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Monday, May 1, 2000

The Internet and the Death of the Sales Tax

E-Commerce Allows Consumers to "Flee" to Low-Tax States

Richard Ault is an associate professor of economics at Auburn University. David Laband is a professor in Auburn’s Forest Policy Center, School of Forestry.

The editors of our hometown daily newspaper, the Opelika-Auburn News, recently came out in favor of taxing Internet commerce. While noting, incorrectly, that sales taxes constitute the “largest source of revenues at all levels of government,” the editors forecast that Internet sales as a fraction of all sales “can only be expected to grow in the near future” and concluded by asking, “Who knows how much more sales tax revenue could be generated, particularly in about five or 10 years, from online sales? What is already a very healthy economy could become even stronger.”

The notion that taxes help make an economy grow stronger is, of course, ludicrous. But the battle over Internet taxation is in full swing. Proponents argue that standard retail stores will lose business and be at a competitive disadvantage if they are taxed and e-commerce is not. This is indisputably correct. Opponents respond that taxation would restrict Internet sales and stunt the economy’s growth. There is merit in this argument. In our view, however, what is really important is that in all likelihood, e-commerce will sound the death-knell on sales taxes as currently configured.

Although Wal-Mart is headquartered in Arkansas, patrons of their local Wal-Mart pay sales tax on their purchases at the rate established by the state in which they reside. The sales tax is collected at the point of purchase and paid by the retailer to the state government. Heretofore, the imposition of excise taxes had little influence on retailers’ location decisions, because most customers would not find it worthwhile to drive to another state just to save a few cents per dollar in state sales taxes. But the Internet changes this situation dramatically—the retailer no longer has a fixed location, and it is not very costly for the consumer to observe merchandise locally but to purchase over the Internet. The consequences of Internet tax freedom are not hard to imagine. Consumers get a discount on goods bought from a virtual store over the Internet as compared to purchasing the exact same items in a real store. The size of this discount equals the sales tax rate prevailing in their state, minus shipping costs. This realized price/tax savings surely has played a major role in the explosive growth of e-commerce.

Some people believe that there is a natural limit to the proportion of sales (and therefore the lost tax revenues) that can be handled through e-commerce because of the expense or impracticality of shipping certain items and lack of customer access to the Internet. However, we are not convinced that either shipping costs or lack of Internet access will prove to be an impediment to growth in Internet sales. It is only a matter of time before items such as groceries, which are both perishable and expensive to ship relative to their value, will be offered over the Internet. In those states where groceries are subject to sales taxation, grocers will have a financial incentive to restructure the checkout. Customers at a particular store will place their orders over the Internet, and be instructed to pick up their merchandise at their current store. This solves the problem of customers wanting to inspect the merchandise firsthand without having to incur additional shipping costs, while permitting stores to offer customers significant price/tax savings. This also means that Internet shopping will not be limited to customers who have personal access to the Internet. Stores will provide access to all customers.

Vendors of heavily taxed items like gasoline will have an especially powerful incentive to structure sales through the Internet. Oil companies can sell coupons tax-free over the Internet that purchasers can redeem at any affiliated station. The implied tax savings to customers (and tax revenue losses to states) will be enormous.

Shriveling Revenues

But taxing e-commerce leads inexorably to the same result—shriveling sales tax revenues. Why? Because now that they can shop electronically, it is virtually costless for consumers to “flee” to low-tax states for their purchases; they no longer need to spend time and money transporting themselves physically to a lower tax state. Firms conducting e-commerce from states with relatively low sales tax rates on Internet commerce will have a competitive advantage over those conducting e-commerce from states with relatively high sales tax rates. Competition will induce profit-maximizing firms to migrate to low-tax states. This migration is virtually costless with the advent of the Internet. Wal-Mart can create an Internet sales location anywhere in the United States for a few dollars. Such migration implies that states with high sales tax rates will lose commerce and the associated tax revenues to low-tax states. Consequently, legislators in the former will find themselves under tremendous revenue pressure to reduce their sales tax rates to attract commerce back. In turn, of course, this puts tax-revenue pressure on other states, which then have financial incentive to lower their sales tax rates, and so on. The result of this process of hundreds of millions of consumers seeking out low taxes with their electronic feet is continuously falling sales tax rates across states.

The question is, can states maintain viable sales taxes at any tax rate greater than zero? It seems doubtful, for two reasons. First, states might attempt to enter into an agreement under which they would all agree to a common sales tax rate. However, as with any cartel, each state would have an incentive to “cheat” by lowering its rate in an effort to attract commerce with the associated tax revenues. Second, even if sales tax rates were uniform across states, consumers would be able to “migrate” to Internet locations based in Mexico, Jamaica, and a host of other foreign locations that, by definition, are not burdened with U.S. sales taxes. Competition between countries for tax revenues will result in lower tax rates on e-commerce everywhere. Duty-free shopping no longer will require you to travel to Barbados; it will be as easy as clicking a mouse in your home anywhere in the United States.

The development of Internet shopping provides consumers with extraordinary shopping mobility. This gives them an ability to avoid the taxman to a degree that heretofore was simply unimaginable, even to the tax authorities. This mobility will, in due course, render sales taxes incapable of being a reliable source of substantial tax revenues. We should not be wasting our time arguing over whether or not to tax e-commerce; the sales tax is dead either way. The coming battle will be over cuts in government spending versus alternative sources of state government revenues.

  • A native Virginian, David N. Laband received his Ph.D. in economics from Virginia Tech in 1981. He is the author of 9 books and over 130 articles in peer-reviewed journals. His research and teaching interests cover a wide range of topics related to economics and policy.