The Inevitability of Internet Sales Tax

The Marketplace Fairness Act (MFA), which recently passed the Senate, carries bipartisan support as it heads to the House of Representatives. It is also supported by some of the nation’s biggest retail companies, including Walmart, Target and Best Buy. Still, the debate over the MFA is heating up.

“The MFA was created to level the playing field for brick and mortar businesses and online businesses,” says Eric Anderson, a professor of marketing at the Kellogg School, who in 2009 studied how sales tax affected online consumer shopping behavior. A key finding from this research was that incentives and search costs affect how consumers respond to online sales tax.

“Suppose a consumer orders a polo shirt online and is paying full price. Will this consumer respond when she discovers that there is 6% sales tax? Absolutely. We see roughly a 20% decrease in demand for a full-priced item. But, suppose that same polo shirt is offered at 30% off—now what happens? We find almost no effect of charging sales tax. Why? Because even after accounting for the sales tax, it is unlikely this consumer will get a better deal elsewhere.”

Before delving into the debate over the MFA, it’s important to clear up a common misconception that online transactions are tax free. In fact, U.S. regulations merely shift the responsibility for tax collection from the online merchant to the consumer. Under existing laws, an online retailer does not have to collect sales tax from consumers who reside in states in which the retailer does not have a physical presence. In these cases, the obligation to pay state sales tax falls on the consumer who must self-report and pay these taxes each year. Unfortunately, this rarely happens.

“This is where traditional retailers are at a disadvantage,” says Anderson. “What further compounds this problem is that certain products are covered by a Minimum Advertised Price (MAP), which, as the name suggests, requires all retailers carrying that product to sell it at or above a minimum price. Such a policy may limit a retailer’s ability to offer a lower price to consumers to compensate for the sales tax—or close the tax wedge.”

So, if a consumer finds a television on Best Buy’s website selling for a MAP of $3,000, she’ll likely find the exact same product at a major online-only retailer like Amazon for the same price. However, multichannel retailers like Best Buy are at a disadvantage as they must collect state sales tax, which can exceed 9% in some states, whereas Amazon currently does not. A $270 tax wedge is often enough to sway a consumer’s choice and provides a strong rationale for the MFA.

In the pursuit of leveling the playing field, an important question will be how to treat small businesses. Large retailers like Amazon have advocated for a small-business exemption for retailers with revenue below $150,000; however, the recent MFA that passed the U.S. Senate placed the exemption closer to $1 million.

Some owners of small brick and mortar shops have questioned why there should be any sales tax exemption. Under the proposed legislation, a small retailer in downtown Chicago is still required to collect sales tax from its customers, but a small online-only retailer would not be required to collect sales tax. Some have viewed this as just creating another unfair playing field among small-business owners.

The argument to protect online small business owners often circles back to the cost of collecting and remitting sales tax. If this process were made easier and less costly, via perhaps a third-party vendor, then it becomes harder to justify the small business exemption.

“Whether the online sales tax effects we found in our research will persist after the MFA depends on how the playing field is leveled,” says Anderson. “In situations where consumers have options from small online retailers that don’t collect sales tax, I expect the effects we found to persist. But, if the playing field is very level, then sales tax will no longer be a factor that influences where consumers purchase.  This may force online retailers who have benefited from the tax wedge to offer new services that allow them to differentiate their offering and attract consumers.”

If the MFA passes the House, it could go into effect as early as October 2013. Whatever challenges it creates, consumers and retailers seem to be gradually warming up to the idea.