in the state. So products sold in stores are taxed while products sold online typically aren’t. That’s the unfairness that brick-and-mortar stores complain about. It’s also the inefficiency that bothers the economists: It gives people a reason to favor online sellers even if they don’t supply the best product at the lowest pre-tax price. State governments bemoan the lost revenue from untaxed online sales.

The Court’s rulings leave the door open to congressional action that gives the states the power to collect taxes from out-of-state sellers, and the Senate has passed a bill to do just that by a wide margin. Many senators in both parties argue that the bill gets rid of an unfair tax break and, by giving the states more authority, promotes federalism.

The case for tax neutrality — for a level playing field between online and offline sales — was strong enough to persuade no less a foe of statism than William F. Buckley Jr. that Internet purchases should be taxed. Supporters of the bill have regularly reminded conservatives of the fact.

It is, however, impossible to have fully fair or neutral sales taxes so long as states are independent of one another. Under the bill, a Massachusetts resident who buys a TV online will pay Massachusetts sales taxes. If he goes over the border to New Hampshire, which lacks a sales tax, and brings his TV home, he won’t. So taxes will give him an artificial reason to buy from the brick-and-mortar store.

Online retailers have complained about the compliance costs entailed in making them figure out what taxes their customers owe to their home jurisdictions. One way the bill addresses that concern is by exempting all companies with revenues under $1 million annually. That concession, however, introduces another distortion: Tax collection will favor small companies over large.

There is an alternative way to level the playing field between online and offline sales, but it has not received much attention in the debate over the bill. The Internet sales tax being proposed is “destination based”: The state where the customer lives and uses the product is the one that levies the tax. The tax on Internet sales, and on sales generally, could instead be “origin based”: The tax could, that is, be paid to the state where the seller is located.

Nothing would change under this regime for a brick-and-mortar store: The store would continue to pay the sales-tax rate of the place in which it is located, and it would continue not to matter what state the customer came from. Online sellers would have to pay the tax based on where they or their warehouses are located, also with no regard to where the customer lives.

Both the origin-based and the destination-based sales-tax regimes would be neutral between online and offline sales, but the origin-based regime would have two advantages. Its enforcement costs would be much lower: It would not make every online retailer charge all of the different sales-tax rates that apply throughout the country. And it would generate competitive pressure on state governments to keep sales taxes low.

Offline sales taxes already involve some competition among states. Massachusetts cannot hike its sales taxes too much without people in the area making more of their purchases elsewhere, and without companies making location decisions accordingly. Destination-based taxation of the Internet would largely eliminate such competition in online commerce: The only way to escape a state’s tax, however onerous, would be for the customer to move.

To escape an origin-based tax, he would merely have to buy from a supplier located in a low-sales-tax state — and online sellers would, all else equal, want to be located there. Because all else isn’t ever equal, sales-tax rates would not converge to zero. It stands to reason that they would nonetheless be lower than they would in the absence of the relatively robust competition of an origin-based system.

This advantage of an origin-based system is, for state governments, a disadvantage: It constrains their ability to raise revenue. That’s why there is no organized campaign for origin-based sales taxes as a way of fixing the distortion caused by states’ not collecting taxes on Internet purchases.

There is yet another alternative open to the states, though, if they want the additional revenue and want to do right by offline sellers. The state governments could make out-of-state companies tell them what their residents are buying as a condition of letting them ship products into the state, and then bill the residents for sales taxes due. (They could set up a system that allowed the residents to be billed while protecting their privacy by, for example, not itemizing their purchases.) From an economic point of view, taxing sales this way would be almost identical to making out-of-state sellers collect and remit the taxes.

This alternative is a non-starter because state governments would not be interested in directly billing customers. The political costs would be too great. In-state customers, who vote on who runs the state governments, would rebel. The federal legislation the state governments want lets them get the money without incurring that political cost, by forcing out-of-state sellers to be the collectors. By leaving that cost in place, the current rule (that states can’t make out-of-state sellers pay taxes) imposes a constraint on the rapacity of the states. The merits of the federal legislation under consideration stand or fall on the proposition that eliminating that political inconvenience for the state governments is in the national interest.

The Supreme Court’s rulings about the limits of state governments’ authority to collect taxes — that it runs no farther than their borders — track with the Founders’ deep concern about those governments’ exploitation of interstate commerce. The states prefer destination-based taxes to origin-based taxes largely because the former let them get a piece of transactions involving out-of-state sellers and the latter confine the enforcement costs of their tax regimes to their residents. That Congress has the power to accommodate this preference does not mean it should exercise it.

Ideally, Congress would set a national standard of origin-based sales taxes. That’s politically impossible for a different reason than aggressive state enforcement against customers: The state governments don’t want to live with that degree of tax competition. The second-best solution is the status quo, in which states have the power to make companies collect sales taxes only if they are within the states’ jurisdiction. That arrangement leaves more space for competition among governments, and any unfairness is a result of the state governments’ own political decisions.

To see what’s wrong with the Internet-sales-tax bill before Congress requires looking at the logic of the Founders’ design. That design was based more on suspicion of the state governments than romanticism about them. It sought to maximize choice, competition, and accountability. It emphatically did not seek to maximize the prerogatives of states. Neither should would-be federalists today.

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