Buyer Beware!

Twenty years ago German company Intershop Communications introduced a web-based store that pioneered the advent of online shopping, an industry that is estimated to reach a $2.5 trillion milestone in 2014. Sites like eBay and Amazon soon followed suit and, just last year, together they earned over $60 billion in revenue.

More than the convenience, broader product selection, and promotions that online retailers offer to consumers, millions of web- savvy shoppers have been drawn to one very appealing feature of the online retail space: no sales tax.

Based on a 1992 Supreme Court ruling that found that web merchants were not required to pay sales tax in states where they did not have a physical presence, online retailers have reaped the rewards of eager consumers hoping to save a few dollars on an online purchase.

In response to a fluctuating economy, cash-strapped states banded together in recent years to pass legislation that would require companies that sell products online to collect sales tax. The bill recently made it through Congress, and state and local governments stand to collect billions.

More than 13 states have already implemented the law and several others are planning to follow suit. Both California and Pennsylvania began imposing the tax September 15, 2012, and Texas and New Jersey agreed to collect sales tax from online purchases starting July 1, 2013, which gave consumers one more tax-free holiday season. “We’ve had a promotional period of buying online sponsored by the government,” remarks Nelson Granados, associate professor of information systems at the Graziadio School of Business and Management. “That has expired.”

At Pepperdine Granados conducts valuable research that investigates how new information impacts consumer behavior, demand, prices in the market, and competition. When news of the required sales tax on online purchases became public, Granados’ research took on new meaning.

Research comparing offline demand to online demand and determining the price elasticity of two channels is scarce. Granados uncovered that price elasticity—how demand responds to a change in price—changes depending on the channel through which items are purchased.

Inspired by his past experience in revenue management for the travel industry, Granados became determined to explore how the online shopping industry would transform when faced with the unique challenges that come with transitioning to an electronic medium for distribution such as the Internet.

It all started with his analysis of different industries and how the Internet influences the informational effect—how new information affects consumer behavior. “The Internet has made consumers smarter just because they can find so much more information online,” he says.

Granados realized that, in any industry, “...while technology affects demand and prices, and though companies were aware of these effects, the market structure is such that existing players don’t react effectively. They don’t change their strategies significantly.”

Granados explains that when businesses are confronted with a channel such as the Internet and its unique regulations, they typically opt to protect their turf rather than respond to newcomers. For established online-only sellers such as Amazon, having no reaction to the new sales tax law could have detrimental effects. “They suddenly lose the tax advantage they had over brick-and- mortar”—companies with only a physical presence—“and even click- and-mortar businesses, which must now face the reality of consumers returning to physical stores.”

To respond to this threat, Amazon has been working strategically on developing more local warehouses that can ship and deliver goods faster and temporarily offer price discounts.

With the sales “loophole” tax now in place, Granados warns of a double effect of the new regulation, the first being an overall decrease in demand as taxes increase. The second: “Those consumers who used to purchase online because they wouldn’t be paying sales tax are now less inclined to go online. Physical stores now have a leveled playing field and can compete for the customer who used to prefer the online channel because of the tax relief.”

So what does the tax ruling mean for consumers? Granados predicted that most price-sensitive buyers would have reacted by changing their behavior. And they did: reports show that, although the total number of online retail transactions went up 24 percent in the last two months of 2012, revenues went up by only 15 percent.

Granados explains that the difference was driven by online price promotions. “Average ticket prices declined by 7 percent, in part because online retailers were forced to collect sales tax and respond to competition from offline retailers. They must now honor more price discounts, which roughly add up to what the price was initially, minus the sales tax.”

“Even though you can’t put a hard causality on it, online businesses have to be more aggressive with their pricing and it seems like that is what they’ve done.” Though not all states have enforced the online sales tax, all consumers must be aware of the tax collection factor. “Even if you buy out-of- state from an online retailer that doesn’t collect tax, you are supposed to declare it in your taxes,” he instructs. “But most consumers are not even aware. The new regulation simply requires online retailers to help collect the sales tax, which will in turn raise awareness.”

Granados, who holds an M.S. in applied economics, an MBA, and a PhD in information and decision sciences from the University of Minnesota, has received multiple awards and recognitions for his research on the Internet market, including the 2007-2009 Julian Virtue Professorship, the Best Publication of the Year by senior scholars of the Information Systems field, and the 2006 Best Paper of the Year awarded by the Journal for the Association for Information Systems.