Safeguarding Internet Tax Fairness

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First, let me thank the committee for the leadership it isshowing on the Internet tax issue, and also for allowing me totestify at this morning's hearing.

Electronic commerce has exploded over the past several years. Inthe United States alone, approximately 39 million people made apurchase online last year-double the number of 1998 Internetshoppers. Total sales may reach $50 billion this year.

Such astonishing growth has many state and local governmentsworried that they are not adequately prepared to tax this flood ofnew commerce. Contrary to the claims of those governments, however,the current federal rules do not exempt electronic commerce fromtaxation; they simply prohibit certain means of collection. Thefederal government should continue to prohibit states from imposingtax collection duties on out-of-state businesses by establishing auniform national jurisdictional standard for taxing e-commercebased on the substantial physical presence test. Such a standardwould reaffirm traditional principles of tax fairness, preserverate competition among states, and avoid years of contentiouslitigation.

But before discussing what should be done, let me state whatshould be avoided: Congress should reject any option thateffectively raises taxes-that results in more money for states andless for taxpayers. In other words, simply authorizing states tocompel use tax collection from out-of-state businesses should berejected out of hand.

Under the 1992 Quill Supreme Court decision, statescan't compel sales tax collection by an out-of-state businessunless that business has a significant connection to the taxingstate-a legal concept known as nexus. There are at least threeimportant reasons to retain and perhaps strengthen the currentnexus standard.

First, there is no hint of a revenue crisis facing states. Theroughly $20 billion in 1999 business-to-consumer online salesrepresented less than 0.3% of total consumer spending.

In an era of almost no inflation, state budgets grew by 5% inFY97 and nearly 6% in FY98. Over the past four years, state taxcollections have exceeded expectations by about $25 billion. Inaddition, all states will split $246 billion over 25 years from the1998 tobacco settlement. With revenues pouring in so rapidly, itcannot credibly be argued that electronic commerce is currentlyundermining the ability of states to provide legitimate governmentservices.

And in-state sales will continue to be a dependable source oftax revenue. Despite the growth of Internet shopping, traditionalretailers had a fantastic Christmas in 1999, enjoying a healthy7.7% increase in sales over the year before.

Why is that? Because local stores cater to a customer's desirefor a hands-on experience, offer immediate gratification, and donot charge for shipping, they will probably always dominateretailing. In addition, shopping is for many people a pleasurablesocial experience that cannot be duplicated online. Thus, Internetsales won't destroy "real" retailers, just as catalog saleshaven't. The human factor still drives shopping and that willlikely always be true.

The second and most important reason to limit state taxingauthority over remote transactions, however, is fairness. When alocal business collects sales taxes, there is a clear link amongtaxes paid, services provided and legislative representation. Localfirms benefit from police and fire protection, roads, wastecollection and other services, so it's proper that they help coverthose costs. Remote sellers don't enjoy any of those services, andshipping companies already pay taxes to cover their use of publicgoods. To force a wholly out-of-state business to collect taxeswould be "taxation without representation," pure and simple.

It is also important to note that local businesses are taskedonly with collecting taxes for the state where they are physicallylocated (origin-based taxation), while e-commerce firms are beingasked to collect taxes for every state where theircustomers live (destination-based taxation). Ernst &Young has estimated that while collecting $1 in taxes coststraditional retailers 7 cents, it could cost Internet retailers asmuch as 87 cents. How is that a level playing field? The bottomline is that only a state where a business is located should havethe right to compel sales tax collection.

Third, the current nexus standard promotes tax competition amongthe states. Electronic commerce gives everyone the opportunity tolive on a virtual border-to take advantage of the fact that nostate, although it is free to do so, currently taxes its exports orvoluntarily collects use taxes for other states. Like a realborder, the Internet can be a potent safety valve that guardsagainst excessive taxation. E-commerce allows consumers who havefound it difficult to travel out of state-the poor, the elderly,and the infirm-to take advantage of tax competition for the firsttime.

Remember that nothing currently prevents a state frominstructing e-commerce retailers within its borders to collectsales taxes on all sales, regardless of the ultimate destination ofthe product-exactly as brick-and-mortar sellers do. State officialsare hesitant to do this because they fear that businesses mightdecide to locate in other states with lower taxes. They call that a"race to the bottom," but it's really just healthy taxcompetition.

So what, if anything, should Congress do? Legislation to codifyand clarify the Quill nexus standard would help businessesto know exactly when they are liable for sales taxes, just asfederal law now does for income taxes. Greater certainty would helpto avoid years of pointless lawsuits. Moreover, a uniform nexusstandard would not adversely impact state efforts to simplify theirtax systems or encourage voluntary collection by businesses.

Ultimately, there should be more equal tax treatmentamong all forms of commerce, but that does not mean abandoningtraditional principles of tax fairness. Congress must not allow aphony revenue crisis to justify quick passage of new taxingauthority for states that would achieve fairness only by treatingall businesses badly.

Thank you.