Trade Policy Analysis No. 9

Tax Bytes: A Primer on the Taxation of Electronic Commerce

By Aaron Lukas
December 17, 1999

Electronic commerce conducted over the Internet has exploded over the past several years. In 1998 online shopping revenues in the United States alone totaled approximately $13 billion, and they are projected to reach $108 billion by 2003—nearly a tenfold increase. Such potentially astonishing growth has many governments worried that they are not adequately prepared to tax this flood of new commerce.

State and local governments in the United States have sensibly begun to examine how electronic commerce will affect their tax systems. Contrary to the claims of those governments, however, the current federal rules do not exempt electronic commerce from taxation; they simply prohibit certain means of collection. The federal government should continue to prohibit states from imposing tax collection duties on out-of-state businesses by establishing a uniform national jurisdictional standard for taxing electronic commerce based on the substantial physical presence test. Such a standard would reaffirm traditional principles of tax fairness, preserve rate competition among states, and avoid years of contentious litigation.

If current state tax systems disadvantage local retailers, states already have it within their power to address the problem. Although reform may be difficult, states are in no immediate danger of going broke, nor do they lack alternatives to the current system of sales and use taxes. The role of the federal government should be to ensure that states do not unfairly export their tax collection burden, thereby impeding interstate commerce.

At the international level, the United States has a special role to play in designing online tax policy. With more computers than the rest of the world combined, America is unquestionably the home of the Internet. It is therefore natural that other countries look to Washington for leadership on the taxation of electronic commerce. Thus, it is vital that the United States stand up for important principles such as tax competition by rejecting proposals to draft American businesses as tax collectors for foreign governments. In addition, the United States should aggressively pursue an Internet free-trade agreement in the World Trade Organization.

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