Drop the Sales Tax

The advisory panel created by Congress to study the Internet sales tax issue is hopelessly divided. Some members want the Internet to be a tax-free zone; others want Congress to require states to collect sales taxes on out-of-state purchases.

But this deadlock isn't necessarily a bad thing. It may well be that the best thing for Congress to do is nothing.

To see why, consider two scenarios: Either online retail purchases peak at a relatively low level, or they grow enough to make a significant impact on state tax collections.

The first scenario is the most likely. According to a study by University of Chicago economist Austan Goolsbee, the loss of tax revenue from e-commerce sales in 1998 was about 0.1 percent of total sales tax revenue. Even using optimistic forecasts of the rate of growth of online sales, this rises only to 1.4 percent of sales tax revenue by 2003.

It is true that online consumer purchases are currently growing rapidly, but mail order and TV shopping also had high rates of growth in their heyday. There are only a limited number of types of goods that people will purchase online, and many of the most popular online purchases such as travel, food, and greetings and services are tax-exempt in most states.

Business-to-business online purchasing will undoubtedly continue to grow for some time. But businesses are paying sales tax on their out-of-state purchases and will presumably continue to do so. (The fact that consumer purchases escape taxation while business purchases don't is ironic, since economic theory would argue that taxing final consumption is generally preferred to taxing intermediate goods.) In the second scenario, online purchases by consumers would continue to grow at a rapid rate and eventually have a noticeable effect on state tax collections.

The Supreme Court has determined that one state cannot unilaterally require another state to collect taxes for it, since the power to regulate interstate commerce is reserved for Congress by the Constitution. However, the Supreme Court has left the door open for Congress to require states to collect taxes for each other.

But voting for such a requirement is a no-win situation for Congress: It would have to take the heat for imposing a tax, but it wouldn't get to spend any of the revenues. Congress is understandably reluctant to move.

If Congress does not force states to collect taxes for each other, they will have to make up for the lost revenue in two ways: by increasing sales tax on offline purchases, - which would make the problem worse - or by increasing the state income tax.

If the states make up for lost revenues by increasing state income tax, in-state merchants would still lobby to cut state sales taxes in order to put themselves on equal footing with out-of-state merchants. In this scenario, all the economic and political dynamics push toward substituting the state income tax revenues for sales tax revenues.

This is a highly desirable outcome since an income tax is a much better way to raise revenue than a sales tax. If you want to raise a given sum of money with the least economic distortion, the best way is to have a small tax rate on a broad tax base. Since state sales tax generally exempts food, medicine and most services, it ends up taxing only about 35 percent to 40 percent of consumption.

A back-of-the-envelope calculation suggests that a 2 percent income tax would raise about as much money as a 5 percent sales tax.

An income tax has negligible compliance costs because almost every state income tax piggybacks on the Federal Adjusted Gross Income. Even states without an income tax would find it very easy to create one.

In 1987, sales tax collections were about $600 per capita. Surely the vast infrastructure necessary to collect this sum via sales tax is not cost-effective.

A broad-based consumption tax would be even better than an income tax in some respects, but the easiest way to implement such a tax would be to make savings tax deductible. Since consumption is, by definition, income minus savings, the compliance costs would be much, much less than the costs of directly monitoring consumption.

The biggest argument against replacing sales tax with an income or consumption tax is that this would make the total tax burden facing state residents explicit. But this is a feature, not a bug. An explicit measure of the state tax burden is the best way to keep taxpayers informed about the cost of their government, and thus to help make state governments more efficient.

- Hal R. Varian (hal@sims.berkeley.edu) is dean of the School of Information Management and Systems at U.C.-Berkeley.

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