MIT Sloan Professors Find Sales Tax Can Decrease Online Purchases More Than 15 percent

Sales Tax Laws Deter Retailers from Opening Stores

CAMBRIDGE, Mass., August 26, 2008 — When online retailers open a physical store, triggering the requirement to charge sales tax, they could see a decrease of more than 15 percent in online sales, according to new research from professors at MIT Sloan School of Management. The professors found in a paper titled, “How does an Obligation to Collect Sales Tax Affect Consumer and Firm Behavior?” that U.S. state sales tax laws have a significant impact on both customer and retailer behavior, providing a disincentive for retailers to establish a physical presence in high-tax states as well as a disincentive for customers to make online purchases when sales tax is charged.

Coauthor and MIT Sloan Marketing Professor Duncan Simester explains that retail websites are required to charge state sales tax once they establish a physical presence in a state such as a retail store, warehouse or office. “On the Internet, we found that when sales tax was charged, demand dropped about 16 perecent,” he said, explaining that customers can look at competing retailers online and find alternative options at better prices.

The authors found that a way to mitigate the decrease in online sales is to offer price discounts. “The deeper the discount, the less likely customers were to look at competing retailers and the smaller the impact of charging sales tax,” said Simester. “You may still have to pay five percent more because of sales tax, but the reality is that you are already getting a good deal so there is less incentive to search elsewhere.”

For retailers who have not yet established a physical presence in high-tax states, the sales tax obligation is a significant deterrent to do so. “The higher the tax rate, the more you may want to avoid that state because the bigger the effects on sales will be,” said Simester. “Retailers that do a large percentage of business through remote channels like the Internet will stay away from high-tax states.”

The authors stated that this phenomenon only applies to the opening of a first store in a state. Once a physical presence is established, the retailer must charge sales tax to residents of that state regardless of how many other stores it subsequently opens in that same state. However, the deterrent to open stores in other high-tax states still applies.

While Internet sales are affected by sales tax, the authors found that there is not a similar effect on catalog sales. “The absence of any change in catalog purchases can be partly attributed to the difficulty of searching for lower prices at competing retailers,” they wrote. Simester explained that since catalog shoppers don't use the Internet to place orders, they have fewer options to find competing retailers because they have to wait to visit a store or for another company's catalog to arrive.

The authors noted that this research has implications for public policy debates because some retailers argue that charging state sales tax on the basis of a physical presence in a state is unfair. Some companies such as Gateway Computers have closed all retail stores in part because of the requirement to charge sales tax for online sales. Other companies have diverted corporate funds to lobbying to ensure they obtain concessions from many states on the collection of sales tax and others have engaged in “entity isolation” where a subsidiary owns all direct sales operations to avoid having to collect sales tax due to retail locations.

In addition to Simester, the paper was coauthored by Sloan School Professors Nathan Fong and Catherine Tucker as well as Kellogg Graduate School of Management Professor Eric Anderson.

Full paper:

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