The Internet Taxation Dilemma

It has all of the trappings of a major showdown. On one side stands the impressive coalition of U.S. Mayors, U.S. Governors, and America's largest retailers. On the other side is the awesome arrangement of members of the U.S. Congress and the majority of the e-commerce community - the fastest growing sector of the U.S. economy. The issue that divides them is whether or not to permit taxation of the Internet and most specifically whether or not states should have the right to force Internet companies to apply state sales tax to their goods and services.

In one sense, a clear winner in the debate will be determined by October 2001 when the current moratorium or temporary ban on most forms of Internet taxation expires. But in a very real sense the fight may be in its most critical stages today. And it currently registers as a draw.

It can be said that no clear victor has emerged largely due to the results of the most recent forum for the debate. It took place in the U.S. Congress where a special panel, established by Congress to make recommendations on the Internet taxation issue came to a gridlock. The panel, the Advisory Commission on Electronic Commerce (ACEC), made up of Internet experts, economists and government officials was marked by heated debate and acrimony throughout the course of its existence. A majority of the members (11 of 19) voted to extend the current moratorium on Internet Taxation by five years. But the Commission requires that 13 of the 19 members vote in the affirmative in order to make the recommendation official. The panel was 2 votes short. And Congress seems anxious to delay any action on the matter.

The group of major retailers, Mayors and Governors argue against the current set-up - which exempts internet businesses from having to collect sales taxes on most goods and services that it sells across state lines - for three reasons. First, they argue that the current system provides preferential treatment to out-of-state online retailers who are not responsible for charging and collecting the sales tax while local retailers have to apply the sales tax on the goods and services they sell. This of course would appear to give online outfits a price advantage. Second, they argue, that if more and more commerce goes from physical stores and onto the Internet, states will lose badly needed revenue as less cash pours into state treasuries from the sales tax. Third, they argue that the current setup is unconstitutional and strips states of their sovereignty and right to raise revenues.

The first argument, that the current system of taxation provides preferential treatment for Internet firms on the surface is true. Internet firms that sell goods across state lines do not have to tack on and collect sales taxes in the state where they are selling goods. If a Virginia on-line outfit sells something to a customer in New Jersey the online company doesn't have to pay N.J. sales tax. If that good were sold in New Jersey at a retail store, the tax would have to be applied to the price. This scenario that is repeated on a daily basis, has caused many to call the current application of the sales tax "inequitable". But the current tax conditions have hardly been produced by the Internet. For years mail-order operations, often owned by major retailers, have been able to avoid paying the sales tax, under law.

Many observers believe that if those who call for 'equality" in Internet taxation were sincere they would not be singling out the Internet for taxation - they also would be going after other operations that are not required to apply and collect sales taxes. These observers ask why the Internet and why now?

Nathan Lewis, analyst and economics editor for Metamarkets.com finds the selective nature of the pro-internet tax groups to be peculiar. " If e-commerce is really no different than catalog shopping, why do we need a tax now when catalog companies haven't been taxed in the same way in the last century or since Sears' mail order service got started?" he questions. Many see the pro-internet tax coalition's cries for e-commerce to be taxed and their relative silence on catalog businesses as evidence that their calls for "fair taxation" are disingenuous. Their critics see their efforts as evidence of opportunism.

The second argument, that the growth of e-commerce has and will result in the loss of revenue for states is also being called into question. Dallas Mayor Ron Kirk, who was a member of the ACEC has stated that e-commerce could cost the states as much as $20 billion a year in lost revenues and that this could affect the delivery and provision of government services.

But there is no data that currently backs that claim. According to the Census Bureau, sales taxes amounted to $193 billion in state and local tax revenues in 1998. The best estimates of some economists have put the amount of state taxes lost to the Internet at $430 million on a total of $7.3 billion in sales. This amounts to 0.2% of taxes collected. From these numbers it is apparent that the loss of state taxes due to Internet-related sales is not hurting state governments in a significant manner. In reality it is mail-order sales that are currently costing states revenue. It is estimated that states are losing as much as $3-4 billion in sales tax revenue from the inability to tax mail-order sales. But again it is the e-commerce industry and not mail-order that is the target of higher taxes.

Many who argue that the Internet is draining tax money away from the states do not factor in how much money e-commerce has and will continue to bring into state treasuries. Bill Kucewicz, editor of GeoInvestor.com believes that the Internet's impact on the economy is actually bringing in more revenue than it is costing the states. He says, " A strong and growing economy is the key factor affecting state tax revenues. To the extent that the Internet helps the economy grow overall, state coffers benefit via the consequent rise in personal income. To impose taxes on the Internet would slow its growth and, in turn, would detract from the national economy's overall growth. Internet taxation, therefore, would run counter to the interests of both the national economy and state-revenue raising. The proponents of Internet taxation must first explain why the states need a new tax-revenue base. There is no evidence that the Internet has had a net negative effect on state tax revenues. The data would instead suggest that the advent of the information-based economy and new Internet entrepreneurial ventures are actually boosting state tax receipts."

Kucewicz cites numbers from official Federal Reserve statistics that show that state and local government budgets have been in surplus for over six years - the exact same time period over which the Internet has grown.

The third argument, advanced primarily by the Governors is that state sovereignty is being eroded by states not having the ability to tax items sold over the Internet. But their argument is confused in the eyes of many observers because it appears the Governors are attacking an effect (no Internet taxation) and not the cause ( a Supreme Court decision in Quill Corp. v. North Dakota). The Quill decision, which was rendered in 1992, ruled that mail-order businesses do not have to collect sales taxes from purchasers living in states where the businesses do not have a physical presence, such as a retail store or an office. But the Quill decision also held that the legislative branch's power to regulate interstate commerce would make it constitutional for Congress to require that companies collect taxes from out-of-state consumers.

It appears that the Governors are laying their hat on the part of the Quill decision that makes it clear that Congress can regulate interstate commerce. The governors are lobbying Congress in the hopes that it will use that power to tax the Internet. But even if Congress did so, the Quill decision would still hold and could be interpreted as giving Internet businesses that are out of state and that use mail-order, the right to decline charging and collecting sales taxes, if they were asked to do so. In other words, the participation of certain out-of-state Internet enterprises in sales tax collection would still be voluntary.

Many observers, including the Center on Budget and Policy Priorities (CBPP) argued that the ACEC could not possibly resolve the Internet tax issue without first making a recommendation on specifically whether or not the Quill decision should be overturned. It appears that the proponents of Internet taxation want the Internet taxed but in a manner which leaves the Quill decision in place. At the same time they argue that their right to taxation is being undermined as a result of the ACEC's recommendations, the Governors are silent on Quill. This is ironic because it was the Governors, some of whom are on the ACEC, that did not strongly advocate that the Quill decision - which is the root of their inability to apply the sales tax to the Internet - be specifically addressed.

Then there is the matter of how the Internet tax would be applied in the first place and whether it would really result in increased revenue for the states. First there are numerous factors that would have to be calculated if the sales taxes were applied. In addition to the 45 sales tax states, a recent study by the accounting firm Ernst and Young found that sales taxes are imposed by 4,696 cities, 1,602 counties and 1,113 school districts and local authorities. All of this information will have to be deciphered and organized in order to make the process of tax collection by retailers possible.

In addition to this, many argue that there are still several factors about e-commerce that will make much of it exempt from state sales taxes, even if the tax were directly applied to Internet transactions. Economist Alan Reynolds, Director of Economic Research at the Hudson Institute, gives five reasons why this is the case. They are 1) most services sold over the Internet are exempt from state sales taxes - like online banking, stock trading, automatic bill paying 2) Most Internet sales of tangible goods are already being taxed 3) Online sales are like catalog orders which are exempt from taxation 4) Most states don't tax drugs and groceries which are sold over the Net 5) Digital products, like downloaded music, online games and video on demand are sold so privately that it would be impossible to tax them without violating privacy laws.

Reynolds also convincingly argues that whatever was eventually taxed would result in new revenue that would hardly be worth the effort. In a paper entitled, "The Futility of an Internet Sales Tax" Reynolds wrote:

Once we take that postulated $100 billion of U.S. online retailing in 2003 and subtract the many Internet deals that are already being taxed, would be exempt anyway, or are effectively untaxable, the number shrinks considerably. A study by Ernst and Young concludes that 63 percent of business-to-consumer sales comprise services and goods not subject to state sales taxes. Cut that to 50 percent for simplicity, and there might be as much as $50 billion of domestic Internet retailing that could, in theory, be subject to state sales taxes.
That $ 50 billion tax base may look tempting, but remember that overall consumer spending in 2003 will be well above $7 trillion and consumer incomes will be higher still. Also, the potential tax base would be rather less than $50 billion because taxing Internet sales would, of course, shrink those sales. University of Chicago economist Austin Goolsbee estimates that "to apply existing sales taxes to Internet commerce would reduce [online] spending by more than 30 percent." That is, trying to tax that puny $50 billion of taxable domestic Internet sales would chop it down to approximately $35 billion.

Therefore, our extremely generous estimate of the Internet sales that might eventually be affected by a state sales tax turns out to amount to only $35 billion in the year 2003, or one-half of one percent of U.S. consumption! A 5 percent tax on that amount would yield only one-tenth of one percent of GDP.

The Black Political Establishment, led by the Mayors, sees taxing the Internet as a means to generating the necessary income to pay for government programs for its constituents. But a review of the taxation issue leaves considerable doubt as to whether their efforts will really result in measurable revenue increases that can achieve what the mayors desire. Furthermore, such revenue comes at a great cost in that it will stifle innovation and slow the Internet economy that is spurring the entire U.S. economy. It is economic growth first and foremost which causes tax revenues to increase. And in this area, state sales tax revenue pales in comparison to what is generated by federal corporate and income taxes, which the Internet has surely increased.

To put the amount of energy on taxing the Internet that the Mayors have and at the same time not devise policies that increase the economic growth that the Internet fosters would appear to be counterproductive. Economist Victor Canto of La Jolla Economics says such a strategy hurts those with the lowest incomes. He says "There are two immobile factors in the U.S.: real estate and poor people in the inner cities, the land can't move and neither can the poor in their efforts to seek jobs due to their lack of money and means of transportation. Therefore you have to make the inner city attractive to businesses, especially Internet businesses. You have to bring jobs to those in the inner city so they can increase their mobility." Canto believes the Mayors and Governors can devise policies that reduce crime and provide fiscal incentives for Internet businesses to setup shop in the poorest areas. He believes that the Mayors, in particular, should use the Quill decision to their advantage. Canto believes that Mayors can actively promote their cities as vehicles that Internet start-up companies can use to sell products to consumers in other states and thus avoid paying state sales taxes. This practice is currently being used by many Internet companies nation wide.

In fact, the CEO of Amazon.com., Jeff Bezos, has admitted that he deliberately based his company in a relatively small state, Washington, in order to be able to tap into the markets of populous states like New York and California with the competitive advantage arising from not having to charge sales taxes on books he sells in those states. " How do we make our area attractive to the likes of a Jeff Bezos? How do we make our cities a place for Internet businesses to go? How do we market the tax advantages of doing business here?" Canto says Big-City Mayors should ask themselves. Canto believes that whatever sales tax revenue states may lose because of the Internet will be more than made up by increased real estate and property taxes (which often fund school districts) and increased state income taxes. These new property and income tax streams will be generated by thriving Internet businesses that create jobs, and which create wealth and attract new residents to the areas where these businesses are located. Rather than attempting to redistribute tax revenue Canto believes that the Mayors should focus on producing more of it via economic growth policies that embrace the Internet.

Tuesday, May 2, 2000

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