Tax "Fairness" and the Internet

The following article originally appeared in the September 7, 2001 issue of the MIRS newsletter in answer to the questions: "Is the plan to extend the current sales and use taxes to Internet transactions a new tax or just the collection of an existing tax?  Should Michigan be part of an interstate compact to administer the tax?  Will it actually hurt existing brick-and-mortar establishments if not imposed?  Will it hurt the development of Internet business if the tax is imposed?"

Stay Engaged

Receive our weekly emails!

In all but a handful of states today, businesses collect sales taxes on many goods they sell within the state where they are based or have outlets.  The Supreme Court has ruled that states and local governments cannot require out-of-state companies to collect taxes for them, since this would interfere with interstate commerce.  States and localities may only require companies with a "substantial physical presence" or "nexus" in their state to collect sales taxes. 

Imagine what collection chaos would ensue if even a small portion of the 87,453 units of government in America were to adopt sales taxes and then try to apply them to Internet sales—up to 3,043 counties, 19,372 cities, 16,628 townships, 13,726 school districts, and 34,683 special districts, each with its own rate and exemptions!  To prevent such chaos and allow for time to think about the issue of Internet taxation, Congress in 1998 instituted a national moratorium on any new taxes directed at electronic commerce.

Gov. John Engler strongly supports a National Governors' Association (NGA) plan that would apply sales taxes to virtually all Internet purchases (as well as catalog and 1-800 number purchases) and deputize a private "third-party entity" to collect and distribute those taxes.  Labeled the "Streamlined Sales Tax Project," the plan would—if enough states approve it and Congress endorses it—begin to harmonize disparate sales and use taxes across the states and perhaps, some fear, open the door to a national sales tax.

Actually, I'm not one who is bothered by diversity among the states in either the manner or the amount that they tax.  It's not "unfair" that New Hampshire has neither a sales tax nor an income tax.  Nor is it unfair that items on which some states impose a sales tax are exempted by other states.  Michigan loses revenue all the time to states that tax less and tax better, and we gain revenue at the expense of those states that tax more and that tax in more harmful ways. That's healthy competition and it's why the states are often called "laboratories of democracy." 

What does concern me are such things as government demanding more of people's incomes when its share is already at or near an all-time high.  I'm concerned about compromising any one state's sovereignty over its tax structure in the name of "streamlining" or homogenizing it with the tax structures of other states.  I'm concerned about scrapping the inherent privacy and anonymity of the sales tax and deputizing some entity to find out who bought what from another state.  And I think we should all be concerned by anything that makes it just a hop, skip, and a jump for the federal government to superimpose its own national sales tax. 

All of these matters make the Streamlined Sales Tax Project more than simply a vehicle to extend an existing tax to Internet transactions.  Combined, they make for some pretty fundamental changes in the way we do things now.

At the same time, Gov. Engler's argument for taxing Internet sales for reasons of fairness and uniformity is not on its face unreasonable.  But it is greatly weakened by other arguments and other factors, not the least of which is the administration's own policies that have riddled Michigan's tax structure with special favors.  In December 1999, state officials authorized a $24.2 million "incentive" package for Webvan Group, Inc, of San Francisco, California.  Webvan operated as an electronic grocery outlet, receiving orders over the Internet and delivering them at prices it advertised as "up to 5 percent less than in local grocery stores."  It was hailed by the wizards at the Michigan Economic Development Corporation as the wave of the future, but then its stock plummeted from $38 per share to pennies when the company went bankrupt a few weeks ago.

In another of many possible examples, the MEDC awarded more than $5 million in tax abatements and job training subsidies to a New York-based company, Boar's Head Provisions, to open a meat products plant in Holland.  It competes with longtime Michigan firms like Koegel of Flint and Kowalski of Detroit.  Three-generation family-owned Koegel (and for all I know, Kowalski as well) has never taken a tax abatement, has always spent its own money to train its own employees, and pays full freight in high-tax Flint.  Where were the "fairness" advocates when the MEDC was doling out some of Koegel's tax dollars to Boar's Head?

Likewise, the Governor's "Renaissance Zones" set up small geographic regions within the state where taxes are much reduced or don't apply at all.  A business can literally move a mile, into a Renaissance Zone, and enjoy a much lower tax burden than its nearby competitors. 

So when advocates of the Streamlined Sales Tax Project scream about "fairness," some of us question whether they really mean it.   In their quiet, private moments, surely they understand why their inconsistent position seems to many of us like nothing more than a grab for more cash.

But what about the fairness issue?  Is it right that bricks-and-mortar businesses within Michigan must remit a sales tax to the state while their out-of-state online, catalog, or 1-800 competitors do not?

In one important sense, it would be blatantly unfair to tax out-of-state vendors that do business in another state over the Internet or by way of catalog and 1-800 number sales.  Taxes are supposed to pay for services that governments provide, such as police protection.  Out-of-state vendors with no physical presence in a state would receive none of the benefits for the taxes they would pay to state and local governments where they do not reside.  Tax freedom on Internet-based transactions regardless of where a business has physical nexus will create an even-playing field for all retailers.  As Virginia Gov. James Gilmore says, "All businesses will compete equally when they compete on the Internet."

It's easy to see the fairness issue this way if you're talking about Michigan reaching across its borders to impose a corporate income tax on, say, an Oregon company that has no "nexus" here.  But advocates of the Streamlined Sales Tax Project such as Michigan's Gov. Engler argue that if their plan is implemented, we would not be doing anything of the kind.  We would simply be collecting an existing sales or use tax from Michigan consumers, not imposing a new tax on out-of-state companies.  The consumer pays it, not the company.  At first blush, it's a plausible argument.  But it is at least partially undermined by the fact that a consumer who sits at his home computer and orders a book from isn't using the roads or any other state service to make the purchase.

By the way, traditional bricks-and-mortar businesses that complain about not remitting sales taxes to Michigan have not offered to forgo the advantages they enjoy from tax-paid streets, sewers, and schools.  And the smart ones are already working to establish their own online presence to sell in other states.

Moreover, Gov. Gilmore adds: "By burdening Internet consumers with new tax burdens, by imposing new tax collection millstones upon Internet-based entrepreneurs, or reporting all sales transactions to third-party tax collection agents of the government who would view the private purchases of each consumer, the evidence is clear that government would severely inhibit the economic growth of the Internet economy and particularly impact small Internet entrepreneurs and consumers."

The privacy concerns Gilmore hints at are very real.  One of the advantages of the sales tax over, say, the income tax, is its anonymity.  When you pay it at a local shop, no one asks you your name, where you live, or anything about your buying habits.  The third-party entity the NGA plan would deputize to facilitate sales tax collection and revenue distribution may very well need to know such things to do the job.

Among the other arguments against the Streamlined Sales Tax Project concerns its likely economic impact on the nascent Internet economy.  A recent study by economists from the University of Chicago and Harvard University estimates that applying sales taxes to electronic commerce would reduce the number of online buyers by 25 percent and total spending on Internet transactions by more than 30 percent.  The study suggests that these sales would not be replaced by ordinary retail sales, since the Internet is probably a net trade creator, generating business that would not otherwise have occurred.

This raises doubts about state government's claims of "lost revenue."  Treasury officials in Michigan, for example, estimate that the state is "losing" upwards of $200 million or more in annual revenue because under the current system of voluntary compliance, barely two percent of online, catalog, and 1-800 number purchasers are declaring their purchases and remitting use tax.  But put aside the fact that $200 million against a total state budget that's approaching $40 billion is a drop in the bucket. The estimates that pour forth from revenue-seekers across the 50 states are suspect for one or more of the following reasons:

1. Business-to-business sales are sometimes included but they would be exempt from sales taxes anyway.  Most estimates put those transactions at 75 percent or more of all Internet transactions.

2. Internet transactions that result in physical sales in local stores are frequently not factored out.  Example: You buy your gasoline, etc., on but you go get it at your corner service station and pay sales tax.  The drug store chain CVS, as an additional example, reports that 60 percent of its online customers pick up their prescriptions at a local store.

3. Estimates of future growth of Internet sales are surely overstated. stocks have crashed.  People don't seem to want to buy groceries and gas, etc. on line.  The novelty of online buying will not last forever.  And if analyses like those from the University of Chicago and Harvard cited above are right, collection of sales taxes on Internet purchases will substantially cut the volume of Internet transactions.

4. Growth in sales tax revenue that comes from Internet-induced economic growth is excluded or underestimated.  Example: a firm starts up in Michigan, selling to customers in other states on line, employing people and buying goods here.  In 1998 alone, the Internet was responsible for 1.2 million new jobs, representing lots of new income and sales-taxable purchases.

5. Some portion of what we purchase on line we would not buy in local stores where we would pay a sales tax.   We might not buy it at all.  Example:  Thinking about the old books and manuscripts I have purchased by the dozens on eBay auctions, I realized that almost none of that I would have bought in any local Michigan store.

6. Estimates of lost revenue are rarely reduced by the amount the states will have to spend in the process of standardizing their sales taxes and then having some compensated third-party collect them.

Whatever additional revenues Michigan might collect if the NGA plan takes effect, advocates for the plan should admit to a desire to dig deeper into our pockets, or tell us where they plan to cut taxes elsewhere.  The overall state and local tax burden in Michigan is still high.  Last year, the legislature in one single stroke approved a bill larded with pork to the tune of more than $600 million.  In spite of endless studies that show no relationship between money spent and student performance, Lansing annually throws more cash at public schools, well in excess of inflation.  If state government needs more money, it's not because it taxes or spends too little.

For more information, please see the Mackinac Center for Public Policy report, "Internet Purchases: To Tax or Not to Tax, Here Are the Questions."

"What concerns me are such things as government demanding more of people's incomes when its share is already at or near an all-time high."