The Federalism Project

American Enterprise Institute

The Weekly Standard
May 15, 2000 Volume 5, Number 33

Yes, Tax the 'Net
Don't Subsidize E-commerce; Instead, Reform Sales Taxes.

by Michael Greve

The National Conference of State Legislatures carted its members to Capitol Hill last month to protest the failure of the Internet tax commission to recommend a vast expansion of state and local tax authority over Internet sales. The commission, known formally as the Advisory Commission on Electronic Commerce, has proved a deep disappointment to the NCSL, the National Governors' Association, and other taxpayer-funded government lobbies, which insist that untaxed e-commerce will wreak havoc on state and local budgets unless Congress provides them with the authority to tax such sales.

This being an election year, Congress is unlikely to act on e-commerce taxes (except, perhaps, to extend an existing moratorium on certain new Internet taxes). But the issue will regain prominence soon after the elections. Moreover, the Internet tax debate is a trial run for a larger fight over a fundamental political divide: Does the New Economy demand a more decentralized and competitive politics or rather the opposite--more government meddling, more centralization in Washington? Cheerleaders for the New Economy, who are certain the answer is less meddling, cannot simply rely on self-propelled economic forces to mow down recalcitrant bureaucracies. To prevail in this fight, they will need to make a principled case for competitive political institutions. The Internet tax debate suggests that they have a ways to go.

We are having that debate because the 45 states and some 7,500 local jurisdictions that tax retail sales want a piece of While sales taxes are based on the purchaser's residence, they are collected by the seller and then remitted to the appropriate state or local government. If a New York citizen purchases a washing machine in New Jersey, the Empire State will want the seller to collect a sales tax. There will be a problem for New York, though, if the seller is not a chain with stores in both states. The Supreme Court has ruled that retailers can be pressed into this tax collection role only if they have a "nexus"--that is, a physical presence-in the taxing jurisdiction. Since Internet stores typically lack such a nexus, a book you purchase from a local retailer is subject to the applicable state and local sales tax, whereas the same purchase from is effectively exempt.

The rapid growth of e-commerce prompted aggressive state efforts to extend tax-collection obligations to Internet retailers. Congress responded in 1998 with the Internet Tax Freedom Act, which imposed a three-year moratorium on new taxes that treat Internet sales differently from comparable sales through other channels (such as mail-order catalogues). This measure also set up the Internet tax commission, composed of business and consumer representatives and of members of the federal, state, and local governments, to study Internet tax matters and submit recommendations to Congress.

As it turned out, the sales tax issue proved too contentious for the commissioners to reach the two-thirds majority needed for formal findings and recommendations. Virginia governor James S. Gilmore, chairman of the commission, instead recorded simple majority votes for informal policy proposals, including a five-year extension of the existing tax moratorium. This decision, and the anti-tax tenor of the commission's report, have induced apoplexy among state and local government representatives, who denounced the commission's work as "flawed," "deceitful," and "reprehensible."

The shrillness reflects the frustration of the pro-tax lobby after having come within an inch of victory. The five state and local government officials on the Internet tax commission, led by Utah governor Michael O. Leavitt, viewed the body as a junior league Congress with a legislative agenda: Cut a deal with the six business representatives to extend tax collection authority to Internet sellers; get the three federal representatives on board; paint the anti-tax commissioners as libertarian lunatics; and get the real Congress to sign off on the deal.

None of the corporate representatives on the commission was truly opposed to extending sales tax collection obligations to Internet commerce. Some favored it: Gateway chairman Theodore W. Waitt would probably have voted for any plan that put his business, which includes retail stores, on a sales-tax par with Dell Computer (whose sales, exclusively on the Internet, currently go untaxed). At any rate, the CEOs--executives of AT&T, America Online, Charles Schwab, MCI WorldCom, and Time Warner, besides Gateway's Waitt--had bigger and very particular fish to fry, such as a permanent ban on Internet access charges (America Online) and a repeal of federal telecommunications taxes (AT&T, MCI). (As with the sales tax moratorium, the commission eventually proposed but did not formally recommend these steps.)

The business representatives did, however, insist on simplifying the existing sales tax system, which forces sellers to comply with tax collection obligations in hundreds of jurisdictions and thus burdens business with extravagant compliance costs. The government caucus could provide no reliable assurance that such simplification would be forthcoming. Frantic closed-door meetings between the Leavitt forces and the business representatives at the commission's final meeting failed to produce a deal, as did a subsequent telephone conference. In the end, the business reps joined the Gilmore faction to propose an extended moratorium for Internet retailers.

Gilmore and his anti-tax allies on and off the commission deserve great credit for staving off the governors' tax grab. They never quite managed, however, to make a principled case for their position. Instead, they relied on "No Internet Tax" slogans and problematic arguments that may yet endanger their momentary victory.

Leavitt's pro-tax forces have been relentless in criticizing the "unfairness" of the existing sales-tax regime, which subjects ordinary retail sales to taxation while exempting identical sales over the Internet. "Main Street" retailers have predictably joined this chorus. (They are organized in the eFairness Coalition and led by such well-known big-box stores as Wal-Mart and Circuit City.) Their position has been seconded by tax economists, whose models ordain that efficient taxes should be simple and neutral.

The Leavitt faction's dogmatic insistence on "neutrality" is a thin disguise for politicians' unbridled appetites. "Neutrality" in practice always means more tax authority over new sources of revenue, never less over existing ones. Chicago economist and Nobel laureate Gary Becker has persuasively criticized his colleagues' obsession with "neutral" and "efficient" taxation as excessively static. A tax haven in cyberspace leaves more money in private hands (a good thing in itself) and, moreover, may increase political pressure to reduce taxes in competing sectors of the economy.

Those valuable political dynamics, however, will likely prove short-lived if the Internet sales tax "exemption" looks like a special-interest favor. Unfortunately, the anti-tax forces have done little to counter that perception. They have tended to paint e-commerce as an infant industry in need of a break-and a particularly deserving industry, since it's so cool and with-it. Gilmore has compared Internet sales tax freedom to such policies as taxpayer-funded stadiums to attract professional sports teams, subsidized shopping malls, and the tax exemptions that states and municipalities shower on favored industries. Such arguments make the commission's proposal to extend the sales tax moratorium sound less like enlightened policy than like another special-interest boondoggle-an ethanol subsidy for the information highway.

The Internet tax commission did hear testimony on more compelling sales tax regimes. A particularly attractive option is to collect taxes on interstate sales not, as now, on the basis of the buyer's place of residence but in the seller's principal place of business.'s sales would then be taxed in the state of Washington, no matter where any particular book has been purchased and shipped.

Such an origin-based sales tax regime would obviate concerns over neutrality and fairness: All sales could be taxed at the same rate by a state or locality and would be so taxed, unless a given jurisdiction decided otherwise. Business concerns over compliance costs and legal uncertainty would vanish, since no seller would have tax collection obligations except in his home state. Most important, an origin-based sales tax system would foster state competition by re-connecting taxation with representation--or, as economists might say, by aligning the economic incidence of taxation with its political incidence. The existing system permits states to export sales tax collection obligations to sellers beyond their borders, providing only that the sellers have a nexus. (Tellingly, virtually all states exempt their own industries.) Under an origin-based system, Governor Leavitt of Utah could impose tax collection obligations for sales through the Internet or any other channel-but only on interstate sales by Utah firms. And of course there would be the healthy risk that over-taxed businesses might flee one state for a more accommodating jurisdiction. Exit rights and tax competition would over time accomplish what voting, all too often, does not-discipline in state taxing and spending.

An origin-based regime was suggested to the commission by independent tax experts and by the Heritage Foundation and the Cato Institute. Fred L. Smith of the Competitive Enterprise Institute argued with characteristic verve that "No taxation without representation" should be the fundamental principle of any sales tax regime. These suggestions went unheeded: Beleaguered and time-pressed as they were, Gilmore and his allies could not be expected to push some comprehensive reform on a complicated issue that no one had quite thought through. But this observation only reinforces the urgency of giving strategic thought to the Internet tax debate and to the broader issues behind it.

Even before the Internet tax commission's report went to the printer, House minority leader Richard A. Gephardt, in a speech to high-tech executives, cheerfully endorsed the expected proposal for an extended moratorium-and then some: No Internet access or transmission taxes. No international tariffs. Phase-out of federal telecommunications taxes. Permanent extension of research and development tax credits. Full deductions for employer-paid education benefits. More visas for skilled foreign workers. Tax credits for investments in broadband technology for rural and low-income areas. And on and on.

While some of these ideas make sense (and others don't), two things are obvious. First, Republicans, some of whom suffer from a residual sense of shame about government favoritism, cannot outbid Democrats at the high-tech subsidy game. Second, Dick Gephardt has not suddenly become an anti-tax crusader. His proposals are of a piece with Al Gore's ludicrous claim to have invented the Internet: Both suggest the contours of a political strategy that would subject the New Economy, along with the old, to political sufferance and control. The Net according to Gore-Gephardt is already the child of a clever industrial policy-incubated by an obscure defense agency and then nurtured by hip politicians with an understanding of Silicon Valley's needs and sensibilities. Along the way, according to this view, political sages have reined in private thugs who contrive to mess with their creation, as when Microsoft impeded technological innovation. "The federal government," Gephardt instructed the high-tech execs, "has a critical role to play in developing public policy to do everything possible to keep this engine running strong."

Between this perspective and the pro-tax governors' agenda, there isn't actually much difference: Gephardt will cash his Internet IOUs for campaign contributions now and for policy concessions not much further down the road. Already, there is talk of using public funds to help remedy a "digital divide" that is said to separate the poor and especially blacks from the New Economy. Already, politicians are demanding "voluntary" industry concessions on Internet indecency ("It's for the children") and privacy issues. Not missing a beat, Gephardt has fawned over the Internet entrepreneurs' "social conscience"--which, should it falter, will no doubt be helped along by responsible politicians.

Too much can be made of these political threats. Too many businesses and citizens have too much at stake to let the Internet become another nuclear industry (which, having been coddled by politicians, could be killed by politicians). A bigger mistake, however, would be to underestimate those threats. The widely, and rightly heralded advantages of an information economy-speed, consumer choice, the leaping of political boundaries on a global scale, disintermediation (the disappearance of easily taxed and regulated middlemen)--also greatly increase demands for centralized government intervention, both by government itself and by organized interests with a stake in the status quo or in uniformity regulation.

To track and tax interstate sales in cyberspace, Michael Leavitt and 31 of his fellow governors have seriously proposed the central collection and processing of computerized customer data on all such sales by a "Trusted Third Party" that is in effect a private IRS. Incongruously, the same governors are attempting to impose "privacy" laws on the use of data by private firms--which use such data mostly to sell stuff, not tax it. Aside from some non-committal harrumphing about privacy, established retailers and the corporate interests represented on the commission did not object. The beneficiaries of a more open, decentralized regime, meanwhile, are fewer, smaller, and less well-organized. They do not lobby so much because they're busy finding customers and doing IPOs.

The "No Internet Tax" slogan exemplifies a tendency, especially among free-marketeers, to rely on the Internet's sex appeal and on rapid technological progress as defenses against political interventions. That anti-political impulse won't do. An escape from the drag of status quo politics will require political entrepreneurship and arguments that resonate with and mobilize diffuse constituencies in defense of future and therefore speculative benefits. Effective resistance to a politically doctored New Economy requires resistance when the political schemes look benign and beneficial, as early on they often will. Instead of exempting new industries from political meddling, the emergence of such industries should be used as an opportunity to reform and discipline the existing institutions and arrangements--in this instance, an existing sales tax regime that is uniformly viewed as absurd. Instead of vague enthusiasm about a "world without borders," what is needed is the recognition that increased economic mobility and interdependence make borders more important: A world without borders is a world without exits, and citizens need exits to discipline government. Business will have to abandon its reflexive search for uniformity and relearn the advantages of interstate competition. A larger, more complex economy needs not more centralized control but the opposite: smaller, decentralized, competitive institutions that can manage complexity in little chunks.

This perspective runs counter both to entrenched interests and institutions and to erroneous but common intuitions. The arguments and the politics need rehearsing. The Internet tax debate is a good place to start.