TechKnowledge No. 25

Closing the Net Tax Debate (Part 3): Taxing Digital Downloads

By Aaron Lukas
October 17, 2001

As parts 1 and 2 of this TechKnowledge series have argued, applying sales taxes to out-of-state Internet purchases-at least in the manner that’s currently being discussed-would be ill-advised. The attempt to coordinate tax collections through the Streamlined Sales Tax Project is unconstitutional, unfair, and anti-competitive.

Most of the debate surrounding Internet taxes has focused on tangible products-items like clothing or stereo equipment-that are ordered online and delivered by common carrier. But electronic commerce also includes the sale of intangible digital products-things like music, software, or medical consultations-that are delivered directly over the Internet. When it comes to those digital downloads, the antitax case is even stronger.

In general, taxes on digital downloads should be the same as taxes on regular goods; 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.

For starters, determining which products are functionally equivalent is a tricky proposition. Is text that’s displayed on a computer screen really the same as a printed book? Is a movie that’s downloaded to a hard drive really the same as a rented video? The answers aren’t obvious. Building on that point, there’s no reason for downloads, which after all are only information, to 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 downloads, which remain a miniscule component of consumer spending.

Besides, 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 Supreme Court’s Quill v. North Dakota 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 Quill, however, doesn’t explicitly refer to tangible products, which suggests that it also applies to information purchased over the Internet. Unless Congress acts to overturn Quill, any state level sales taxes on digital downloads will likely be unconstitutional. Of course, if Congress preempts the states’ ability to tax digital downloads-as Rep. Cliff Stearns’s (R-Fla.) H.R. 2421 would do-that legal question will be moot. But even assuming such legislation failed and 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.

Which brings up a final point: taxing the online sale of intangibles is problematic because of intractable 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 the 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 hypothetical. MasterCard and Mondex have been testing “smart cards” for several years, while 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 digital payment systems provided by companies in Canada and elsewhere. Given the near impossibility of enforcing compliance in the face of these technologies, the revenue potential of taxing digital products is probably small.

In short, taxing digital downloads would be more trouble than it’s worth. Even some state agencies that support taxing 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 and the ease with which the taxes could be avoided.

Critics of untaxed digital downloads argue that because most purchases are made with a credit card, the billing address could be used to determine tax jurisdiction. But with the rise of digital cash, that argument will no longer hold. In any case, reliance on credit card companies would be impractical for other reasons. Services purchased with a credit card are typically billed directly to the credit card company address rather than to the consumer’s location. 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, individuals 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. Tax administrators could seek to verify such 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 cardholder 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 hands 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 thinks that sales taxes should be applied more uniformly online, the unique nature of digital sales makes them a poor tax target. The biggest effect of allowing states to tax them would probably be an unwillingness on the part of e-tailers to set up shop in the United States.

Aaron Lukas (aaronl [at] cato [dot] org) is a Trade Analyst 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.