Remember When the Internet Was a Tax-Free Paradise?

Despite the dreadful consequences that taxing the Internet will cause, something that I covered in a previous piece on this website, Congress seems dead set on bringing sales taxes to the Internet. Unfortunately, this effort gained a powerful and respected ally this past week.

In his recent Wall Street Journal op-ed, Tax Internet Sales, Stimulate Growth, Art Laffer argues in favor of allowing states to force Internet retailers outside their borders to collect sales taxes on their behalf. I must respectfully disagree with Professor Laffer on this issue.

Professor Laffer, one of the fathers of Supply-Side economics, made one of the great contributions to the study of political economics with his introduction of the Laffer Curve. The Laffer Curve recognizes a basic fact about human behavior: individuals are not automatons absent of free will; we respond to incentives and change our behavior accordingly. Thus, while it is obvious that a zero percent tax rate will result in no tax revenue for the government, a one hundred percent tax rate will also produce no tax revenue. After all, who is going to work when he is prohibited from keeping any of the fruits of his labor?

The application of the Laffer Curve in public policy reveals a fundamental difference between Supply-Side economists and Austrian economists. While Supply-Siders argue for lower taxes, they do so in order to maximize tax revenue. In other words, they believe that the optimal tax rate is the one which produces the most revenue for the government. On the other hand, the Austrian argument for lower taxes has nothing to do with the amount of revenue a tax produces. Austrians recognize that every tax, whether an income tax, a property tax, a sales tax, or what have you, causes its own unique distortions in the market. Leaving aside the moral and private property arguments against taxation, Austrians believe that all taxes must be opposed because taxation is an impediment to optimal market performance.

Despite arguments to the contrary, an Internet sales tax is, de facto, a new tax. Yes, residents who buy goods from out of state Internet retailers currently are required, by law, to report these transactions and pay sales taxes on them. But almost no one does so, and these laws are rarely, if ever, enforced. Hence, while this tax may exist in the law codes of various states, it has yet to significantly appear in the real world. Not only will consumers, especially the middle class, feel the weight of a new tax, we cannot say for certain what its economic impact will be. For instance, the tax boon which studies claim an Internet sales tax will produce has proved grossly inflated in reality. As the Laffer Curve illustrates, individuals respond to incentives. Raise taxes on Internet sales and you are going to reduce the amount of Internet sales.

Professor Laffer claims that if states are allowed to collect sales tax on Internet transactions, they will be able to lower their income tax rates and experience increased economic growth:

“Therefore – as with any pro-growth tax reform – the sales tax base in the states should be broadened by treating Internet retailers similarly to in-state retailers, and the marginal income-tax rate should be reduced such that the total static revenue collected by the state government is held constant.”

While the income tax is the most egregious of all taxes and its reduction would be welcome, the problem with this argument is that the more likely outcome is that state governments will gladly stuff this additional revenue into their coffers without lowering any other taxes. As Professor Laffer himself points out, “the absence of these [Internet sales tax] revenues has not served to put a lid on state-government spending.” Experience has taught us that nothing puts a lid on government spending. Providing the states with an additional revenue source will not put them on more sound fiscal footing. It will only serve to make their governments that much bigger and more intrusive.

It is true that the current system unfairly punishes brick-and-mortar retailers. However, the solution is not to also punish Internet retailers (and consumers) with an additional tax. Instead, we should work toward reducing or eliminating the taxes to which brick-and-mortar retailers are subject. Isn’t it also unfair that some states impose a higher sales tax rate than other states? Should we then advocate that low-tax states raise their sales tax rates in the name of fairness? Of course not. We all recognize that tax competition between the states is a good thing because it limits the ability of the states to impose exorbitant taxes. Doesn’t the Internet, which is virtually tax-free, represent the ultimate in competition?

There is also a political component to this issue. Despite the arguments of Senator Lamar Alexander (R-TN), allowing a state to force a retailer in another state to collect taxes on its behalf does not strengthen states’ rights. In fact, the opposite is true. This is an assault on the sovereignty of the states. After all, retailers in California would be forced into the role of tax collectors for Massachusetts and visa-versa. Alexander peppers his argument with references to the Constitution and the Tenth Amendment, but this is the sort of stuff that the Constitution was supposed to prevent, not encourage!

By the way, remember the days when conservatives actually opposed taxation instead of, in the words of Alexander, being added to an “honor roll” when they propose more taxes?

Finally, an Internet sales tax policy is not pro-growth. Yes, imposing sales taxes on Internet retailers may benefit some brick-and-mortar retailers (especially the big box stores), but it will hurt the Internet retailers and all the businesses connected with them. Will the net result be economic growth? Who knows, but what is certain is that some businesses will benefit while others are harmed. We ignore Bastiat’s Broken Window at our own peril.

The best way to encourage economic growth is to eliminate as many taxes as possible and to lower the rates of those that remain. Allowing the states to impose sales taxes on the Internet is a step in the wrong direction.