To Tax and Tax Not

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Event Summary

With the 1998 Internet Tax Freedom Act halfway through its three year moratorium on new or discriminatory taxes on E-commerce, individuals and organizations on all sides of the issue are preparing for a major battle over whether states should be permitted to levy and collect sales taxes from transactions concluded over the Internet. Industry and government associations from all sides are staking out their positions, and the topic has reached into the presidential campaign. The major political question pits sales taxes as stiflers of commerce against taxes as enablers of services.

Somewhat caught in the middle on this issue are states that have become E-commerce hubs. With their economies benefiting from the presence of a thriving Internet industry, they are afraid to do anything to upset the apple cart. Meanwhile, both their Main Streets and shopping malls are complaining about business being lost to tax-free online retailers, and pointing out that lost revenues mean lower taxes. In a downturn both retailers and state services could be severely compromised. The nation of Singapore doesn't have problems with this balance. They are providing tax incentives to lure E-commerce trading centers.

Market Impact

Massachusetts Governor Paul Celluci made sales taxes of Internet commerce a prominent point in his State of the State Address on January 20. "It makes no sense to put a sales tax on Internet commerce," he announced. In fact, he had earlier overruled his own Department of Revenue and declared Massachusetts an "Internet tax-free zone," thereby waiving state sales taxes on Internet services that were still permitted under the Internet Tax Freedom Act. That Act put a hold on new taxation of Internet access and on "multiple or discriminatory taxes on electronic commerce." The law did not prevent states from using existing sales tax laws to tax sales within a state, and states are free to collect sales tax for items sold over the Internet and delivered within the state. They cannot compel companies in their state to collect taxes on items delivered out of state, nor can they compel out-of-state companies to collect sales tax on items delivered within their state.

Politics is a major shaping force in the taxation debate across the nation. Presidential candidates Bill Bradley and Al Gore have issued statements in which they support the current moratorium and look forward to a tax policy that "encourages the astonishing growth of the Internet" without "stripping states and localities of the revenue they need to educate our children and fight crime." Republicans also generally support the current moratorium, and some -- like Steve Forbes and John McCain, say that they will make the Internet a permanent tax-free zone. George Bush does not argue for a permanent ban, possibly because his home state of Texas has no income tax and relies more than most states on sales tax revenues.

As evidence of how critical this issue is seen by politicians of all stripes, commentator William F. Buckley, Jr., devoted the very last edition of his long-running Firing Line show to a debate on the question "The Federal Government Should Not Impose a Tax on Electronic Commerce." Conservatives such as former Representative Jack Kemp argued that E-commerce does not fundamentally hurt retail stores. Pointing to as an example, he suggested that since book sales are up nationwide it was not the case that online book sales would otherwise have gone to retail merchants. His opponents included columnist Robert Kuttner, who pointed to a loss of $5 billion per year in state and local tax revenues due to catalog shopping. Kuttner says that the annual loss of revenues due to the Internet will increase by $2 billion each year.

Another important issue raised in this national debate is the so-called Digital Divide. This refers to the growing gap in opportunities between those who have access to the Internet and those who don't. The term was originally coined to refer to educational disadvantages that would result as those with more disposable wealth were able to provide this new resource for their children or their school districts, while the poor and the nearly poor would slip further behind in education and job opportunities. However, if Internet shopping is favored with a tax exemption, the economic effect is a surcharge on the purchases of those who cannot afford Internet access, further widening the divide. As pointed out by Dallas' Mayor Ronald Kirk, this would "shift a disproportionate burden for paying for local government to the poorest of Americans." Mr. Kemp countered that the Internet economy would create wealth that helps the poor through creation of jobs and through "the ability of many companies from Microsoft to Oracle to Sun to Intel to be giving away computers free to schools." That there is a Digital Divide is supported by such studies as one by pollster Mark Baldassare. He found that in California 43 percent of those with incomes over $80,000 bought gifts over the Internet, but that only 7 percent of those with incomes below $40,000 did/ He also found that while 20 percent of all adults shopped online, only 7 percent of Latinos did.

What is needed, of course, is real information about how much the absence of sales taxes on Internet purchases hurts the states (and bricks-and-mortar retailers), and to what degree sales taxes would hurt E-commerce. Unfortunately, unbiased information is not yet available. There is a National Advisory Commission on Electronic Commerce (ACEC), a joint creation of industry and government that was formed as a result of the Tax Freedom Act, that might be such a body. However, with three months to go before issuing its report, it has given strong signals already that it is strongly in the camp of those opposed to any form of Internet taxation. Its chair, Virginia's Governor James Gilmore is a long-standing opponent of taxation and has reportedly proposed that one way to bridge the Digital Divide is to use money currently earmarked for welfare. One piece of evidence that might buoy those supporting Internet taxation is the recent holiday season, in which clicks-and-mortar retailers, who are subject to some taxation, did about as well as pure-play Internet retailers.

A proposal for a national sales tax on Internet purchases has been submitted by Senator Ernest "Fritz" Hollings (D-SC) as the Sales Tax Safety Net and Teacher Funding Act. His bill would require the Federal Government to collect sales taxes on transactions that are currently exempt. Monies collected under this bill would be distributed to states for use in funding education. Hollings' bill attacks one of the serious problems with other attempts to garner tax revenues from Internet sales. There are 50 states, most of which have sales taxes, and over 700 local taxing authorities that might want a piece of the action, just as they now get it on retail sales within their jurisdictions. On-line merchants have protested that the record keeping necessary to collect and pay sales taxes would be overwhelming. However there are software products that now are used by companies that need to comply with multiple tax codes which could clearly solve most of this problem. The two largest vendors are Taxware and Vertex. In fact, Taxware is developing software that could be used to implement a proposal by Governor Michael Leavitt (R-Utah) that companies voluntarily agree to collect taxes and use a "trusted" third party to make distributions to the states. Hollings' bill essentially makes the U.S. Treasury that trusted third party.

The most important issue is probably the economic effect of taxing or not taxing Internet sales. States and localities argue that they suffer a loss of revenue that impacts their ability to provide services. Retailers argue that they are playing to a different, and more onerous, set of rules than are the Internet companies. Regions that are centers of E-commerce argue that sales taxes will depress the booming economy, and that the growth of the Internet economy will make up for any loss in retail tax revenues. Committed anti-tax politicians argue on principle against adding another tax. Every side has numbers to back up its claims; all are sketchy and inconclusive.

A study from the American Bar Foundation and Harvard Law School concludes that the fervency found in each of the competing positions is misplaced. The study concludes that "[t]he results suggest that the costs of not enforcing taxes are quite modest and will remain so for several years. At the same time, compliance costs are likely to be low and the benefits of nurturing the Internet diminishing over time." In such a situation, the study suggests, a continued moratorium is the best policy.

User Recommendations

We believe that some form of taxation of Internet transactions is inevitable. The rising Internet economy, even if it lasts, provides benefits that are substantially regional. Just as the tourist trade that benefits from the Los Angeles movie industry is only a few blocks from such economically deprived areas as Watts, the existence of Seattle's hotbed of Internet activity doesn't do much for lumber and paper workers who have lost jobs in other parts of the state. Similarly, there's no obvious place in Internet commerce for the majority of retail workers - and one in five American workers is involved in traditional retailing.

Companies that wish to engage in the policy debate should, in the short run, contact the ACEC; in the long run we believe their best strategy is to work for ways, perhaps along the lines of Senator Hollings' bill, that will make tax collection, when it comes, minimally intrusive.

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