Congress Plays Jeopardy with the Net’s Next Tax Battle

This essay originally appeared in TechCentralStation on April 24, 2001.
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Although most Americans don’t realize it, the war over Internet taxation isnearly over, and it’s the taxpayers who are losing. As Congress rushes toaddress this contentious issue before the existing Internet tax moratoriumexpires in October, a new Net tax measure has gained enough momentum to makeits passage this session a depressing probability.

The complementary bills, S. 512 (Sen. Byron Dorgan, D-N.D.) and H.R. 1410(Rep. Ernest Istook, R-Okla.), enjoy bipartisan support in both chambers ofCongress. They would essentially authorize the creation of a state-run taxcartel to collect sales taxes on cross-border commerce, electronic andotherwise. More than half the states have expressed interest in taking partin a multi-state sales tax regime.

Although the Constitution makes it clear that state governments aregenerally prohibited from taxing or regulating interstate commerce, Congresscan override this restriction and sanction such anti-competitivearrangements. This is what the Dorgan-Istook bill does.

And while current Supreme Court precedents maintain that states cannotrequire remote interstate vendors (mail order, catalog, or Internet) tocollect sales taxes unless those vendors have a physical presence within thetaxing jurisdiction, Congress can override this sensible prohibition on“taxation without representation,” as well. Again, the Dorgan-Istook billdoes so.

If Congress allows state and local governments to launch such a EuropeanUnion-style tax collection system, federal lawmakers will be putting theirimprimatur on a de facto national sales tax on interstate commerce. The onlyupside: The current tax bias against brick-and-mortar retailers would beended. Unfortunately, this leveling of the playing field would come byplacing more businesses under government’s yoke.

Many Americans will be shocked to learn that the Net tax battle may turn outthis badly. How has the tide turned?

First, opponents of Internet taxation mistakenly placed too much faith in amoratorium that didn’t do what everyone thought it did: prohibit states fromtaxing out-of-state sales. Thus, the anti-tax forces are now left defendinga do-nothing policy that no interest group really supports.

The second reason the Net tax debate has turned sour is that opponents ofnew tax authority haven’t had a unified alternative. The issue wasoversimplified to reduce the cause to a “Don’t Tax the Net” bumper-stickerslogan. As a result, the anti-tax forces stuttered when faced with thecharge that a “tax-free” Internet amounted to little more than an unfairhigh-tech industrial policy.

A final mistake was made in framing this issue as one of granting specialtax status to the Internet—offering a high-tech twist on the old “infantindustry” argument. This spawned an alliance of state officials and largebrick-and-mortar merchants, both of whom fought to extend America’s archaicsales tax system to the Internet. Many politicians want to tax Internetsales because it’s a cash cow for them. And many retailers back the taxbecause it will curb their competition.

Simply, large retailers saw an opportunity to strangle their smallercompetitors with a burdensome tax code—and they want to do it in the name offairness. These retailers talk about “justice for Main Street” and a “levelplaying field” to argue that Internet vendors should be forced to collecttaxes on out-of-state sales. What a shame. Those retailers could have usedtheir lobbying muscle to fight for the end (or serious reform) of the salestax, rather than using it as a club to beat up competitors.

In hindsight, the anti-tax forces should have (a) favored replacing salestaxes with a better type of consumption tax, and (b) highlighted thebenefits of interstate tax competition and the anti-competitive aspects ofextending state tax authority over remote sales.

Everyone knows that sales taxes are problematic. So why apply an outdated,inefficient and increasingly unworkable tax system to the Internet (which isarguably the most modern and efficient retailing technology ever devised)?Why not scrap that tax system altogether? One alternative would be a“savings exempt income tax,” where taxpayers exempt all savings from theirtaxable income, resulting in uniform taxation of the consumption base.

But the trump card of those who oppose new Internet tax authority for statesshould have been tax competition. Most people don’t realize it, but nothingis stopping states from “leveling the playing field” on sales taxes. Eachstate has the legal authority to tax all transactions that originate withinits borders (i.e., an “origin-based” tax). But no state chooses to tax salesthat in-state businesses make to out-of-state buyers. In other words, statespurposefully exempt their exports from sales taxes.

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

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

For those who support limited government, the best hope on the Net-tax frontmay now be that Congress will fail to act. If that happens, sales taxes willcontinue to be controlled by the Supreme Court precedent that forces statesto compete to keep their tax rates reasonable.