Commentary

A Taxing Time of Year?

By Aaron Lukas
December 23, 1998

‘Tis the season for Internet shopping! Well, sort of. It’s actually the season for all kinds of shopping, with record-breaking consumer spending this year. Online holiday sales are expected to top $2.3 billion, but that’s a mere snowflake in the overall blizzard of retail activity.

Electronic commerce is catching on, however, and with more than 140 million people online, it’s no longer the exclusive domain of computer nerds. Thus, Newsweek recently declared that “it’s beginning to look a lot like an e-Christmas.” On the same day, U.S. News & World Report observed that “shoppers from east to west seem determined to avoid traffic jams at the mall, long lines at the post office, and last-minute dashes to the supermarket.”

But Internet shoppers are also avoiding something else: sales taxes. And thanks to the newly enacted Internet Tax Freedom Act, “tax-free” will be the rule for at least three years.

That leaves some observers and state officials decidedly short on holiday cheer. For example, a recent article by technology commentator James Ledbetter denounced restrictions on Internet taxation as “unfair” to those who shop in stores. Similarly, a wire service story accused Internet vendors of enjoying a “free ride” and warned that local retailing could cease to exist. Not to be outdone, Congress appointed a commission earlier this month to study the issue.


Without doubt, limiting states’ taxing authority leads to unequal taxation. Nevertheless, such limitations are a crucial component of American federalism.


Of course, not all Internet purchases are tax-free, just those made across state lines. Out-of-state Web vendors — like their catalog cousins — aren’t required to collect sales taxes except in states where they maintain a physical presence. In other words, electronic commerce is treated exactly the same as mail-order business. And the Supreme Court has held that states have no authority to tax mail-order sales outside their borders absent explicit congressional authorization. Instead, most states ask consumers to pay a “use tax” in lieu of a sales tax on all purchases. Few consumers volunteer.

At first glance, the pro-tax case sounds reasonable: why should identical items be taxed differently depending on how they’re purchased? Theoretically, they shouldn’t be. But in the real world, there are several reasons why allowing states to tax out-of-state electronic commerce is bad policy.

First, there is no immediate danger of large revenue losses for traditional retailers or, by extension, for state tax authorities. Local stores cater to a customer’s desire for a hands-on experience, offer immediate gratification, don’t charge for shipping, and so will probably always dominate retailing. What’s more, 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.

Empirical evidence supports that conclusion. In an era of almost no inflation, state budgets grew by 5 percent in FY97 and by more than 6 percent in FY98. Over the past four years, state tax collections have exceeded expectations by about $25 billion. It appears that there will be a sizable revenue windfall this year as well. With revenues pouring in so rapidly, it’s just not credible that electronic commerce is undermining state tax collections.

Second, differentiated tax rates create healthy competition that helps keep local rates under control. For example, some residents of Manhattan drive to Delaware to avoid sales taxes - an option that has undoubtedly curbed the profligate fiscal habits of New York politicians. Electronic commerce serves as a similar safety valve that guards against excessive taxation.

If states and localities feel compelled to tax their citizens more heavily, they still have the tools to do it. There will always be income taxes, property taxes, gas taxes, hotel taxes and the like. Perhaps what states really seek isn’t equity or revenue security but rather a new source of funds that doesn’t require voter approval.

Finally, there is something inherently unsettling about states’ exercising legal authority outside their jurisdictions. By what right can New York force a firm in Florida to act as its tax collection agent? Even if it were constitutionally permissible, it would set a dangerous precedent with enormous potential for conflict.

Without doubt, limiting states’ taxing authority leads to unequal taxation. Nevertheless, such limitations are a crucial component of American federalism. Absent those restraints, confiscatory state tax rates — which are the true injustice — would worsen. To improve their business climate, states should cut taxes, not scheme to collect more.

For its part, Congress should stubbornly refuse to bow to state demands for new taxing authority. The Internet Tax Freedom Act was a good start in ensuring that traditional principles of remote commerce apply to the online world; Congress should consider making it permanent.

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