TechKnowledge No. 7

Avoiding a Net Tax Cartel Catastrophe

By Aaron Lukas and Adam D. Thierer
May 3, 2001

Legislation to extend the Internet tax moratorium was introduced recently by Sen. George Allen (R-VA) and Rep. Chris Cox (R-CA). Their taxpayer-friendly bills have gotten some welcome attention recently, but unfortunately, it may already be too late to overcome the momentum of competing pro-Net tax legislation sponsored by Sen. Byron Dorgan (D-ND) and Rep. Ernest Istook (R-OK).

The Dorgan-Istook legislation, S. 512 and H.R. 1410 respectively, enjoys bipartisan support in both chambers of Congress. Like Allen-Cox, these bills would extend the current ban on multiple or discriminatory Internet taxes. But the similarities end there. Dorgan-Istook would also authorize the creation of a state-run tax cartel to collect sales taxes on cross-border commerce, electronic and otherwise. More than half the states have expressed interest in taking part in a multi-state sales tax regime.

Although the Constitution makes it clear that state governments are generally prohibited from taxing or regulating interstate commerce, Congress can override this restriction and sanction such anti-competitive arrangements. This is what the Dorgan-Istook bill does. And while current Supreme Court precedents maintain that states cannot require remote interstate vendors (mail order, catalog, or Internet) to collect sales taxes unless those vendors have a physical presence within the taxing jurisdiction, Congress can override this sensible prohibition on “taxation without representation,” as well. Again, the Dorgan-Istook bill does so.

If Congress allows state and local governments to launch such a European Union-style tax collection system, federal lawmakers will be putting their imprimatur on a de facto national sales tax on interstate commerce. The only upside: The current tax bias against brick-and-mortar retailers would be ended. Unfortunately, this leveling of the playing field would come by placing more businesses under government’s yoke.

Many Americans will be shocked to learn that the Net tax battle may turn out this badly. How has the tide turned? First, opponents of Internet taxation mistakenly placed too much faith in a moratorium that didn’t do what everyone thought it did: prohibit states from taxing out-of-state sales. Thus, while the Allen-Cox approach of extending the current Net-tax moratorium isn’t a bad idea, it’s important to understand that it wouldn’t permanently prevent the Dorgan-Istook cartel idea from going forward.

The second reason the Net tax debate has turned sour is that opponents of new tax authority haven’t had a unified alternative. The issue was oversimplified to reduce the cause to a “Don’t Tax the Net” bumper-sticker slogan. As a result, the anti-tax forces stuttered when faced with the charge that a “tax-free” Internet amounted to little more than an unfair high-tech industrial policy.

A final mistake was made in framing this issue as one of granting special tax status to the Internet-offering a high-tech twist on the old “infant industry” argument. This spawned an alliance of state officials and large brick-and-mortar merchants, both of whom fought to extend America’s archaic sales tax system to the Internet. Many politicians want to tax Internet sales because it’s a cash cow for them. And many retailers back the tax because it will curb their competition. Large retailers saw an opportunity to strangle their smaller competitors with a burdensome tax code-and they want to do it in the name of fairness. These retailers talk about “justice for Main Street” and a “level playing field” to argue that Internet vendors should be forced to collect taxes on out-of-state sales. Instead, those retailers could have used their lobbying muscle to fight for serious reform of the sales tax, rather than using it as a club to beat up competitors.

In hindsight, the anti-tax forces should have (a) favored replacing sales taxes with a better type of consumption tax, and (b) highlighted the benefits of interstate tax competition and the anti-competitive aspects of extending state tax authority over remote sales. Everyone knows that sales taxes are problematic in a digital age. So why apply an outdated, inefficient and increasingly unworkable tax system to the Internet? One alternative would be a “savings exempt income tax,” where taxpayers exempt all savings from their taxable income, resulting in uniform taxation of the consumption base.

But the trump card of those who oppose new Internet tax authority for states should have been tax competition. Most people don’t realize it, but nothing is stopping states from “leveling the playing field” on sales taxes. Each state has the legal authority to tax all transactions that originate within its borders (i.e., an “origin-based” tax). But no state chooses to tax sales that in-state businesses make to out-of-state buyers. In other words, states purposefully exempt their exports from sales taxes.

So why don’t states treat all merchants the same by having them collect the local sales tax regardless of where the buyer lives? When you walk into Wal-Mart, checkout clerks don’t ask you where you live; they collect the taxes due where the store is located. We could treat Internet sellers that way. But states fear that a few low- and no-tax rogue states might lure businesses away. Politicians call that a “race to the bottom.” But it’s really just healthy tax competition.

The politician’s answer to this problem is to have Washington step in and sanction a multi-state tax cartel. The current effort is called the “Streamlined Sales Tax Project,” or SSTP. As OPEC raises your oil prices by undercutting competition among oil producers, an Internet tax cartel will remove the pressure on states to keep taxes low for fear of losing businesses. By closing the escape hatch from the taxman, the SSTP will allow states to raise taxes and increase spending.

For those who support limited government, the best hope on this front may now be that Congress will fail to address the issue. If that happens, sales taxes will continue to be controlled by the Supreme Court precedent that forces states to compete to keep their tax rates reasonable. While inaction may not be ideal, it’s a lot better than the alternative.

Aaron Lukas (aaronl [at] cato [dot] org">aaronl [at] cato [dot] org) is a Trade Analyst and Adam Thierer (athierer [at] cato [dot] org) is the Director of Telecommunications Studies at the Cato Institute in Washington, D.C. (www.cato.org/tech). A version of this article appeared on Tech Central Station.com