TechKnowledge No. 23

Closing the Net Tax Debate (Part 2): Identifying the Real Sales Tax Drain

By Adam D. Thierer
October 5, 2001

The moratorium on state and local government “multiple or discriminatory” taxation of the Internet as well as taxes on Internet access is set to expire shortly, and Congress is debating the merits of extending or making permanent those restrictions on state and local taxing activity. The existing Internet Tax Freedom Act (1998) moratorium does not, however, prohibit the states from attempting to collect sales or use taxes on goods purchased over the Internet. What pro-tax state and local officials are really at war with is not the ITFA but 30 years of Supreme Court jurisprudence that has not come down in their favor. The ultimate goal of the pro-tax crowd is to overturn cases such as National Bellas Hess v. Illinois (1967), Complete Auto Transit, Inc. v. Brady (1977), and Quill v. North Dakota (1992), in which the Supreme Court ruled that states could require only firms with a physical presence in their states to collect taxes on their behalf.

Ever since those decisions were first handed down, state and local tax officials have worked tirelessly to eliminate or at least water down their guidelines, largely in an effort to tax catalog or mail order sales. Luckily for companies and consumers, Congress has so far not allowed the states to set their own ground rules for the taxation of interstate commerce, which would upset the delicate constitutional balance by giving the states too much authority over the interstate marketplace. [See: “Closing the Net Tax Debate (Part 1): Debunking Level Playing Field Myths,Cato TechKnowledge #22].

More important, what this effort to tax the Internet really comes down to is a classic case of misplaced blame. In their zeal to find a way to collect taxes on electronic transactions to supposedly “level the (sales tax) playing field,” most state and local officials conveniently ignore the fact that current sales tax system is perhaps the most unlevel playing field anyone could possibly have designed.

Several politically favored industries and politically sensitive products receive generous exemptions from sales tax collection obligations or the taxes themselves. Food and groceries, agricultural products and production, and clothing all receive sales tax exemptions in most states and localities. That creates massive confusion in defining the sales tax base in some states. For example, are marshmallows and granola bars a “food” or a “candy” product? If they are labeled “candy,” they are taxed in some states; if classified as “food,” they are not. Likewise, the tax treatment of shoes varies widely. Some states exempt all shoes as clothing while others impose taxes on tennis shoes or cowboy boots as luxury items. There are endless debates among tax officials about product definitions.

Despite the definitional quibbles and the problems brought on by the growing number of exemptions, sales tax collection remained fairly effective in the post-World War II period since a sizable portion of the American economy was still subjected to the tax. When the sales tax was first being formulated during the 1930s to supplement income and property taxes, which were less effective during the Depression, tracing and taxing the sale of commodities were a far more rudimentary undertaking, because the Industrial Age economy of the time was primarily goods based. In other words, most commodities were tangible goods that typically were sold over the counter in most business establishments. That made sales tax collection fairly routine.

But as America began a gradual shift to a service-based economy in subsequent decades, serious strains were placed the sales tax system since sales taxes had traditionally been collected on goods, not services. Therefore, the vast majority of “service-sector” industries and professions receive a blanket exemption from sales tax obligations. A partial list of the professions exempted from the sales tax in most jurisdictions includes business services, banking and financial services, construction and contracting, health services, media services and advertising, and transportation as well as a wide variety of other personal and professional services.

The sales tax was not designed to capture those activities and, therefore, as the service sector became a larger portion of the American economy, the overall tax base shrank accordingly. Limited efforts have been made by some states to expand sales tax coverage to include services, but those efforts have met with staunch corporate and consumer opposition. Regardless, the combined effect of the service-sector exemptions and exemptions for “special” goods-producing industries such as agriculture and clothing, has been the gradual diminution of the sales tax base in America.

In fact, in a December 2000 study in the National Tax Journal, economists Donald Bruce and William F. Fox of the University of Tennessee Center for Business and Economic Research estimated that the sales tax base as a percentage of personal income has fallen from roughly 52 percent in the late 1970s to less than 42 percent today. That is just a complicated way of saying that the current sales tax system hits only about 40 percent of all individual consumption. In other words, America’s primary method of taxing consumption - the sales tax - doesn’t hit even half the consumption activity in the economy. Worse yet, as the sales tax base has been gradually eroding in recent decades, evidence suggests that average sales tax rates have been going up. In other words, we now have a rising average tax rate over a shrinking tax base. That is the textbook definition of an inefficient tax. Optimally, economists want a low tax rate over a very broad tax base.

Does this mean that state and local policymakers should scrap the sales tax system entirely and learn to rely on other tax bases such as property and income? Not necessarily. It is just to say that citizens should be cognizant of the deficiencies of the current system and not allow state and local policymakers to trick them into thinking that the Internet is to blame for the holes in their sales tax bases. Although state and local officials would have us believe that the Internet and electronic commerce are driving a bigger wedge into their sales tax bases, the reality is something much different. Electronic commerce sales constituted a surprisingly low 0.92 percent of aggregate retail sales in the second quarter of 2001 according to U.S. Department of Commerce data. This is down from a whopping high of 1.09 percent in the fourth quarter of last year. In light of those numbers, it’s hard to see how the Internet is to blame for the declining sales tax base.

So next time you hear state or local officials pleading for Congress to save them from the massive sales tax drain brought on by the Internet, tell them to first clean up the mess they’ve created. And if they really want to find a way to “level the playing field” and tax Internet transactions, an origin-based sales tax system would allow them to do so in an economically efficient and constitutionally sensible way. In the meantime, however, Congress would be wise to extend the existing ITFA moratorium on multiple and discriminatory taxes, as well as Internet access taxes, and let beneficial Supreme Court precedents continue to govern the interstate marketplace for electronic commerce transactions.

Adam Thierer (athierer [at] cato [dot] org) is director of telecommunications studies at the Cato Institute in Washington, D.C. To subscribe, or see a list of all previous TechKnowledge articles, visit www.cato.org/tech/tk-index.html.