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Another View On Internet Taxation


Because of its impact on the world economy and the potential it has to foster economic growth or leave Blacks behind - the structure of the Internet Economy is of the greatest importance. And while most Blacks are not paying attention, America's political establishment and larger business community are shaping the tax policies that will affect the Internet and its potential growth the most. As such maneuvers continue we will keep you informed of the different viewpoints and opinion leaders in the battle to control the Internet and the level of prosperity that it generates. The latest contribution to the discussion is an article entitled "Tax Time : How to think about the Internet sales tax quandary" written by Jonathan Zittrain and Rebecca Nesson. It appears in the current online edition of the New Republic. Just another perspective to consider in this debate.

Tax Time


Utah Governor Mike Leavitt has a pretty tough job these days. As a leading spokesman for the National Governors' Association, he has the unenviable task of showing up at congressional hearings to argue in favor of some taxes that are already on the books but are both politically unpopular and increasingly difficult to collect without congressional assent. He's trying to keep state sales tax alive.

So when John McCain convened a hearing on extending the Internet Tax Freedom Act (ITFA) a few weeks ago, Leavitt was there. Anti-tax advocates love this measure: it preserves the two-year-old moratoriums on multiple and discriminatory taxation of Internet commerce, as well as a ban on any new taxes on Internet access. For them, any bill that bans taxes is a good bill, even if--as in this case--it only bans taxes that no one wanted to impose in the first place. Leavitt, on the other hand, is more worried about a matter the bill neglects to address: a state's right to collect sales tax on goods sold over the Internet. Fearful that Congress would pass a hollow bill and leave the critical issue untouched, Leavitt argued against it on the grounds that it was unfair to states, which won't be able to provide essential services as commerce goes online and tax revenue dwindles, and unfair to "Main Street" stores, which won't be able to compete with their online counterparts when the former charge tax and the latter don't. Backed by bricks-and-mortar retailers who share similar fears and interests, Leavitt and 41 other governors prevailed on McCain to table the bill.

Now Leavitt and just about everyone else with a stake in the Internet tax issue are descending on Capitol Hill in search of bills or amendments favorable to their interests. Each side is making arguments about what to do about Internet sales tax, and when to do it. Anti-taxers such as Grover Norquist and Virginia Governor James Gilmore want Congress to act immediately to make the ITFA moratorium permanent, lower telecommunications taxes, and ban a bunch of arguably new taxes, like tax on the sale of digital goods. Most important, avid anti-taxers vehemently oppose any action that would make it easier for states to collect sales and use taxes on goods purchased from out-of-state businesses. On Leavitt's side are most of the state governors and big retailers like Wal-Mart, who want Congress to promise that in the near future it will give the states permission to do just that. Rhetoric aside, the facts show that it's OK--perhaps even desirable--to let Internet sales go essentially tax-free for a while. In time, however, the piper should be paid.

Although the ITFA is only two years old, the moratorium on collecting sales tax from out-of-state sellers dates from 1992. In Quill v. North Dakota the Supreme Court held that without congressional permission, the states simply aren't allowed to force wholly out-of-state merchants to collect sales tax on their transactions with in-state customers. The Court reasoned that the burden to sellers of calculating, collecting, and remitting every state and local sales tax was simply too great. For a state to require a seller to collect, the seller must have "nexus"--simply stated, physical presence--with the customer's state. The Supreme Court left it to Congress to lift Quill's sales-tax moratorium.

This is decidedly inconvenient to the states, which, in the eight years since the Court handed down the Quill decision, have seen increasing amounts of interstate consumer trade (primarily through mail-order catalog sales) escaping tax. Of course, most states have a "use tax," which consumers are supposed to remit to state and local governments whenever they manage to avoid paying a sales tax, but no consumer does (at least for anything smaller than cars and boats, where registration offers states the opportunity to explicitly demand the tax).

Realizing that it's probably impractical--and politically suicidal--to push for enforcement of the use tax, state and local governments have devoted their energies to ending the Quill moratorium, giving rise to all sorts of dramatic rhetoric about the calamities that might befall states without sales-tax revenue. Lisa Cowell, the executive director of the pro-tax E-Fairness Coalition, framed the ITFA issue as a struggle over "whether or not states are going to be allowed to raise the revenue to teach our children, to protect our families and build our roads."

Yet if you examine the numbers, you'll see that Quill's moratorium on Internet sales tax has yet to cause anything approaching the chaos some pro-taxers fear. Internet sales are still quite small compared to the revenues states collect from sales tax more generally. The latest census figures show that sales tax generated $193 billion in revenues for state and local governments in 1998. The best estimate, from the latest census and Forrester Research data, of state revenue lost in 1998 because of the Internet sales tax moratorium is $210 million, or less than one-quarter of one percent of total state and local tax revenues. Even when extrapolated through 2003, the total losses still do not reach two percent of the total state and local tax revenues.

In fact, far from hurting the economy, the Quill moratorium is actually proving to be beneficial. Keeping out-of-state sales tax-free subsidizes the infant e-commerce industry, creating an incentive for people to use the Internet for shopping. In this regard it works the same way as the ITFA's moratorium on new taxes on Internet access, which lowers the barrier for people to go online in the first place. The economy benefits from this because the Internet yields positive "network externalities;" that is, it becomes more useful to everyone as more people use it. (This is a general phenomenon of networks; compare how useful a fax machine might be to someone when only ten others own one versus when millions of others own one.) When people buy online, they're not simply taking sales away from existing retailers; they're creating new markets that expand the economy overall. Services like eBay--which uses the benefits of networks to create a better market than can be created by flea markets and yard sales--can truly be considered new economic activity.

The anti-taxers find in this new activity strong evidence for making the current moratoriums permanent (or, as New Hampshire Senator Judd Gregg put it, "keeping the Internet from being pecked to death by a thousand chickens looking to assess taxes against it.") But Gregg's words, if true, aren't necessarily enduring: a subsidy to an infant industry should not become a subsidy to an established industry--and no one doubts that e-commerce is quickly becoming an established industry. The kinds of statistics that counsel forbearance now are the same ones that show that Internet sales should be taxed later. The most recent figures from the Census Bureau estimate $5.3 billion in e-commerce sales in the fourth quarter of 1999. According to Forrester Research, that number will soar to $108 billion in online retail sales by 2003. Although it's difficult to make predictions beyond that, it's possible that revenue loss from online, interstate transactions--the ones for which Quill currently blocks sales-tax collection--could amount to ten percent of total sales tax revenue.

As e-commerce grows, and the harm to states from lost sales-tax revenue grows with it, it becomes very difficult to deny that taxes ought to be collected on Internet sales. Tax experts may have differing personal views as to whether taxes should be raised or lowered generally, but they tend to agree that it's better to tinker with rate than to tinker with scope when seeking to adjust the public's tax burden. As the use of the Internet continues to mature and the benefits of the network externalities discussed earlier are reaped, distinctions such as "in-state/out-of-state" or "ordered through the Internet/ordered in a store" become truly arbitrary. Local merchants, many of whom receive only a four to five percent profit on their wares, should not forever pay a sales tax while their online and/or out-of-state counterparts do not.

The problem for Leavitt and the rest of the pro-taxers, of course, is that the simple fact of states losing revenue isn't enough reason to end the Quill moratorium. When Quill was decided eight years ago, mail-order sellers generated far more tax-free revenues than e-commerce did last year. The real problem--the high burden of collecting sales tax on Internet purchases--must be solved before Congress is likely to be persuaded to change Quill.

The greatest contributor to the high collection burden is the total lack of uniformity in state and local tax bases. As anti-taxers never tire of pointing out, even the simplest goods are treated in vastly different ways in different places. A 1999 Ernst & Young report commissioned by the anti-tax E-Commerce Coalition found that Wisconsin collects taxes on "any beverage which is not 100% juice…[w]hile Pennsylvania taxes juice if it has less that 24% real fruit juice, [and] Texas requires at least 99% real fruit juice to be exempt." Nor is the problem limited to the state level. The report identifies 7,458 state and local tax jurisdictions; other estimates run as high as 30,000. Throw in tax holidays--days when the usual sales tax on a certain product does not apply--and tax schemes can reach dizzying levels of complexity.

Realizing the necessity of reform, Governor Leavitt announced at the ITFA hearing that the states have begun to work together on designing a simplified tax system, a pilot version of which could be ready this fall. The pro-taxers fear that if Congress approves the ITFA extension or some other Internet tax measure before the new system is ready, it will wash its hands of the entire issue, leaving Quill untouched and making the sales-tax moratorium permanent. Leavitt therefore used his appearance at the hearing to plead for enough time to complete the system.

Although it would more than double the length of his mercifully short bill, McCain would be wise to include language giving Leavitt and the states the chance they need. The optimal change to the ITFA extension bill would add a carrot and a stick to encourage the simplification process. The carrot should be a promise that Congress will change Quill's definition of nexus and allow the states to collect sales tax from out-of-state merchants if they adhere to three simplification principles: there should be uniform rules about what items and services are subject to tax and how those items are defined; while rates can vary from one state to the next, each state should have a single sales-tax rate; and sellers should be able to remit taxes to a single agency that would collect those taxes and pass them along to the appropriate state. The stick should be a deadline by which the states must accomplish this simplification or the promise of ability to collect will evaporate.

To be sure, adopting these simplification principles will be politically difficult for state and local governments. But with billions of dollars of tax revenue at stake, they have a large incentive to comply. Leavitt and the other governors at least deserve a chance to put their system into effect. While they work on it, the Net can enjoy its infant subsidy.

JONATHAN ZITTRAIN is the executive director of the Berkman Center for Internet & Society and a lecturer on law at Harvard Law School. REBECCA NESSON is a student affiliate of the Berkman Center and a student at Harvard Law School.


Cedric Muhammad

Tuesday, May 9, 2000

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