Should Internet Sales Be Taxed?

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As hardworking Americans fatten already overflowing state government coffers this tax season, they should be aware that many state and local officials would like to squeeze them harder. But few taxpayers are aware of it because the latest skirmish in the battle to tax electronic commerce is being fought, not in public, but in federal court.

Last October the Internet Tax Freedom Act established an Advisory Commissionon Electronic Commerce to study Internet tax issues and make recommendationsto Congress. The members of that commission were appointed last fall, butthe National Association of Counties and the U.S. Conference of Mayors filedsuit this month in federal court to block them from meeting. The plaintiffsclaim that the panel is unfairly biased in favor of business and againststate and local government. It's not right, local politicians say, that thecommission might be sympathetic to consumers and taxpayers.

At the heart of the controversy are sales taxes. Currently, states can'tforce an out-of-state business to collect them unless that business has aphysical presence in state. The result is that when a purchase is madeacross state lines, sales taxes often aren't paid. Few states have made anyreal effort to collect those "lost" taxes directly. Instead, state and localofficials want Congress to let them draft out-of-state firms as taxcollectors.

Why do states-which are enjoying record budget surpluses-want to tax remotecommerce? "We figure we're losing over $200 million annually from directmarketing, catalog and Internet sales," explains Clare Long, Ohio's deputytax commissioner. She'll have to excuse taxpayers if they fail to shed atear of commiseration.

Proponents of expanded state taxing authority usually offer three argumentsin support of their position.

The first is neutrality-the notion that products should be taxed the sameregardless of how they're purchased. The current system, they contend,distorts economic activity because consumers might buy a product online onthe basis of tax considerations rather than "real" economic criteria.

Well, tax neutrality is certainly an important component of economicefficiency, but so are low rates. E-commerce serves to inhibit excessivetaxation: when tax rates get too high, it provides consumers with a shoppingalternative. That alternative induces state and local governments to keeptax rates down.

Moreover, allowing states to tax out-of-state e-commerce would effectivelybe a tax increase imposed without ever having to bring the issue to a vote.That's a dream scenario for politicians but a nightmare for taxpayers.

Second, state and local officials also argue that it's only fair to let themtax e-commerce. Since local retailers have to collect sales taxes, theargument goes, they're at a disadvantage when competing with remote sellers.Thus, allowing states to tax remote commerce would "level the playing field"between electronic and traditional retailers.

That reasoning turns the concept of fairness on its head. If states areconcerned about local retailers, they should address the issue by reducingtax rates. Minnesota policymakers, for example, are considering eliminatingthe sales tax on certain products that are easily acquired online.

And is it really fair to force out-of-state firms to act as tax collectorswhen they don't benefit from state services? When a local business collectssales taxes, there is a clear linkage between taxes paid, services provided,and legislative representation. Local firms benefit from police and fireprotection, roads and waste collection and other state services, so it'sproper that they help cover those costs. Remote sellers don't enjoy any ofthose services.

Third, some analysts warn of a dire future when states will be unable toraise enough money to provide essential services. "State and localgovernments face an ever-dwindling source of revenue, one that will directlyaffect its ability to provide infrastructure and other fundamentalservices," writes John Minan of the University of San Diego.

Dwindling? In 1998 many governors submitted budget proposals that increasedspending by more than 7 percent, roughly three times the rate of inflation.On average, states estimate an increase in general fund spending of 5.7percent for fiscal 1998 and 6.3 percent for fiscal 1999, only two statesreduced their fiscal 1998 budgets. Those percentages are almost twice therate of inflation plus population growth.

The truth is that the battle over taxation of e-commerce has little to dowith economic efficiency, equity or the provision of essential services. Thereality is much simpler: state and local officials want to control anever-expanding portion of our incomes. E-commerce-by providing a means toavoid punishingly high sales tax rates-threatens to check that impulse. Nowonder the politicians are worried.