Cato Policy Analysis No. 494 October 23, 2003

Policy Analysis

The Internet Tax Solution
Tax Competition, Not Tax Collusion

by Adam D. Thierer and Veronique de Rugy

Adam D. Thierer is director of telecommunications studies and Veronique de Rugy is a policy analyst at the Cato Institute.


Executive Summary

A heated debate is once again under way in Congress over the tax treatment of electronic commerce and the Internet Tax Freedom Act of 1997. The ITFA imposed a moratorium on state and local taxes on Internet access and banned "multiple or discriminatory" taxes on electronic commerce. That moratorium was intended to last only three years but was extended by Congress in 2001 for another two years. It will lapse on November 1, 2003.

The ITFA has been a remarkably misunderstood or misinterpreted statute and has very little to do with what really lies at the heart of this debate—the effort by state and local governments to collect sales and use taxes on remote vendors in interstate commerce (mail order, catalog, and e-commerce companies). Contrary to press reports and statements made by some members of Congress, the ITFA moratorium does not directly affect the ability of states and localities to impose sales and use taxes on purchases made over the Internet.

What 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. Their ultimate goal is to overturn those precedents, which held that states could require only firms with a physical presence—or "nexus"—in their jurisdictions to collect taxes on their behalf. State and local tax officials have worked to eliminate or water down these restrictions on their tax reach but thus far have not been able to get around them or convince Congress to authorize the imposition of collection obligations on interstate vendors.

Although extending the existing ITFA moratorium and continuing to uphold the Supreme Court's nexus jurisprudence makes good sense, Congress must also take an affirmative stand against efforts by state and local governments to create a collusive multistate tax compact to tax interstate sales. Other options exist that state and local governments can pursue before looking to impose unconstitutional tax burdens on interstate commerce. Of course, getting runaway state spending under control would go a long way toward solving many of their supposed problems. Merely extending sales tax collection responsibilities to electronic commerce—which constitutes less than 2 percent of all retail activity in the United States—will not solve the fiscal crisis that state and local governments have created through their profligate spending habits.

Full Text of Policy Analysis No. 494 (PDF, 40 pgs, 377 Kb)

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