The Grinch Who Taxed the Internet | Commentary

Outgoing Senate Majority Leader Harry Reid, D-Nev., seems poised to take one last shot at changing how online purchases are taxed. Reid has signaled he’ll bring the unpopular Marketplace Fairness Act up for a vote by tacking it onto the Internet Tax Freedom Act, which is headed for certain renewal.

Passed in 1998 with bipartisan support, the ITFA bars states from taxing access to the Internet and imposing discriminatory Internet-only taxes. The legislation will expire on December 11 and pressure from the tech sector is on for its renewal. While the ITFA has proven enormously popular and indisputably successful, it has little to do with online sales taxes.

Instead, the collection of sales taxes on the Internet has been shaped by a 1992 Supreme Court case, Quill v. South Dakota, which established what is known as a nexus requirement. Currently, an online purchase is taxed only if the seller has a physical presence, called nexus, in the buyer’s home state.

For example, if a Californian goes online to buy socks from a seller in Texas, the exchange only triggers a sales tax obligation if the Lone Star retailer has some type of physical presence, like a store or warehouse, in the Golden State. (Consumers may technically be obligated to remit a “use tax” to their home state, but these have proved difficult to enforce.)

Far from being a tax loophole, this approach puts the principle of “no taxation without representation” into practice. With the seller, not the buyer, responsible for remitting the tax, this arrangement prevents businesses from being taxed by states where they have no political voice. Moreover, they do not benefit from the services those taxes fund.

It also preserves tax competition among states, prevents states from exporting their tax regimes beyond their borders, keeps compliance costs in check by requiring businesses to file taxes only in their home state and minimizes the amount of personal consumer data collected and reported.

A coalition of big box retailers, revenue-hungry states and pro-tax politicians have lobbied for more than a decade to change this with the so-called Marketplace Fairness Act, which would empower state tax authorities to reach across their borders to tax and audit business in other states. This is fraught with harmful unintended consequences for businesses and consumers.

The United States has more than 10,000 distinct sales tax jurisdictions, each with its own rates, definitions, exemptions and tax holidays. The compliance costs for a small seller of having to calculate, collect and remit for all of those jurisdictions would often prove cost-prohibitive.

MFA proponents promise “free” compliance software to retailers, but a recent study found that setup alone would cost midsized online and catalog retailers (those with between $5 million and $50 million in annual sales) between $80,000 and $290,000, plus $57,500 to $260,000 annually in system maintenance and potential audits. Such audits could come from states where a seller has shipped a product but has never set foot in.

Moreover, consumers should worry about their personal shopping information being circulated around the country during the audits.

Consumers would be especially harmed by the MFA’s assault on tax competition among states. Enabling states to export their tax regimes creates a de facto state sales tax cartel that will reduce the downward pressure to keep sales taxes low. The result will be to siphon more money out of taxpayer pockets and into state tax coffers—a strong motivation for state and local governments to lobby strenuously for the MFA.

The faults of the MFA have not been lost on voters. It consistently polls as unpopular across party lines; opposition jumps to 70 percent when those polled are told the MFA would allow state tax officials to collect taxes from the residents of other states.

This isn’t to say that there’s no need for online sales tax reform. But the MFA is a cure worse than the disease.

Alternative solutions exist. One idea being explored, an origin-based approach, where all types of sales are taxed at the business’ principal place of business, would preserve tax competition, confine states to acting within their borders, keep compliance costs low, mitigate consumer privacy concerns and level the playing field by treating all retailers the same. It deserves serious consideration in the new Congress.

In the meantime, Sen. Reid should bring a stand-alone ITFA renewal bill to the floor for a vote and leave the Internet sales tax issue for another day. Instead of pushing the unpopular and burdensome MFA on Americans, he could enjoy spending his waning days as Senate leader doing his Christmas shopping — online.

Jessica Melugin is an adjunct fellow with the Competitive Enterprise Institute, a free-market think tank in Washington, DC.