Rethinking State and Local Reliance on the Retail Sales Tax: Should We Fix the Sales Tax or Discard It?

I. INTRODUCTION Electronic commerce (e-commerce) has appeared with the suddenness of a comet. Having first been detected as a tiny speck emerging from the constellation Geek less than five years ago, ecommerce is now upon us. E-commerce raises questions about many key fiscal institutions we take for granted, among them the use of the retail sales tax (RST) to finance state and local governments.1 In part, questions about the RST arise because the tax, as it currently finctions, is an anachronism that reflects its origins in the Industrial Age nearly 70 years ago; since the RST was created without a firm conceptual basis and "just growed," it is not surprising that it is defective-or that e-commerce magnifies its defects.2 But the problem may be deeper than this; even if reformed, the RST may simply not be suitable to serve as the most important source of tax revenue of state and local governments in the twenty-first century. This paper examines these issues. First, after briefly discussing tax policy objectives, it describes the defects of the typical RST, noting how e-commerce aggravates these defects. Then it examines ways that have been proposed to fix the R.ST system to accommodate ecommerce. Finally, it asks whether it would not be better to revamp the finance of state and local government, by substituting either a value added tax (VAT) or increased reliance on the income tax for the state and especially the local RST. Appendix A discusses fallacious arguments for exempting electronic commerce from sales and use taxation. Appendix B reproduces an "Appeal for Fair and Equal Taxation of Electronic Commerce" that has been signed by more than 170 academic tax specialists. Appendix C is the proposal for massive simplification of sales and use taxes I submitted to the Advisory Commission on Electronic Commerce in December 1999. Appendix D indicates how a state VAT could be implemented. II. OBJECTIVES OF TAX POLICY In order to identify defects in tax policy, it is necessary to have criteria against which to judge policies. The following is a list of commonly accepted objectives of tax policy. Because the conventional criteria of economic neutrality, equity, simplicity, and transparency are well-known and the purpose of writing this article is not to produce a treatise on tax policy, the discussion of those criteria is brief. I describe principles of tax assignment in greater detail, since they are not as well-known, but lie at the heart of the analysis that follows. A. Conventional Tax Policy Criteria Most textbooks describe the following criteria of good tax policy. 1. Economic neutrality The case for economic neutrality is based on the belief that markets do fairly well in determining, inter alia, what to consume, what to produce, how to organize and finance production and distribution, where to locate economic activity, and whether to save and invest or consume.3 A tax is neutral if it does not interfere with these decisions. For example, a sales tax that applies equally to all consumption occurring in a given jurisdiction is relatively neutral (distorting only the choice of where to live, a decision not likely to be much affected by the level of sales taxation), whereas a tax on all production occurring in the same jurisdiction is less likely to be neutral, as it distorts the choice of where to locate production. A tax that applies selectively to only some consumption or some production distorts choices of what to consume or what to produce. Finally, a tax on capital goods discourages investment. 2. Equity Equity is essentially a matter of what society believes to be fair. Equity can be placed in two categories. Horizontal equity involves collecting similar amounts of tax from those in similar circumstances. vertical equity involves collecting differing amounts of tax from those whose circumstances, commonly measured by their income, differ; a tax satisfies this criterion if tax liabilities differ systematically in ways that society believes are appropriate. …