Commentary

An Internet Tax Nightmare

By Aaron Lukas
This article appeared in the Washington Times on July 2, 1999 and The Record (Bergen County) on July 6, 1999.
The U.S. Advisory Commission on Electronic Commerce met this past week in Williamsburg, Virginia to discuss the future of Internet taxes. The meeting had state and local politicians sweating, but not from the summer heat.

It’s a fascinating story. States are awash with cash right now, but fear the good times won’t last. As more people engage in untaxed cross-border shopping over the Internet, politicians argue, state sales tax revenues will plummet. The National Governors’ Association says that state governments could be “losing” up to $20 billion a year by 2003 (a wildly inflated figure, by the way). So these “forward-thinking” leaders are seeking to boldly tax where no state has taxed before. Electronic commerce: the final fiscal frontier.

Their success is far from assured. Under federal law and the U.S. Constitution, a state can exercise only limited powers beyond its own borders. Thus, a state cannot force an out-of-state business to collect sales taxes unless that business has some physical connection to the taxing state — a legal concept known as “nexus.” Consumers are supposed to voluntarily pay a “use tax” on all out-of-state purchases. Few people are aware of that obligation, however, and no state has ever made a serious effort to let them know.

In the past, most commerce took place within state lines so states did not view the restriction on their taxing authority as a major problem. The rise of mail-order sales prompted states to sound the alarm, but the predicted revenue crisis never materialized. Now they’re at it again. As Dean Andel, a member of the Advisory Commission, has noted, “There was a time in the early 1980s when mail order was growing at rates comparable to today’s Internet sales. During those years, the same pro-tax lobby who is now beating the drums to tax the net was calling to tax mail order sales.”

This time the states are proposing a compromise. Congress would authorize them to force out-of-state firms to collect sales taxes. In exchange, a single tax rate would be set for each state, making it easier for businesses to calculate how much they’re supposed to collect and for whom. The states figure that such a deal would bring more businesses into the pro-tax camp. Some large online vendors love the idea, since they collect taxes anyway and think the plan would disadvantage smaller competitors. It’s a win-win situation for big business and state and local government; only taxpayers and small businesses lose.

State officials rightly fear a public debate over their plan. State and local tax rates were set at a time when restrictions on cross-border tax collection were the norm. It’s impossible to “lose” revenue that was never anticipated, but allowing states to tax remote commerce would raise new revenue — a de facto tax increase that would escape voter scrutiny. That’s a dream scenario for politicians, but a nightmare for taxpayers.

So instead of openly campaigning for higher taxes, state officials are hawking fairness. In-state businesses have to collect taxes, they say, so why not make out-of-state firms do the same thing? That brilliant strategy has paralyzed potential opposition from groups like the U.S. Chamber of Commerce that fear offending “Main Street” retailers.

But most Americans realize that it isn’t right to force out-of-state firms to act as tax collectors when they don’t benefit from state services. 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 do not enjoy any of those services.

As Commission member Grover Norquist has said, the problem for Main Street “isn’t the Internet; it’s the high sales tax rates.” Clearly, the fairness argument is intended to distract from the real agenda of covertly raising taxes. If not, states would lower rates as they broaden the sales tax net. With most state budgets in surplus, taxpayers should reasonably expect any reforms to be revenue neutral at a minimum. California’s Electronic Commerce Advisory Council has recommended that each state “review the tax-base-broadening revenue impact of the new system and consider reducing its sales tax rate,” but such advice is rare.

If a fiscal crisis is really on the horizon, states have only themselves to blame. In 1998, many governors submitted budget proposals that increased spending by more than 7 percent, roughly 3 times the rate of inflation. States estimate an average increase in general fund spending of 5.7 percent for fiscal 1998 and 6.3 percent for fiscal 1999, with only 2 states reducing their fiscal 1998 enacted budgets. That’s almost twice the rate of inflation plus population growth.

At the end of the day, the battle over Internet taxation has little to do with equity or a shrinking tax base. The reality is much simpler: state officials want to control an ever-expanding portion of our incomes. Electronic commerce, by providing a means to avoid punishingly high sales tax rates, threatens to check that impulse. No wonder politicians are sweating.

Aaron Lukas is an analyst at the Cato Institute’s Center for Trade Policy Studies.