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How to Tax E-Commerce without Killing Entrepreneurship (and eBay)

A new study says that eBay (EBAY) sellers are consistently neglecting to collect sales tax. Seeing potential for billions in tax revenue, highly leveraged states are increasingly interested in a new law that would enforce tax collection for online sales. The idea has reignited a debate over whether e-commerce should be treated the same as brick-and-mortar sales: how do we tax Web business without discouraging online entrepreneurship?

The eBay study, which appears in the National Tax Journal, found that only 18% of eBay sellers got around to charging sales tax, and that even sellers recording tens of thousands of transactions weren't religious about it. (Professional sellers do not fall under the sales tax caveat that makes exception for yard sales and classifieds.)

EBay automatically gives sellers the option of adding tax when invoicing buyers, but most ignore it. That may be an increasingly perilous move, given a new tax statute going into effect in 2012 that requires third-party payment services like PayPal to report sellers' gross revenues to the IRS in a new "1099-K" form. (Though the law isn't yet in effect, a California eBay seller has already been forced to pay $15,000 in back taxes in the spirit of the new regulation.) Now a Massachusetts representative has introduced the so-called "Main Street Fairness Act" that would force all online entities to charge sales tax.

Brick-and-mortar retailers -- many of whom have operations online -- are some of the most vocal proponents of the new online tax laws. The members of the pro-tax lobby, which includes Best Buy (BBY), WalMart (WMT), Target (TGT) and others, already collect sales tax online, regardless of the buyer's state, and see Web-only retailers as having an unfair advantage.

Though eBay has been sanguine in its official statements, saying it is "confident" that regulators will protect small Internet retailers, its PR reps did tell Forbes by email they believed that, if enacted, the law "is sure to harm the economy and kill small-business jobs."

As I've argued before, more aggressive enforcement of e-commerce taxation would actually be much worse for eBay than its actual constituent sellers, or for standalone Web entrepreneurs. While the biggest eBay sellers would probably suck it up and begin charging tax, smaller sellers (wary of paperwork, and relying on thinner margins) might simply defect from the auction site, opting instead to run a cash business outside PayPal's purview to avoid the new revenue-reporting requirement. Of course, the de facto agora for cash transactions also happens to be eBay's thorn-in-the-side rival Craigslist, and as Craigslist becomes bigger -- and less tied to geographical area -- it could represent more and more of a source of attrition for eBay's core usership.

There may yet be a solution. As the Senate Finance Committee argues this week over whether to renew the Bush tax cuts, some economists are suggesting that a Value Added Tax might be one way to make the tax cuts permanent without mauling the Federal government's bottom line. (House Speaker Nancy Pelosi is a proponent of the idea.) The VAT looks like an unlikely choice on the federal level -- the Obama administration says it's not considering the option -- but the VAT solution might be more apt for online sales.

Unlike a sales tax, which is collected at the time of the transaction, VAT is collected throughout the production process of a given good. The benefit of the VAT is that there is a strong incentive for a seller to collect VAT from his buyer, so that he can deduct the tax he paid when he purchased his raw goods. In both cases, the end-user pays the tax, but only in the VAT scenario does the seller actually care whether or not the government gets its cut.

The VAT also treads lightly in the political realm, where right-wingers are loath to support any kind of new taxation. (Not a single Republican has signed on in support of the "Main Street Fairness Act.") Conservatives typically argue that taxes put a damper on growth -- but perhaps more importantly, that they create "distortions" in supply and demand, since a tax can act as a powerful and artificial disincentive to buy. Value-added taxes also cause distortion, just like sales tax, but the disincentive is generally considered to be much weaker, meaning that small business online wouldn't have to suffer as painful a drop in sales if online taxes were enforced. (More accurately, the tax is more of a disincentive on consumption than production. And according to classical economics, this is good, because supply creates its own demand.)

Because of the way they are collected, VATs also tend to collect the bulk of their revenue from imports. (To read why, check out this excerpt on Google Books.) Since many of eBay's highest-volume sellers are importers selling, say, bicycle parts from China or textiles from India, this would mean that the new online tax burden wouldn't be placed squarely on domestic buyers -- another boon.

From music downloading to e-commerce, the era of "Wild West" commerce (or, as in the case of piracy, non-commerce) on the Web appears to be waning. While it makes Web entrepreneurship seem less appealing, taxation of online sales will at least quiet administrators who claim they're being cheated out of billions of dollars that could go towards roads, schools and works projects. Are those infrastructural improvements worth raising the cost of online entrepreneurship? That remains to be seen.