Commentary

Should Internet Sales Be Taxed?

By Aaron Lukas
March 12, 1999

As hardworking Americans fatten already overflowing state government coffers this tax season, they should be aware that many state and local officials would like to squeeze them harder. But few taxpayers are aware of it because the latest skirmish in the battle to tax electronic commerce is being fought, not in public, but in federal court.

Last October the Internet Tax Freedom Act established an Advisory Commission on Electronic Commerce to study Internet tax issues and make recommendations to Congress. The members of that commission were appointed last fall, but the National Association of Counties and the U.S. Conference of Mayors filed suit this month in federal court to block them from meeting. The plaintiffs claim that the panel is unfairly biased in favor of business and against state and local government. It’s not right, local politicians say, that the commission might be sympathetic to consumers and taxpayers.

At the heart of the controversy are sales taxes. Currently, states can’t force an out-of-state business to collect them unless that business has a physical presence in state. The result is that when a purchase is made across state lines, sales taxes often aren’t paid. Few states have made any real effort to collect those “lost” taxes directly. Instead, state and local officials want Congress to let them draft out-of-state firms as tax collectors.

Why do states-which are enjoying record budget surpluses-want to tax remote commerce? “We figure we’re losing over $200 million annually from direct marketing, catalog and Internet sales,” explains Clare Long, Ohio’s deputy tax commissioner. She’ll have to excuse taxpayers if they fail to shed a tear of commiseration.

Proponents of expanded state taxing authority usually offer three arguments in support of their position.

The first is neutrality-the notion that products should be taxed the same regardless of how they’re purchased. The current system, they contend, distorts economic activity because consumers might buy a product online on the basis of tax considerations rather than “real” economic criteria.

Well, tax neutrality is certainly an important component of economic efficiency, but so are low rates. E-commerce serves to inhibit excessive taxation: when tax rates get too high, it provides consumers with a shopping alternative. That alternative induces state and local governments to keep tax rates down.

Moreover, allowing states to tax out-of-state e-commerce would effectively be a tax increase imposed without ever having to bring the issue to a vote. That’s a dream scenario for politicians but a nightmare for taxpayers.

Second, state and local officials also argue that it’s only fair to let them tax e-commerce. Since local retailers have to collect sales taxes, the argument goes, they’re at a disadvantage when competing with remote sellers. Thus, allowing states to tax remote commerce would “level the playing field” between electronic and traditional retailers.

That reasoning turns the concept of fairness on its head. If states are concerned about local retailers, they should address the issue by reducing tax rates. Minnesota policymakers, for example, are considering eliminating the sales tax on certain products that are easily acquired online.

And is it really fair 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 linkage between taxes paid, services provided, and legislative representation. Local firms benefit from police and fire protection, roads and waste collection and other state services, so it’s proper that they help cover those costs. Remote sellers don’t enjoy any of those services.

Third, some analysts warn of a dire future when states will be unable to raise enough money to provide essential services. “State and local governments face an ever-dwindling source of revenue, one that will directly affect its ability to provide infrastructure and other fundamental services,” writes John Minan of the University of San Diego.

Dwindling? In 1998 many governors submitted budget proposals that increased spending by more than 7 percent, roughly three times the rate of inflation. On average, states estimate an increase in general fund spending of 5.7 percent for fiscal 1998 and 6.3 percent for fiscal 1999, only two states reduced their fiscal 1998 budgets. Those percentages are almost twice the rate of inflation plus population growth.

The truth is that the battle over taxation of e-commerce has little to do with economic efficiency, equity or the provision of essential services. The reality is much simpler: state and local officials want to control an ever-expanding portion of our incomes. E-commerce-by providing a means to avoid punishingly high sales tax rates-threatens to check that impulse. No wonder the politicians are worried.

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