Taxes: Main Street v. eStreet

Today’s topic involves an issue about which I am conflicted. Should states be allowed to “tax” internet merchants? I put “tax” in quotes because that's not actually what's going on. The real question is: should states be allowed to force internet merchants to collect sales taxes from customers? This is a much more complicated issue than it seems at first glance. Here is the problem as each side sees it:

1. The State View: Americans buy about $10 billion a year from the internet (and growing). But as a practical matter, states can’t tax this. Technically, they can and do tax it, but they can only collect the tax from the purchaser. Indeed, most states have laws requiring you to report what you purchase and pay tax on that. . . fat chance.

From the state perspective, this is lost revenue. To solve this problem, states keep trying to force internet retailers (e-tailers) to collect sales taxes just like bricks and mortar retailers do. Right now, e-tailers don’t do that, and states don’t have the power to force them.

The reason states can’t force this is the way jurisdiction works in the United States. To be able to regulate (and tax) a business, that business must have some “nexus” to the state. But the term “nexus” isn’t clearly defined. Operating a warehouse within a state clearly constitutes a nexus. Having a retail operation does too. But what if people buy from your catalog or off your webpage? So far, the courts have always said that is not enough to form a nexus. Thus, states can’t force e-tailers to collect sale tax for them. . . though they keep trying.

California is the latest state to try. What they’ve done is to declare that any e-tailer who deals with local sellers has a nexus to the state. Amazon falls into this category because it partners with small businesses all over the country including California. Because of this bill, Amazon has begun terminating its relationship with all of these people if they are located in California (10,000 were terminated in July). Amazon is also trying to get this bill repealed by referendum.

2. The Main Street Retailer View: Main Street retailers hate companies like Amazon. They have no choice but to collect the sales tax imposed by the state. Thus, they are at a disadvantage to the e-tailers, and the disadvantage can be serious. In liberal states like Illinois, for example, it can reach nearly 12% with local surcharges. That’s a significant handicap when the e-tailer doesn’t have to collect those taxes.

Extending this argument to its natural conclusion, retailers argue that if this situation is not remedied, then e-tailers will eventually wipe out retailers. But keep a couple things in mind. First, these are the same retailers who wiped out the mom and pop shops two decades ago. . . so their argument rings a little hypocritical. Secondly, there are other benefits the retailers get (like property tax breaks) that are not given to the e-tailer. Third, the retailer business model may be defective, and rather than trying to force a tax hike on e-tailers, maybe they should be looking for new services to lure customers back into their stores. Fourth, some products simply aren't amenable to the e-tailer model.

3. The eStreet Internet Retailer View: The e-tailer response is twofold. First, to allow states to force them to collect the tax would make them a special case that violates 200 years of jurisprudence. It’s the business equivalent of letting New York haul you into court just because you sent a letter to someone who lives in New York.

Secondly, e-tailers make a practicality argument. There are 8,000 different tax jurisdictions in the US, each with different rules, procedures and rates, which change at a moment’s notice. Moreover, these jurisdictions don’t align with zip codes. Thus, it would be a practical nightmare for a company like Amazon to assess and collect the right amount of tax. It would be impossible for smaller e-tailers. This change could effectively kill off all but the largest e-tailers.

4. My View: Politically, I am conflicted on this. As a firm believer in federalism and the 10th Amendment, I generally favor letting states handle their own affairs. . . even if they make a mess of it. So they should be allowed to tax whatever activity goes on inside their borders provided they don’t discriminate against out-of-state companies. But that argument really doesn’t apply here because they can tax these transactions, they just can’t get it collected the easy way. States have a right to regulate themselves, they don’t have a right to regulate outsiders just because it makes things easier for the state.

And practically speaking, I think it would be disastrous to allow 10,000 tax regimes to force themselves upon e-tailers. What’s more, how can we then be sure they are being treated fairly (i.e. that there is no discrimination against out-of-state companies)? Suppose a single sales tax is imposed on both retailers and e-tailers. That sounds fair, but what about the property tax breaks, utility discounts or other things the retailer gets that reek of local favoritism?

I don’t care for the idea that in the long run we are likely to end up with most retailers going out of business in favor of e-tailers (e.g. book and music stores). But on the other hand, these e-tailers have been very good for consumers even beyond the sale tax issue and the death of the retailer may be inevitable unless retailers find some way to improve their business model.

Right now Senate Democrats are trying to come up with a bill (the Main Street Fairness Act) to “solve” this problem. Amazon supports it, eBay opposes it. Frankly, this sounds like it will impose a fairly heavy regulatory burden on e-tailers. I suspect Amazon likes it because it will make it hard for smaller competitors to enter its market. eBay probably opposes it because eBay relies on thousands of small sellers, who would likely end up violating the new rules.

There may be no good answer, but when in doubt, I find myself coming down against any solution offered by Democrats with the support of the biggest company in the field and with the support of trade groups looking for a little protectionism for their members. So if I had to vote right now, I would vote to leave the system as it is.

What do you think? How would you solve this problem?