Internet sales tax and the prisoners' dilemma

In the field of game theory, where we study strategic behavior, the prisoners' dilemma is a classic problem.  It goes like this:  Imagine you and a friend committed a crime together.  You are both caught, put in separate rooms, and given the chance to confess and testify against each other.  If niether of you confesses, you will both get one year in prison for a minor charge.  If one of you confesses, he will go free and the other one will go to prison for seven years.  However, if both of you confess, you will both go to prison for five years.

To understand the dilemma, it helps to take a moment and think about what you would do in this situation.  To help you make your decision, here is a table that shows what your sentence will be depending on what decision you and your friend make:

  Friend confesses Friend stays quiet
You confess 5 years Go free
You stay quiet 7 years 1 year

If your friend confesses, is it better for you to confess or stay quiet?  What if your friend stays quiet, is it better for you to confess or stay quiet?

What makes the prisoners' dilemma problem so interesting is that no matter what the other person does, your sentence will be slightly better if you confess than if you don't.  If both people give succumb and confess, however, they are both much worse off (five years in prison) than if they had stayed quiet (one year in prison).  In other words, even though both people refusing to confess seems like an ideal outcome, refusing to confess is a very risky strategy because you will be much worse off if your friend chooses to betray you.  It seems like quite a paradox, but it's true, and it can lead to some tricky situations in real-life, too.

Internet Sales Tax

In the United States, sales tax has never been charged on the sale of physical goods if they are shipped across state lines.  In recent times, however, some states have decided to change this and charge sales tax on inter-state sales.

Some people think that the states are just grasping for any revenue they can find in order to make ends meet.  Others think that not taxing internet sales is a true loophole, an unfair advantage that rewards internet companies and punishes brick-and-mortar stores.  If there are reasons to encourage interstate commerce by not charging sales tax, then Amazon certainly seems to be pushing them to the limit.  They are actually setting up fulfillment centers around the country so many of their shipments don't actually cross any state lines, but they're still claiming that they don't have to pay sales tax in those states as an out-of-state company.  If they can get away with that, it definitely seems like an unlevel playing field, the type of advantage for mega-corporations over small businesses which doesn't sit right with me.

Ultimately, it seems that taxing sales within a state but not taxing anything that crosses state lines doesn't make much sense.  If the government deserves to take 6-10% of every dollar we spend to create quality roads, safe cities, and a functioning economy to make commerce possible, then why exempt some things just because they travel longer distances?  Why discourage people from buying locally and encourage them to use distant companies that will waste energy driving things across an imaginary line solely to avoid taxation?

States that are trying to start charging sales tax on internet purchases, however, are having trouble because they're in a prisoners' dilemma...

The states' dilemma

States would like to charge sales tax to recover the revenue they're losing as people purchase more and more goods online.  The problem is that Amazon can punish any state that enacts an internet sales tax by canceling all Amazon affiliate accounts and ceasing construction spending in that state.  In effect, they're playing the states against each other, making sure it's in each state's best interest to not charge internet sales tax, even though the states would all be better off if they all charged internet sales tax.  If every state charged internet sales tax, it would be better for all of them.  Amazon wouldn't cancel its affiliate program anywhere, as it's certainly more profitable to have an affiliate program than not to.  Similarly, having a network of geographically distributed warehouses would still likely be a smart business move, so Amazon would maintain their expansion and construction around the country and would be similarly unable to use that as a bargaining piece to pit the states against each other.

In part 2, I explain a way we can solve the internet sales tax problem in a way that's fair to all the states and also to internet retailers, and how it relates to the prisoners' dilemma problem in general.