Taxing the Internet

On the eve of a scheduled meeting mid-December 1999 of the Advisory Commission on Electronic Commerce, the Clinton administration issued its first policy statement on Internet taxes. It should come as no surprise that, despite the president’s avowals that the era of big government is over, the policy statement objected to proposals that would ban the collection of sales taxes on Internet purchases.

Consumers buying products on-line currently enjoy the same immunity from state and local sales taxes the U.S. Supreme Court has carved out for mail-order catalog sales. The Court ruled a decade ago that requiring retailers located in one state to collect sales taxes from consumers in another unconstitutionally encroaches on interstate commerce. Hence, sales taxes are due on mail-order and Internet purchases only if the retailer has a “physical presence” in the customer’s state of residence. Although consumers in most states are obliged to report and pay “use” taxes on items purchased elsewhere, that requirement is rarely enforced.

In 1998, Congress imposed a three-year moratorium on new Internet taxes to allow study of the issue, but with billions of dollars worth of tax revenue at stake, the debate is heating up. The supporters of legislation aimed at overturning the Supreme Court’s ruling argue that their goal is simply to restore “neutrality” to the sales tax code, that is, to ensure that purchase decisions are not distorted by differences in tax rates across jurisdictions. Currently, they say, the existence of an Internet tax haven places local retailers who must collect appropriate sales taxes at an unfair competitive advantage relative to Internet and mail-order retailers, and closing the Internet tax loophole would not impose a new tax but simply level the retail playing field. The partisans of Internet sales taxes also point to the fact that state and local tax governments lose considerable tax revenue when customers purchase items over the Internet from retailers located in other jurisdictions — tax revenue that is sorely needed to finance schools, roads, and other essential public services.

The opponents of such taxation emphasize that electronic commerce does in fact generate substantial revenue for state and local governments from a variety of tax sources, including business and personal income taxes, and that additional tax revenue is hardly needed at a time when the economy is booming and most state government budgets are awash in black ink. Moreover, given that there are some 30,000 separate state and local tax jurisdictions in the United States, each of which sets its own sales tax rate and applies that rate to a different mix of goods and services, figuring the tax due on each Internet or mail-order transaction would be an administrative nightmare for retailers, most of which operate on very thin profit margins.

Overlooked by virtually everyone participating in the debate on Internet taxes are the benefits to taxpayers of America’s federal system of government. As is the case in ordinary markets, competition between the nation’s 30,000 separate state and local tax jurisdictions helps hold tax rates down to their cost-effective minimum. If one state or city imposes a sales tax rate that is too high in relation to the quantity and quality of public services those taxes help finance, its tax base will tend to shrink as businesses and consumers relocate to other jurisdictions having lower taxes, better roads and schools, or both. But moving is costly. The ability to avoid high local taxes by making purchases over the Internet or through mail-order catalogs supplies an alternative margin of competition that forces governments to be more fiscally responsible.

While it is true that local retailers are thereby placed at a competitive disadvantage, it is also true that mail-order businesses and “e-tailers” have a competitive disadvantage of their own in the form of the shipping and handling charges which their customers must pay. Local retailers therefore have an opportunity to get business lost to catalog sales or the Internet back. They can do so by providing services consumers value — and are willing to pay for — or by lowering their prices so that, inclusive of sales tax, the prices they charge are equal to or less than those charged by Internet retailers inclusive of shipping and handling charges. That is how competition is supposed to work. When the playing field is instead leveled by forcing Internet companies to raise their prices by collecting sales taxes and remitting them to the treasury of the state where the purchaser resides, the competitive market process is short-circuited.

Proposals to tax Internet commerce are nothing more than thinly veiled attempts to protect inefficient local retailers and local governments from the beneficial forces of competition. It is unwise public policy to correct the “distortive” effects of the Internet tax haven by introducing yet another distortion. This is especially true of sales taxes, which are highly regressive, placing the heaviest tax burden on low-income Americans. Far better to allow the flourishing competition from e-commerce to help mute the distortions created by existing taxes.