Testimony

Sales Taxes On Digital Downloads

By Aaron Lukas
October 4, 2001
Iowa Legislature’s Electronic Commerce Task Force

Good morning Chairman Van Fossen, Chairman McKibben, and members of the task force. I’d like to thank you for inviting me to appear before you today. My fellow panelists are addressing the general case for and against Internet sales taxes, so I’m going to focus my remarks in a slightly different direction. Namely, the potential application of sales taxes to digital goods and services.

Before I address that topic, let me just note that I think that Internet taxes in general, as they’re currently being discussed, would be ill-advised. The attempt to cartelize tax collections through the Streamlined Sales Tax Project is, in my opinion, unconstitutional, unfair, and anti-competitive. The last thing that overtaxed Americans need as their country flirts with recession is an effective tax increase, especially one that undermines long-term tax competition. But I’ll leave it to other panelists to make that case so that I can focus on digital downloads, an area where I think the anti-tax case is the strongest.

As you know, the bulk of electronic retailing involves the sale of tangible products—like clothing or stereo equipment—that are ordered online and then delivered by common carrier. But electronic commerce also includes the sale of intangible digital products—things like music, software, or e-books—that are delivered directly over the Internet. In addition, the Internet makes it possible to provide traditional services that are “produced” at one location and “consumed” somewhere else, such as medical or legal consultations.

In general, taxes on digital downloads should be the same as taxes on regular goods; in other words, the means of delivery shouldn’t govern tax treatment. Such “technologically neutral” taxation would not treat the sale of a paperback book any differently from the sale of, say, a digitized book.

Operationally, however, there are good reasons to diverge from that rule, as Iowa has done in the past and as I think it should continue to do. In the interest of time, I’ll cover just the four reasons that I think are most important.

First, determining which products are functionally equivalent is a tricky proposition. Is text that’s displayed on a computer screen really the same thing as a printed book? Is a movie that’s downloaded to a computer hard drive really the same as a rented video? The answer isn’t obvious.

Second, building on that first point, there’s no reason that downloads, which after all are only information, should be classified as “goods” rather than “services.” Since most states don’t apply comprehensive taxation to services, and few states tax intangible products aside from basic utilities, there’s no obvious reason to extend sales taxes to the downloads that remain a miniscule component of consumer spending—currently only about six tenths of one percent.

Third, even if technological neutrality is desirable, it doesn’t override due process and interstate commerce considerations; therefore, only firms with substantial ties to the state should be expected to collect taxes. Some revenue authorities have suggested that because the Quill Supreme Court decision—which governs sales taxes applied to out-of-state businesses—dealt specifically with the sales of tangible personal property, it doesn’t apply to sales of products or services delivered online.

The language of the Quill decision, however, doesn’t explicitly refer to tangible products, which suggests that it also applies to information purchased over the Internet. In other words, unless Congress acts to overturn Quill, any state level sales taxes on digital downloads will likely be unconstitutional.

Incidentally, legislation is pending in Congress that would specifically preempt the states’ ability to tax digital commerce. But even assuming that legislation dies, and even more improbably assuming that a state successfully made its case in court, the victory would be illusory. The fluid nature of digital commerce means that states may have trouble collecting taxes even on downloads from in-state firms, much less on remote transactions.

That brings me to my fourth point: that taxing the online sale of intangibles is problematic because of major enforcement issues.

Many online shoppers don’t feel comfortable giving unnecessary personal information to a Web site. Consequently, they may refuse to type the information in, choose to shop at a site that doesn’t require it, or simply lie. It’s remarkably easy for buyers to misrepresent their location or to have a third party in another state purchase the product or service and simply forward it with a click of a mouse. It’s also possible for sellers of digital products to locate in foreign jurisdictions that would not enforce tax collection requirements. It would be very difficult, for example, to collect tax on the transmission of content sent from abroad and paid for by digital cash or smart card-untraceable encrypted “virtual money” that’s spent exactly like cash and leaves no paper trail.

Such technologies are more than a hypothetical possibility. MasterCard and Mondex have been testing “smart cards” for several years, while anonymous payment systems such as PayPal and E-gold already boast millions of customers. The offshore gambling industry—which is illegal in the United States—thrives using similar systems provided by companies in Canada and elsewhere. Given the near impossibility of enforcing compliance in the face of these payment technologies, the revenue potential of taxing digital products is probably small.

In short, taxing digital downloads is simply more trouble than it’s worth.

That’s not an uncommon conclusion. Even some state agencies that support allowing the states to enforce tax collection on out-of-state sellers of tangible goods recognize the all but insurmountable hurdles to taxing information delivered over the Internet. California’s Electronic Commerce Advisory Council, for instance, has recommended that “the status quo be maintained for taxing the interstate sale of intangibles and provision of services.” Its report cites both the difficulties associated with establishing a buyer’s identity and location as well as the ease with which the taxes could be avoided as reasons not to attempt the taxation of digital commerce.

Critics of exempting digital downloads from taxes argue that since most purchases are presently made with a credit card, the billing address could potentially be used to determine which state has jurisdiction over a sale. But with the ongoing rise of digital cash and other unaccounted payment systems, avoidance problems would, at best, be only postponed.

In any case, relying on credit card companies to collect taxes is perilous for other reasons. Services purchased with a credit card are typically billed directly to the credit card company address rather than to location where the buyer consumes the service. The only information available to tax authorities would be the billing address on file with the credit card company. But that address need not have any connection to where a digital product or service was actually downloaded and consumed. It wouldn’t work for corporate cards, for instance. In addition, any such approach could be readily abused. An individual could avoid taxes by establishing a billing address in another state by using a post office box, the address of friends or relatives, a second home, or a business. Services are even available that allow mail to be sent to a private center that forwards the mail to a second address. Tax administrators could seek to verify consumer’s information on an individual basis, but enforcement would be expensive.

Even if a credit card-based identification system could be made to work, it would raise troubling privacy issues. Currently, governments don’t have access to credit card company data unless a particular card holder is suspected of committing a crime. The use of credit card data for tax collection purposes would put a detailed record of a person’s buying habits in the hand of government authorities on a regular basis, without the normal judicial protections. The possible abuses of that information are enormous and it’s doubtful whether many individuals would easily accept such a system. At best, it would encourage consumers to make their digital purchases from companies outside the United States.

In conclusion, there is no compelling reason to tax digital downloads. Even if one believes that sales taxes should be applied more uniformly online, the unique nature of digital sales makes them a poor tax target. The biggest effect that Iowa would see from attempting to tax them would probably be an unwillingness on the part of e-tailers to set up shop here.

Thank you for your time and I look forward to your questions.