Sales Tax and E-Commerce — Not a Simple Problem

In the age of e-commerce, sales taxes are a difficult problem. Currently, online retailers such as Amazon.com are under the same rule as mail-order sellers traditionally have been: they only have to collect sales tax from customers located in their state (or states in which they have a physical presence). Recently, this has gained greater attention due to several states passing measures to count affiliate program members (kickbacks for links on blogs, etc.) as a physical presence, so Amazon.com would be required to collect sales tax from customers in any state in which one of its affiliates resides. These affiliates are often private individuals and do no direct sales for Amazon — only referrals — but, in an effort to regain their tax base, states are wanting to see them as a physical presence.

I do not question that e-commerce is presenting significant problems for local economies. Money spent online does not stay in the local economy, and moving sales out-of-state does decrease the tax base for state income taxes. While most states require residents to pay sales tax themselves on out-of-state purchases, it is likely that few actually do so. Particularly in the present time of tight state budgets, this certainly isn't helping matters.

It is tempting to just say, as many states are attempting to, that Amazon.com should collect sales tax sales to their residents. Citizens for Tax Justice recently published an article accusing Amazon.com of fostering tax evasion and calling the Supreme Court ruling instituting the current system “misguided”.

I think this is an overly simplistic analysis of the situation. There is a complex tangle of issues surrounding sales tax in the U.S., and placing local requirements on Internet-based sellers creates further problems that I think are likely to be worse than the current woes.

Not just Amazon.com

First, any rules would not only apply to Amazon.com. While it is easy to point at Amazon.com as a big meanie, waltzing through cyberspace and draining local economies dry, they aren't the only vendor that benefits from the ease the internet brings to interstate commerce. All manner of sellers have arisen on the internet, selling anything from coffee to used books to who knows what. It is easy to put up a store and sell products to anyone anywhere in the nation (or world) who wants them. The internet provides an unprecedented opportunity for niche manufacturers and vendors to get their wares in front of people. With this comes the opportunity to have viable businesses that would never make it if their markets were restricted to what was available pre-internet.

While Amazon.com is a large company with substantial resources to cover things like sales tax compliance, small vendors are not. As I go through the remaining points, remember: additional legal and financial requirements burden Amazon.com. They destroy small businesses or entirely prevent them from ever being started. Is this stifling of competition and market innovation really the price we want to pay to get our tax revenues back from Amazon.com purchases? If it's practically impossible to start a new small business selling on the Internet due to the exorbitant cost and liability of interstate commerce, it just doesn't make sense to try out new business ideas.

Not just collection

Sales tax is not just a matter of collecting the right tax. The tax also has to be remitted to the appropriate state revenue agency. Further, many (most? all?) states require vendors to have a sales tax permit in order to collect sales tax. Is it reasonable to require an e-commerce vendor to acquire a sales tax permit in every state where they want to sell? Is it reasonable to require mom-and-pop to apply for 48 or 50 sales tax permits to use internet sales to boost their small business's market and sales?

Not just state

Further, sales tax does not only apply at the state level — local governments have sales tax as well. If e-commerce retailers are required to collect state sales tax, should they also be required to collect county and city sales tax as well?

Figuring out the sales tax owed on a purchase is not simple. For starters, zip code is insufficient — there are places where there are multiple sales tax rates in effect in the same zip code (I believe Pocahontas, IA is one such place — last I knew, the city of Pocahontas had a local option sales tax in place, but the rest of the county did not). In order to resolve this, it is necessary to have detailed, current data on jurisdictional boundaries and tax rates, and to do complex geolocation to figure out what tax rate applies to a particular shipping or billing address.

There is also the matter of what is taxable. I would be very surprised if the set of items to which sales tax applies is entirely uniform across the U.S.

The complexity of sales tax collection and remittance, along with the requisite sales tax permits, would be prohibitively costly to small businesses and entrepreneurs.

Now, there is an opportunity in this for payment processors to step up and make it easier. PayPal, Google Checkout, and similar services could provide sales tax calculation, collection, and remittance services for their customers. It could alleviate many of the difficulties — they could obtain the sales tax permits and take care of figuring out which tax rate to apply to the customer based on billing address. That does not, however, fix the problem of which items are taxable.

Not just taxes

Finally, while taxes are the currently-pressing issue, the principles at work are not limited to taxes. There is the broader question of what responsibility interstate, particularly internet-based, vendors and service providers have for the local laws applicable to their customers. Is an e-commerce site responsible for making sure that its customers can legally buy its products?

With the countless laws on the books in various states and municipalities, how is an entrepreneur supposed to find out to whom they can and cannot sell their product? Do we want a legal environment where doing business on the Internet exposes individuals to civil and perhaps criminal liability for the local laws applicable to any potential customer?

Amazon.com may have the resources to do sufficient due diligence to avoid these kinds of issues (although it is still a difficult and costly proposition). Small businesses and entrepreneurs almost certainly do not.

Not a simple problem

Allowing things to continue as they are poses problems for state and local governments struggling to make budgets work. Requiring online vendors to collect sales tax creates numerous substantial problems of its own, however, particularly by making it extremely burdensome to start a new business.

On the other hand, requiring individuals to personally pay sales tax on their online purchases destroys one of the major advantages of a sales tax — namely, that the citizen doesn't need to worry about tracking, reporting, and filing the tax; it is handled by the vendor.

There is not an easy solution to this problem. Simplifying the sales tax system somehow would help. Introducing homogenized sales tax like several Canadian provinces use, where tax is payed to the national government and a portion returned to the province, could help, but would not interact well with the mostly-federalist setup of the United States. There may also be promise in using a value-added tax (VAT), where each state can collect taxes on the contributions of its economy to the overall product.

I am convinced, however, that simply calling for the big online retailers to start collecting sales tax on everyone is an overly naïve solution that creates at least as many problems as it solves.

Thanks to Ben Fields for the lively Twitter discussion yesterday that gave me some good ideas, helped sharpen my thoughts, and motivated this post.