Solution to internet sales tax and the prisoners' dilemma

In part 1, I gave an overview of the prisoners' dilemma problem and how it applies to the internet sales tax issue that the US is facing.

Conditional Cooperation

One way to solve the prisoners' dilemma problem is by introducing conditional cooperation.  (I will be using the terms cooperating and defecting instead of the terms I used last time, staying quiet and confessing, respectively.)  If you choose to "conditionally" cooperate, then you automatically cooperate whenever your friend cooperates and automatically defect whenever your friend defects.  If you both choose to conditionally cooperate, that is the same as both of you cooperating.  With this option, your personal sentence in each possible situation is shown in the following table:

  Friend defects Friend conditionally cooperates Friend cooperates
You defect 5 years 5 years Go free
You conditionally cooperate 5 years 1 year 1 year
You cooperate 7 years 1 year 1 year

The important thing to notice about this table is that all of the punishments in the third row are worse than the respective punishments in the second row, which means that it's never better for you to choose unconditional cooperation over conditional.  A rational person would never choose unconditional cooperation, so we can actually eliminate the entire third row.  We also assume your friend will behave rationally and never unconditionally cooperate, so we eliminate the entire third column.  Then the table looks like this:

  Friend defects Friend conditionally cooperates
You defect 5 years 5 years
You conditionally cooperate 5 years 1 year

You can see that it's in both of your interests to cooperate conditionally and get the one-year sentence.

In terms of the original prisoners' dilemma, this is obviously cheating.  It's clear that a prisoner would never really be allowed the option of conditional cooperation, so it doesn't really solve the original theoretical quandary.  However, where the prisoners' dilemma appears in real life, often there is room to explore creative solutions.  There is certainly nothing stopping the state legislatures from adopting a conditionally cooperative solution to the internet sales tax problem.

Preliminary solution

Suppose the states start passing laws that say they will collect sales tax on interstate purchases beginning on the earliest date in which at least 45 other states collect sales tax on interstate purchases.

It's a conditional solution that incentivizes all the states to work together.  It allows the states to come up with a solution instead of waiting for one to be imposed on them by the federal government.  It removes most of Amazon's power to play one state against each other.  Now Amazon could still choose to pursue sanctions on any state that passed this conditional law, but I think that would be a public relations nightmare for them.

Of course, in this form it would pretty much devastate interstate commerce.  And I'm not talking about the lost sales due to customers having to pay sales tax with their purchases.  If you feel like I do that there's no reason not to charge sales tax on interstate commerce, then not charging it today amounts to a subsidy of interstate commerce over brick-and-mortar stores, with unfortunate side-effects.

When I say that interstate sales tax would devastate e-commerce, I'm talking mainly about the burden of regulatory compliance.  Consider the headaches for any company, especially a small one, suddenly forced to comply with the state sales tax laws of fifty different states:

  • Different states have different tax rates.  Each state may have totally different definitions for classes of items that are taxed at different rates, or not taxed at all.
  • Even worse, some states may charge sales tax on anything that is shipped from that state and others may charge sales tax on anything shipped to that state, which means customers much pay sales tax two or more times on some goods.
  • States differ in the paperwork that needs to be filled out by companies when they pay sales taxes, in accounting periods for sales tax calculations, in due dates for sales tax payments, and, obviously, in where and how to send the money.

Even though large companies like Amazon are complaining the most about this regulatory burden, it's difficult to say whether the effect will be more harmful to large businesses or small businesses.  Amazon would certainly have a huge initial project to classify each product they sell under the rules of fifty different states so they can calculate how much tax they owe on each item.  A smaller internet retailer that only sells a thousand items would have a much easier time classifying their items.  However, the ongoing expense of constantly filing different forms in each state and sending the money to fifty different places may require hiring a full-time accountant (or more) at a small company, which is a much larger burden proportionally than a few hires at Amazon who can spread the cost over their millions of annual sales transactions.

With some more creativity, we can come up with some compromises that drastically reduce this compliance burden without impacting the taxes states need to collect:

  • Charge tax on all physical goods, with no special rates or exemptions.
  • Split the tax evenly between the state it's shipped from and the state it's shipped to.
  • Set a uniform tax rate for all states.
  • Phase the tax in gradually.
  • Provide a centralized website for companies to report all their sales and pay one tax, which will be distributed to the appropriate states.

Ideally, states would even roll their existing intra-state sales tax collection into this scheme, further simplifying the sales tax collection process.

Refined solution that's fair to everyone

Incorporating the improvements in the previous section, I propose a sales tax law along these lines:

"This state will charge sales tax on interstate purchases beginning on the earliest date in which at least 45 other states collect sales tax on interstate purchases or on January 1, 2012, whichever is later.  Sales tax must be collected by the selling party.  All physical goods will be taxed at the same rate and no physical goods will be exempt from sales tax.  Items will be taxed at a 2% rate for the first twelve months that the sales tax is in effect, a 5% rate for the next twelve months, and an 8% rate after that.  Half of the sales tax will go to the state where the item is shipped from and half of the sales tax will go to the state where the item is shipped to.  The selling party is required to report their total sales for each tax period divided up in two ways: first, by which state it was shipped from, and second, by which state it was shipped to.  The selling party will then pay one payment, consisting of the total sales amount times the current sales tax rate to a national sales tax body who will then disburse the funds to the appropriate state governments."

This is still just a sketch.  I'm open to suggestions, and even have a few ideas myself.  But I'm hoping it's a good start to a simpler and fairer sales tax scheme.  What do you think?

Footnote: It looks like there is already a group trying to do something similar, the Streamlined Sales Tax, and twenty-four states have already signed on.  It doesn't sound as simple as the scheme outlined above, but it's definitely an attempt to accomplish the same thing.  Interestingly enough, it exempts "small" online and catalog businesses.  An interesting question is whether it requires a federal statue to legitimize it, which is what the Main Street Fairness Act is trying to do.