1. Referee Report:
The Internet as a Tax Haven?
The E↵ect of the Internet on Tax Competition
David R. Agrawal, 2014
Melika Liporace
November 17, 2014
1 Summary
The aforementioned paper investigates the e↵ect of e-commerce availability on tax competition be-
tween localities in the U.S., examining both the theoretical predictions and the empirical results. To
do so, the author uses the U.S. sales tax system that interestingly relies on a decentralized multi-layers
setup - state, county, municipal and sub-municipal levels. To research the main question, whether in-
ternet constitutes a tax haven or actually helps enforcing taxes, he distinguishes two types of e-shops:
websites without nexus - that are not required to pay sales tax to localities - or with nexus - that
must then collect local sales taxes given the location of their consumers. It follows that two competing
e↵ects are at stake: either Internet creates a way for consumer to escape local taxes, constituting a
virtual tax haven, that will lead to an ine ciently low tax rates, as suggested by tax competition
theory; or Internet gives the possibility to jurisdictions to collect taxes on firms that are not physically
implemented, retains consumer that would have crossed border and hence could reduce competitive
pressure between localities.
Both of these hypotheses rely on a theoretical analysis, based on a similar model, in which two
border towns that are 1 unit long and 1 unit populated are located in di↵erent states, with di↵erent
state sales tax rate - relatively, high and low. The consumers have inelastic demand and can obviously
cross-border (mobile tax base). The two towns compete in a Nash game and want to maximize local
tax revenue. When solving the model as such - no internet, benchmark solution - the author finds
a Nash equilibrium in which the high-tax state town sets a lower local sales tax than the low-tax
state town. To account for the tax haven hypothesis, Agrawal introduces a fraction of population to
have access to the untaxed online commodity - hence escape from taxes revenue - and thus creates
a downward pressure on tax rates. The high-tax state locality will however lowers its tax rate rel-
atively less, as it was already pressured by lower prices outside. Unsurprisingly, two notable factors
modulate this asymmetry in response: the magnitude of the tax di↵erence between states and the
cost of cross-bording. Finally, the author proposes a model for the anti-haven e↵ect of internet, by
assuming that online shopping, even taxed, can be preferred by consumers because of their intrinsic
preferences. Hence, consumers that would have crossed the border previously now shop online, which
creates an upward pressure on tax rates, which is similar across localities. In a last theoretical step,
Agrawal examines the asymmetrical e↵ect of internet on taxes with regard to town size; to isolate
this e↵ect, he assumes similar state tax rates between towns and find that untaxed online purchase
access lowers local tax rates in small localities less than in large ones, as its tax base is relatively small.
To test which hypothesis is better-suited, the author confronts the predictions to empirical data.
Concerning taxes, the Pro Sales Tax’s national database records sales tax rates at town, county, data
and district level. Agrawal restricts the sample to states with municipal sales taxes, identified in Cen-
sus Places from 2010 American Community Survey (ACS), and as cross-section from 2011. Concerning
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2. Internet penetration, he obtains data from July 2011, using the National Broadband Map, collected by
the National Telecommunications and Information Administration (NTIA) and the Federal Commu-
nication Commission. As robustness check, he instruments Internet through lightning density, which
is measured by flash density using the National Oceanic and Atmospheric Administration’s Severe
Weather Database, from 1996 to 2011.
The empirical methodology follows two steps. A baseline specification is first conducted as a cross-
sectional OLS regression of tax rates on Internet usage - as such and interacted with town size -,
geographic, political and demographic controls, and including state fixed e↵ects; the Internet usage is
best (highest R2 in univariate regression) proxied by access to 4 providers , but alternative measure,
such as a combination of Internet related variables, are used as robustness checks. The first results are
consistent with a downward pressure on tax rates, as ”a one standard deviation increase in Internet
penetration lowers local tax rates by 6% of average rate”. To correct for the constraints on the tax
rates (between 0 and 1), the author implements a fractional response model, which leads to similar
results and is preferred for subsequent analysis. As verification, he runs a Tobit setup - as long as
di↵erent response functions specification, e.g. Cauchy distribution - and finds consistent estimates.
Extra robustness checks include di↵erent sets of controls and county fixed e↵ects; the significance of
the coe cient indicates that results are not driven by omitted variables common to counties. Finally,
as an alternative to the population x Internet penetration interaction term, and to account for the
asymmetry in response depending on the size, Agrawal splits the sample between small and large
jurisdictions (divided w.r.t median, alternatively mean). As predicted, the response in small towns is
not significantly di↵erent from zero, while the response in large localities is of greater magnitude.
The second step of identification focuses on a discontinuity approach, as the state sales tax rate
discontinuously changes at the border. Hence, the only omitted spatial threat to identification would
now require to have asymmetric e↵ects on local tax rates depending on the locality state. The speci-
fication now includes distance to the border, as such, interacted with a high-tax state dummy - which
allows the e↵ect of distance to vary asymmetrically between high and low tax state localities - in-
teracted with the internet variable and with both the internet variable and high-tax state dummy -
which once more allows the e↵ect of distance to vary not only w.r.t distance to the border but also
asymmetrically between high and low tax state juridictions. For all of these terms, a cubic polynomial
is included rather than the usual linear term. Note that the author verifies that the observable control
variables do not change at borders; almost none of them do. The results are once more consistent
with theory: Internet e↵ect is mainly significantly negative for low-tax state; the results are stronger
when focusing only on large towns; the closer to the border, the bigger the asymmetry of the response;
the smaller the state tax di↵erence, the smaller the response. The analysis is reproduced at a county
level - as well as inside metropolitan statistical areas (MSA) - and finds similar results. To check that
the e↵ect is driven by di↵erence in Internet penetration rather than a border e↵ect, a placebo test is
performed for towns in di↵erent counties but find similar e↵ect of Internet on tax. As a final step, he
creates a dummy for states that have above average firms with nexus - using (partial) data from Bruce,
Fox and Luna (2014) -, which he interacts with all the Internet terms in the discontinuity design; he
finds that for towns with above average e-firms with nexus, a positive e↵ect of internet on tax rates
can be observed. Hence, the empirical findings seem to be in accordance with the theoretical predic-
tion, with the haven e↵ect to be prevalent on average, but the anti-haven e↵ect to be observable as well.
2 Contribution to Literature
Tax competition is not a new topic in public finance and economics literature. An arguably first model
of tax related migration dates back to 1956, with Tiebout theory of the welfare enhancing auto-sorting
households mobility. More critical on tax competition, Oates (1972) properly opens up the way to tax
competition theory, modeling a Nash equilibrium resulting in a suboptimal tax rates because of in-
tergovernmental competition - finding still used as an argument against tax havens. Many theoretical
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3. papers followed, including Nielsen (2001) on which Agrawal bases his model. He adds the tax evasion
possibility o↵ered by e-shopping. Although standard literature models behavior of contributors and
adds costs of tax avoidance, as proposed by Slemrod (1994) for instance, demand is simply inelastic in
this model. In that sense, Agrawal takes a step backward from literature. One could argue the reason
to be avoiding unnecessary complexification of the model. We will however discuss that element in
the following section. As a result, only the revenue leakage function is modeled, and specified as an
already used specification forms. Maybe a more daring contribution in the theoretical part concerns
the anti-haven e↵ect, for which Agrawal assumes preferences to shop online. Nevertheless, once more,
no micro-based model is set to describe the consumer preferences or choices.
The article tackles another sensitive issue, that is tax avoidance. Tax havens are a well-known
topic in public finance literature, but their e↵ects are still discussed. If tax havens are generally viewed
as bad, since they increase tax competition, which leads to a decrease in welfare (see e.g. Slemrod
and Wilson, 2009). Other scholars modulate this results, like Johannesen (2010) that argues that
tax havens diminish attractiveness of the competed prize and hence could lead to an increase in tax
revenues. Further empirical evidence from Desaia, Foleyb and Hines (2006) would indicate that tax
haven stimulate investments, promoting in fine growth; this positive enlightement on tax havens is
developed further by Hines (2010). The paper relates largely on that literature by its setup, as e-
commerce can be viewed as a tax-leakage, hence becoming virtually and practically a tax haven.
Arguably, the contribution is more empirical than theoretical. If tax competition is quite an old
issue, both theoretically and empirically, e-commerce is not. Yet, many empirical papers already tried
to tackle this issue, by linking internet and tax. However, the recent literature emphasized the e↵ect
of tax on internet purchase, studying the change in consumer behavior under these new technology
opportunities. We could for instance cite Goolsbee (2000), Ballard and Lee (2007) or Einav et al.
(2014). Some other papers investigate the revenue consequences of the aforementioned e↵ect, such as
Bruce and Fox (2000) or Alm and Melnik (2012). However, none of them studies the e↵ect of online
shopping on taxes.
This issue is nonetheless central in both media and academic world. Notably, taxation debates are
and always have been a sensitive topic in media, as it constitutes more than an economical question, a
political issue and concerns every citizen (and non-citizen). The debate on technology and its influence
on growth, employment and poverty is also famous - or maybe infamous. Dating back to industrial
revolution, the place of technology in the economical development has aroused passions for a long
time. Quite naturally, the mixed issue of tax and technology surely interests media.
Even more light has been shed on this issue recently in U.S. media, as the Marketplace Fairness
Act was discussed. This bill would require online firms that have no physical presence in any state (no
nexus) to still pay the sales and use1 taxes to states in which they provide consumers. If the debate
dates back to 2013, the news page of the o cial website2 indicates that the question is still actual -
and that tweets about it are still trending and numerous.
More than the popular and trending topic examined, the tax policy implications of the paper can
be underlined. As the paper does not rely on empirical evidence only, but is backed up by theory, the
mechanisms at stake are salient, meaning that not only do we know what e↵ect internet penetration
have on taxes, but also we have an insight on how it is a↵ected. As the relation is complex - depends
on the relative quantity of firms with or without nexus in the state, the size of the town, its location
and its neighbors - the reliance on theory seems necessary; it does contribute to validate the theoret-
ical framework as each mechanism at stake seems to be validated by one or the other specifications.
Hence, one could argue that Internet is not necessarily a tax haven, as anti-haven e↵ects are empiri-
1
although discussed in the paper, this tax was not explained in the above summary, as it is indicated that it is largely
under enforced, leading to practically no e↵ect, for our analysis at least
2
see http://marketplacefairness.org/news/
last consultation on the November 16, 2014
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4. cally observable as well. Overall, general conclusion can be drawn as the dominant e↵ect depends on
the nature of the locality - its size, state, firms composition, etc. We note the tax haven e↵ects seems
however dominant in most of the cases; yet, even as such, conclusions from former empirical work
discussed above could be recovered.
The magnitude are also of similar size throughout the paper, which reassure the faith in their
consistency and relevance. All and all, the paper is quite strong in addressing a new issue by using old
methods and theories. If nothing is really revolutionary in methodological matters - no breakthrough
on instrumental variables or never-used-before specification and econometrical methods - the findings
are still relevant to both social and academic interests.
3 Weaknesses and Main Issues
Overall, both theoretical and empirical procedures are well rooted and strongly backed up by previous
analysis. However, some elements can be qualified as missing or not very convincing. In a theoretical
matter first, it is interesting to note once more that behavior of consumer is not properly modeled.
Although the indi↵erent consumer is properly defined, and implicit micro-based theory is used, con-
sumer preferences are not specified.
Specifically, inelastic demand is assumed; as the results concern tax variations, a price variation
may occur, leading the inelastic demand assumption to be used. It is nevertheless not really credible,
especially when the author cites Einav et al. (2014) contribution to the field. Einav et al. (2014)
indeed measures the online shopper sensitivity to sales taxes and find ”a price elasticity of around -2
for interested buyers”, which is a substantial value. At first glance, it would be particularly interesting
to conduct an analysis of elastic demand of consumers - at least online shoppers - in the anti-haven
setup. As we expect an increase in tax rates, prices are expected to raise, and the beneficial e↵ects
from more local buyers through online shopping (less cross bording) could be o↵set by the decrease in
demand due to the increase in prices. Potentially, local jurisdictions could endogenize that response
and potentially not increase their tax rates, or at least not as much as predicted by the theory exposed
in the paper.
A second concern could raise from the measure of internet penetration. Let us recall that both the
baseline and discontinuity specification include internet penetration - that is an indication of online
purchases, that cannot be included as such on pain of endogeneity - this measure has to be proxied.
As explained previously, given the di↵erent variables of his database (any access to internet, speed of
connexion, number of providers) the author first uses the variable that maximizes the univariate re-
gression R2 when regressed on state-level Internet usage from the Consumer Population Survey (CPS).
His second measure is a combination of available mentioned data, following Lubotsky and Wittenberg
(2006). His final strategy is to IV internet usage from a weather based variable, that is, lightning
strikes, arguing that ”power disturbances increase the cost of investing in IT, which then lowers IT
investment and Internet usage”.
If all the methods have precedents in literature, their relevance is here arguable. The first univari-
ate R2 argument is convincing, although it relies on pure empirics and no real theory: why would four
or more providers be a better measure than three or more providers? - the argument of competition to
explain quality, price and in fine access to internet is strong, but the exact variable chosen could just
be a matter of sample, for which the R2 was by chance maximized. Still, the method has precedent
and the argument stays somewhat valid.
The same cannot be said concerning the IV used. The author acknowledges that ”lightning may
be correlated with weather conditions or topographical features, which are unlikely to be correlated with
tax rates unless weather related amenities influence public good preferences”. Yet, it seems logical for
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5. the weather condition to be directly correlated to public good demand! Indeed, when a town is subject
to more lightning strikes, more public investment should be made in infrastructure that could both
prevent or stand lighting strike damages. This requires more taxes. Hence, the instrument used does
not fulfill the exclusion condition and should not be implemented. Even though it merely reflects one
more robustness check, it should not have any value on the consistency of the results and should not
be accounted for.
The main issue - that is usually corrected by IV - is simultaneity in the specification. It is indeed
probable that the sales tax rates influences the quantity of internet providers, as well as the other
Internet related variables. Competition is likely to be fiercer in low-tax environment; even if the In-
ternet providers were not to be levied directly according the sales tax rates, the general fiscal system
of the state would be correlated to the sales rate, and which would influence the quantity of Internet
providers. Hence, the dependent variable would have an e↵ect on the independent variable, whose
coe cient is of interest; i.e. reverse causality bias. Let us note that he argument that makes other
internet related variables relevant for the co-proxying in the second measure of Internet penetration,
also discredit them as exogenous. As explained above, the IV methodology used here is not a viable
solution to this issue, as the exclusion restriction could be not met.
Another minor issue could also arise from the ”split sample” analysis. As described previously,
Agrawal argues that the ”split sample approach is preferable to interacting I with the log of popula-
tion” and divides the sample above and below the median of the population by localities. He then
assesses that: ”the sub-sample of “large” towns contains 97% of the population from the full sample;
this suggests this subsample analysis is still economically meaningful and applicable”. However, the
analysis is conducted on both sub sample: small and large towns. The e↵ect from small towns is
theoretically predicted to be negligible, and the empirics indeed find insignificant coe cients. Yet, the
size of the sample let us doubt whether the sub-sample of small towns is representative. It follows that,
even if it is true that the results are not inconsistent with the theory, they are not properly consistent
with it neither, as they should not have indicative value because of the small size of the selected sample.
4 Further Research
Although already quite dense, some further analysis could have been, or should be, conducted. The
first obvious step forward would be a welfare analysis. As argued before, the issue treated in the pa-
per is a peculiar public issue, that relates to multiple social matters, such as inequalities, government
e ciency or public investments. A welfare analysis could be particularly adapted as the specification
tested relies on a proper theoretical model. The straightforward analysis would simply concern the
change in revenues of localities compared to the change in prices (implicitly, the change in consumer
surplus). However, the assumption of preferences for online shopping per se raises the question of other
element entering the consumer surplus, such as higher diversity of goods, or even higher e ciency of
purchasing due to broader availability of information. Furthermore, as discussed above, a behavioral
model for the consumer could be required. From then, the author could estimate the change in local
revenues due to internet penetration, by identifying change in demand, allocation of demand - foreign,
online or local - and change in taxation.
Another interesting factor in the welfare analysis would be the distribution of internet access and
its influence on price discrimination. If internet is perceived as a tax havens, which in fine would
increase tax rates, and is furthermore accessible to the richer class rather than randomly assigned, it
can become a regressive taxation system and would be socially unacceptable - rich people have access
to tax-free goods whereas poorer consumers deal with sales tax. On the other hand, if tax-free online
shopping is preferred by consumers that have more time, whereas richer citizens prefer going to a
nearby store, internet would be seen as a tool towards e ciency - would tend to equalize marginal
cost of time and money for both parties. Finally, no matter the assumptions, e-commerce allows for
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6. price discrimination - online auctions, or di↵erences in tax rates - which could lead, to some extend,
to increased e ciency. Once more, it could be interesting to model the consumer behavioral maxi-
mization, to allow for elastic demand and perform a more relevant welfare analysis.
Another behavioral model could concern the governments. In the paper, the author considers both
localities to maximize the tax revenues - in a Nash game setup. It could be interesting to consider
other objective, especially for small towns. Agrawal acknowledges this element when referring to
”less sophisticated” small jurisdictions, that would then be ”less strategic” in their taxation behavior.
Without rushing into the rent-seeking breach of political economy, we could imagine a case where
small localities have a fixed revenue they try to achieve. The other analysis, at the other extreme of
rationality, would obviously be the benevolent government that tries to maximize the overall surplus
of their town. A final step could be to consider both competition and cooperation equilibrium in the
Nash game, with or without internet, to make final policy implications.
Finally, regarding the empirics, it could be interesting in future exploitation of data to use a panel
data setup. If at the time of the publication, internet related variables were available only as cross-
sectional, future availability could lead to an analysis allowing for town fixed e↵ects, removing almost
any risk of omitted variable bias, except time-varying factors that would influence towns asymmetri-
cally across border. We could argue that technology-acceptibility as part of the behavioral preferences
of the citizens could constitute such a factor: it depends on the initial levels of technology but is time
varying; it could be regional but evolves di↵erently across border, especially in the case of small vs.
large jurisdictions, or as a general trend the would be state specific (but once more time-varying). In
that case, panel data would not be the perfect solution. It would however reinforces the findings of
the paper by narrowing the possible biasing unobservables.
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