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Safeguarding Internet Tax Fairness

by Aaron Lukas

This article appeared on cato.org on February 12, 2000.

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First, I would like to thank the committee for the leadership it is showing on the Internet tax issue, and also for allowing me to testify at this morning's hearing.

Electronic commerce has exploded over the past several years. In the United States alone, approximately 39 million people made a purchase online last year—double the number of 1998 Internet shoppers. Total sales may reach $50 billion this year.

Such astonishing growth has many state and local governments worried that they are not adequately prepared to tax this flood of new commerce. Contrary to the claims of those governments, however, the current federal rules do not exempt electronic commerce from taxation; they simply prohibit certain means of collection. The federal government should continue to prohibit states from imposing tax collection duties on out-of-state businesses by establishing a uniform national jurisdictional standard for taxing e-commerce based on the substantial physical presence test. Such a standard would reaffirm traditional principles of tax fairness, preserve rate competition among states, and avoid years of contentious litigation.

But before discussing what should be done, let me state what should be avoided: Congress should reject any option that effectively raises taxes—that results in more money for states and less for taxpayers. In other words, simply authorizing states to compel use tax collection from out-of-state businesses should be rejected out of hand.

Under the 1992 Quill Supreme Court decision, states can't compel sales tax collection by an out-of-state business unless that business has a significant connection to the taxing state-a legal concept known as nexus. There are at least three important reasons to retain and perhaps strengthen the current nexus standard.

First, there is no hint of a revenue crisis facing states. The roughly $20 billion in 1999 business-to-consumer online sales represented less than 0.3% of total consumer spending.

In an era of almost no inflation, state budgets grew by 5% in FY97 and nearly 6% in FY98. Over the past four years, state tax collections have exceeded expectations by about $25 billion. In addition, all states will split $246 billion over 25 years from the 1998 tobacco settlement. With revenues pouring in so rapidly, it cannot credibly be argued that electronic commerce is currently undermining the ability of states to provide legitimate government services.

And in-state sales will continue to be a dependable source of tax revenue. Despite the growth of Internet shopping, traditional retailers had a fantastic Christmas in 1999, enjoying a healthy 7.7% increase in sales over the year before.

Why is that? Because local stores cater to a customer's desire for a hands-on experience, offer immediate gratification, and do not charge for shipping, they will probably always dominate retailing. In addition, shopping is for many people a pleasurable social experience that cannot be duplicated online. Thus, Internet sales won't destroy "real" retailers, just as catalog sales haven't. The human factor still drives shopping and that will likely always be true.

The second and most important reason to limit state taxing authority over remote transactions, however, is fairness. When a local business collects sales taxes, there is a clear link among taxes paid, services provided and legislative representation. Local firms benefit from police and fire protection, roads, waste collection and other services, so it's proper that they help cover those costs. Remote sellers don't enjoy any of those services, and shipping companies already pay taxes to cover their use of public goods. To force a wholly out-of-state business to collect taxes would be "taxation without representation," pure and simple.

It is also important to note that local businesses are tasked only with collecting taxes for the state where they are physically located (origin-based taxation), while e-commerce firms are being asked to collect taxes for every state where their customers live (destination-based taxation). Ernst & Young has estimated that while collecting $1 in taxes costs traditional retailers 7 cents, it could cost Internet retailers as much as 87 cents. How is that a level playing field? The bottom line is that only a state where a business is located should have the right to compel sales tax collection.

Third, the current nexus standard promotes tax competition among the states. Electronic commerce gives everyone the opportunity to live on a virtual border-to take advantage of the fact that no state, although it is free to do so, currently taxes its exports or voluntarily collects use taxes for other states. Like a real border, the Internet can be a potent safety valve that guards against excessive taxation. E-commerce allows consumers who have found it difficult to travel out of state—the poor, the elderly, and the infirm—to take advantage of tax competition for the first time.

Remember that nothing currently prevents a state from instructing e-commerce retailers within its borders to collect sales taxes on all sales, regardless of the ultimate destination of the product—exactly as brick-and-mortar sellers do. State officials are hesitant to do this because they fear that businesses might decide to locate in other states with lower taxes. They call that a "race to the bottom," but it's really just healthy tax competition.

So what, if anything, should Congress do? Legislation to codify and clarify the Quill nexus standard would help businesses to know exactly when they are liable for sales taxes, just as federal law now does for income taxes. Greater certainty would help to avoid years of pointless lawsuits. Moreover, a uniform nexus standard would not adversely impact state efforts to simplify their tax systems or encourage voluntary collection by businesses.

Ultimately, there should be more equal tax treatment among all forms of commerce, but that does not mean abandoning traditional principles of tax fairness. Congress must not allow a phony revenue crisis to justify quick passage of new taxing authority for states that would achieve fairness only by treating all businesses badly.