An Analysis of Internet SalesTaxation and the Small SellerExemptionbyDonald Bruce and William F. FoxUniversity of Tennessee Center forBusiness and Economic Research,Knoxville, TNforunder contract number SBAHQ-12-M-0183Release Date: November 2013This report was developed under a contract with the Small Business Administration,Office of Advocacy, and contains information and analysis that were reviewed byofficials of the Office of Advocacy. However, the final conclusions of the report do notnecessarily reflect the views of the Office of Advocacy.
Table of ContentsExecutive Summary3Introduction7A Brief History of Sales and Use Taxes in the U.S.10The Legal Framework Surrounding Remote Commerce, and State Responses14The Federal Policy Response18Small Seller Exceptions in Practice21Evaluating Small Seller Exception PoliciesAdministration and ComplianceEconomic EffectsRevenue Consequences23232425Research Questions and Data26ResultsQuestion 1: How Many and What Share of Online Retailers are Small?Question 2: What Share of Online Sales Occurs among Retailers Above the SSE?Question 3: What are the Impacts of Various SSE Levels?Question 4: To What Extent Are Larger Online Retailers Already Collecting SalesTaxes?Question 5: How Would Federal Legislation Affect the Number of Retailers Below theSSE?Question 6: How Are Sales Tax Compliance Costs Related to Firm Size?Question 7: How Do Small Online Retailers Differ from Larger Ones?27273132Discussion and Conclusion39References43132343536
List of FiguresFigure 1. State Sales Tax Collections as a Share of Total State Tax Revenues, 201112Figure 2. Sales Tax Bases as a Percent of Personal Income, 201013List of TablesTable 1: Estimated Number and Share of Retailers with Sales above Various SSEThresholds30Table 2: Share of Total Estimated American Online Retail among the Top Retailers31Table 3: Distribution of Nexus States among Online Retailers34Table 4: Sales Tax Nexus among Top 1,000 Online Retailers34Table 5: Characteristics of the Top 1,000 Online Retailers by Size Category37Table 6: Primary Sales Categories of the Top 1,000 Online Retailers by Size Category382
Executive SummarySales taxes are a critical component of state and local government revenue systems in theUnited States, accounting for nearly one-third of all state taxes and nearly one-quarter ofall state and local taxes. Sales tax systems are facing significant pressure for a number ofreasons, including the recent growth in online and other remote transactions that takeplace between in-state buyers and out-of-state sellers. The Courts have ruled thatbusinesses must have nexus—typically physical presence—in a state before they can betaxed by a state or required to collect and remit the state’s taxes. The Courts have alsodetermined that only Congress has the authority to redefine nexus.As the internet has grown along with online shopping, the impact of the taxwedge between local and remote commerce has become even more important for stateand local governments. Bruce, Fox, and Luna (2009) estimated a 2012 state and localrevenue loss of 11.4 billion as a result of online transactions. In response, and in theabsence of federal action to redefine nexus, state and local governments have gone togreat lengths to pursue legal and policy options to restore their shrinking tax base in orderto maintain the level of public services. States have tried working together, broadeningnexus definitions, imposing reporting requirements, and seeking to collect use taxesdirectly. None of these approaches is likely to be very effective, though they maygenerate some revenues and are ways of increasing pressure for federal legislation. Asthings currently stand, federal legislation is the only effective means of significantlyaltering states’ ability to collect taxes that are due on remote sales.Federal policy developments have important implications for America’s smallbusinesses. On one hand, the current tax environment favors online sellers vis-à-vis localsellers. Jordan (2012) and Hall (2013) are among those that have provided anecdotalevidence suggesting that some local sellers have actually gone out of business as a resultof being unable to compete with their tax-advantaged remote counterparts. On the otherhand, the majority of online sellers are themselves small businesses, so the taxenvironment has afforded them a significant competitive advantage. These onlinecompanies are concerned about the potential for a policy change at the federal levelrequiring them to collect and remit sales taxes on all taxable purchases; this wouldrequire them to keep track of state and local tax rules and rates and reduce theircompetitive advantage vis-à-vis local merchants.In recognition of this, all of the serious federal policy proposals have includedsome form of small seller exception (SSE) in order to protect the smallest sellers from3
being driven out of business by a new tax collection responsibility. Virtually every majorfederal, state, and local regulation involves some form of small firm exception inrecognition of the disproportionate compliance burden that is borne by smallercompanies. States generally do not include SSEs in their sales taxes; the more commonmanner of offsetting the collection burden on smaller sellers in existing state sales taxpolicy is to provide a system of vendor discounts as partial compensation (although suchsystems have been reduced over time) and to allow less frequent tax filing. Decisionsboth on whether to allow a small seller exception and on its size threshold require fullconsideration of the implications for state and local sales tax revenues, the possibledistortions of economic activity, and administrative and compliance costs.The Marketplace Fairness Act of 2013 would permit states to require online andother remote vendors to collect the sales tax for the destination state in the same mannerdone by brick-and-mortar firms today. The bill requires states to simplify their taxstructure before they can require firms to comply, and it applies only to firms with grossannual U.S. online sales during the preceding year of at least 1 million. This reportexamines the potential impacts of the various SSE levels on small businesses. It uses datafrom Internet Retailer’s Top 500 and Second 500 Guides, which provide a wealth ofinformation for the top 1,000 online sellers by sales volume each year. The sales amongthese companies represent the majority of all American online business-to-consumercommerce. These and other data sources are used to examine the following sevenquestions:1. How many and what share of online retailers are small?Estimates of the number of online sellers vary widely. On the high end, Bailey etal. (2008) estimate that 5 million online sellers exist, and more than 99.9 percent of theseare small. With an SSE of 1 million, only a very small number of companies wouldactually be required to collect and remit sales taxes with an SSE at 1 million. Within theInternet Retailer Top 1,000, 974 companies have sales exceeding 1 million. Adding infirms that are not included in the Internet Retailer data, a more realistic estimate is on theorder of 1,817, or less than 0.1 percent of all online sellers.2. What share of online sales occurs among retailers above the SSE?Retailers above any of the reasonable SSE levels being discussed probablyaccount for more than half of total U.S. online retail sales. Approximately 57.3 percentof total U.S. retail e-commerce takes place among the largest 974 companies with totalonline sales of at least 1 million each.3. What are the impacts of various SSE levels?4
A higher SSE threshold exempts a slightly larger number of retailers but stillcaptures the majority of online retail activity. Conversely, a lower SSE thresholdincludes more companies but does not add measurably to the covered share of total onlineretail.4. To what extent are larger online retailers already collecting sales taxes?Many of the larger online retailers are already collecting sales taxes for manystates in which they currently have nexus. A sample analyzed for this study shows theaverage large online retailer collects sales taxes in about 18 states, representing about47.2 percent of total national, state, and local sales tax collections. This suggests thatslightly more than half of the universal tax collection obligation would represent apotential new burden for the average retailer in our data.5. How would federal legislation affect the number of retailers below the SSE?While the pursuit of increased profits would likely outweigh the marginal benefitsfrom tax planning efforts to remain below the SSE threshold and avoid triggering thesales tax obligation, the theoretical effect on size distribution was examined. The numberof online sellers with sales within 100,000 of a 1 million SSE threshold is estimated at365. This suggests that any efforts to downsize or remain under the SSE would havelittle to no impact on the number or share of companies below the threshold.6. How are sales tax compliance costs related to firm size?To the extent that compliance costs are fixed, they represent a larger share ofprofits for smaller-scale enterprises. Some mechanisms are in place to alleviate much ofthe compliance burden, even for smaller retailers. First, the Marketplace Fairness Actcalls for states to provide free software to online retailers to calculate the tax.Additionally, the sales tax computation, collection, and submission functions cangenerally be outsourced to third-party service providers for a fee, and the MarketplaceFairness Act relieves firms from penalties as long as approved software and vendors areused.7. How do small online retailers differ from larger ones?Online sales grew more quickly for smaller online retailers than for larger firmsbetween 2010 and 2011. This suggests that retailers below the SSE threshold in one yearmay find themselves at or above it by the following year. The smallest size class of5
online sellers is dominated by web-only retailers. Their share declines quickly as sizeincreases; correspondingly larger shares of the larger size classes are increasingly madeup of Retail Chains. Larger retailers have more unique product codes on their web sites,significantly more visits and unique visitors per month, and their response times areshorter. The share of retailers with a store locator feature on their web site, a store pickup option, or catalog quick-order availability increases with retailer size. Larger onlineretailers are more likely to be in the Apparel/Accessories, Computers/Electronics andMass Merchant categories. Conversely, the share of retailers in the AutomotiveParts/Accessories, Flowers/Gifts, Food/Drug, Housewares/Home Furnishings, Pet Care,Sporting Goods, and Toys/Hobbies categories declines with retailer size. This suggeststhat an SSE policy would represent a more significant burden to retailers in particularsales categories if the potentially exempt retailers that are not in our data reflect thecharacteristics of our smallest category of included companies.To summarize, an SSE provision would reduce administration and compliancecosts for small online merchants, but it would also increase the possibility of behavioralresponses by both retailers and their customers (thus reducing economic efficiency andoverall welfare). It would also reduce the potential revenue gains to state and localgovernments by exempting a portion of online sales from taxation. Small firms wouldnot necessarily be harmed or helped by legislation such as the Marketplace Fairness Act.The uneven sales tax collection playing field in the current policy environment hashelped many small online retailers at the expense of many small Main Street vendors.Existing Main Street vendors—small and large alike—would continue to bedisadvantaged relative to many online and mail-order vendors that would be protected byan SSE. At the same time, while small out-of-state firms would continue to benefit fromthe differential treatment made possible by the SSE, some of those firms might bediscouraged from growing above the SSE threshold. Main Street vendors and onlinefirms that crossed the threshold would have to bear the compliance costs associated withcollecting the tax as well as the potential loss in sales that could be expected among firmsthat have to collect the tax. As a result, firm growth rates could be expected to slowsignificantly after they crossed the SSE threshold. The end result is that the economywould likely be composed of a larger-than-efficient number of small e-commerce firms.6
IntroductionSales taxes are a critical component of government revenue systems at the state and locallevels in the United States. They account for nearly one-third of all state-level taxrevenue and nearly one-quarter of all state and local tax revenue. Despite these highpercentages, state and local sales tax systems are facing significant pressure for a numberof reasons, including the recent growth in online and other remote transactions that takeplace between buyers in one state and sellers in a different state (or country). In manycases, the out-of-state seller has what is called nexus in the buyer’s state—often someform of physical presence, such as a store or warehouse—and collects the appropriatesales tax and remits it to the buyer’s state tax authorities. In other cases, however, theout-of-state seller is not connected to the buyer’s state and no tax is collected.All states with general sales taxes have companion “use tax” systems that areintended to capture the tax revenue that would have been collected had the out-of-statesale taken place in the buyer’s state of residence. In other words, if a buyer purchasessomething from an out-of-state seller, and if that item would have been taxable in thebuyer’s state, then the buyer technically owes use tax if the seller does not collect andremit the equivalent sales tax on his or