Sales Taxes On Digital Downloads

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Good morning Chairman Van Fossen, Chairman McKibben, and membersof the task force. I'd like to thank you for inviting me to appearbefore you today. My fellow panelists are addressing the generalcase for and against Internet sales taxes, so I'm going to focus myremarks in a slightly different direction. Namely, the potentialapplication of sales taxes to digital goods and services.

Before I address that topic, let me just note that I think thatInternet taxes in general, as they're currently being discussed,would be ill-advised. The attempt to cartelize tax collectionsthrough the Streamlined Sales Tax Project is, in my opinion,unconstitutional, unfair, and anti-competitive. The last thing thatovertaxed Americans need as their country flirts with recession isan effective tax increase, especially one that undermines long-termtax competition. But I'll leave it to other panelists to make thatcase so that I can focus on digital downloads, an area where Ithink the anti-tax case is the strongest.

As you know, the bulk of electronic retailing involves the saleof tangible products--like clothing or stereo equipment--that areordered online and then delivered by common carrier. But electroniccommerce also includes the sale of intangible digitalproducts--things like music, software, or e-books--that aredelivered directly over the Internet. In addition, the Internetmakes it possible to provide traditional services that are"produced" at one location and "consumed" somewhere else, such asmedical or legal consultations.

In general, taxes on digital downloads should be the same astaxes on regular goods; in other words, the means of deliveryshouldn't govern tax treatment. Such "technologically neutral"taxation would not treat the sale of a paperback book anydifferently from the sale of, say, a digitized book.

Operationally, however, there are good reasons to diverge fromthat rule, as Iowa has done in the past and as I think it shouldcontinue to do. In the interest of time, I'll cover just the fourreasons that I think are most important.

First, determining which products are functionally equivalent isa tricky proposition. Is text that's displayed on a computer screenreally the same thing as a printed book? Is a movie that'sdownloaded to a computer hard drive really the same as a rentedvideo? The answer isn't obvious.

Second, building on that first point, there's no reason thatdownloads, which after all are only information, should beclassified as "goods" rather than "services." Since most statesdon't apply comprehensive taxation to services, and few states taxintangible products aside from basic utilities, there's no obviousreason to extend sales taxes to the downloads that remain aminiscule component of consumer spending--currently only about sixtenths of one percent.

Third, even if technological neutrality is desirable, it doesn'toverride due process and interstate commerce considerations;therefore, only firms with substantial ties to the state should beexpected to collect taxes. Some revenue authorities have suggestedthat because the Quill Supreme Court decision--whichgoverns sales taxes applied to out-of-state businesses--dealtspecifically with the sales of tangible personal property, itdoesn't apply to sales of products or services deliveredonline.

The language of the Quill decision, however, doesn'texplicitly refer to tangible products, which suggests that it alsoapplies to information purchased over the Internet. In other words,unless Congress acts to overturn Quill, any state levelsales taxes on digital downloads will likely beunconstitutional.

Incidentally, legislation is pending in Congress that wouldspecifically preempt the states' ability to tax digital commerce.But even assuming that legislation dies, and even more improbablyassuming that a state successfully made its case in court, thevictory would be illusory. The fluid nature of digital commercemeans that states may have trouble collecting taxes even ondownloads from in-state firms, much less on remotetransactions.

That brings me to my fourth point: that taxing the online saleof intangibles is problematic because of major enforcementissues.

Many online shoppers don't feel comfortable giving unnecessarypersonal information to a Web site. Consequently, they may refuseto type the information in, choose to shop at a site that doesn'trequire it, or simply lie. It's remarkably easy for buyers tomisrepresent their location or to have a third party in anotherstate purchase the product or service and simply forward it with aclick of a mouse. It's also possible for sellers of digitalproducts to locate in foreign jurisdictions that would not enforcetax collection requirements. It would be very difficult, forexample, to collect tax on the transmission of content sent fromabroad and paid for by digital cash or smart card-untraceableencrypted "virtual money" that's spent exactly like cash and leavesno paper trail.

Such technologies are more than a hypothetical possibility.MasterCard and Mondex have been testing "smart cards" for severalyears, while anonymous payment systems such as PayPal and E-goldalready boast millions of customers. The offshore gamblingindustry--which is illegal in the United States--thrives usingsimilar systems provided by companies in Canada and elsewhere.Given the near impossibility of enforcing compliance in the face ofthese payment technologies, the revenue potential of taxing digitalproducts is probably small.

In short, taxing digital downloads is simply more trouble thanit's worth.

That's not an uncommon conclusion. Even some state agencies thatsupport allowing the states to enforce tax collection onout-of-state sellers of tangible goods recognize the all butinsurmountable hurdles to taxing information delivered over theInternet. California's Electronic Commerce Advisory Council, forinstance, has recommended that "the status quo be maintained fortaxing the interstate sale of intangibles and provision ofservices." Its report cites both the difficulties associated withestablishing a buyer's identity and location as well as the easewith which the taxes could be avoided as reasons not to attempt thetaxation of digital commerce.

Critics of exempting digital downloads from taxes argue thatsince most purchases are presently made with a credit card, thebilling address could potentially be used to determine which statehas jurisdiction over a sale. But with the ongoing rise of digitalcash and other unaccounted payment systems, avoidance problemswould, at best, be only postponed.

In any case, relying on credit card companies to collect taxesis perilous for other reasons. Services purchased with a creditcard are typically billed directly to the credit card companyaddress rather than to location where the buyer consumes theservice. The only information available to tax authorities would bethe billing address on file with the credit card company. But thataddress need not have any connection to where a digital product orservice was actually downloaded and consumed. It wouldn't work forcorporate cards, for instance. In addition, any such approach couldbe readily abused. An individual could avoid taxes by establishinga billing address in another state by using a post office box, theaddress of friends or relatives, a second home, or a business.Services are even available that allow mail to be sent to a privatecenter that forwards the mail to a second address. Taxadministrators could seek to verify consumer's information on anindividual basis, but enforcement would be expensive.

Even if a credit card-based identification system could be madeto work, it would raise troubling privacy issues. Currently,governments don't have access to credit card company data unless aparticular card holder is suspected of committing a crime. The useof credit card data for tax collection purposes would put adetailed record of a person's buying habits in the hand ofgovernment authorities on a regular basis, without the normaljudicial protections. The possible abuses of that information areenormous and it's doubtful whether many individuals would easilyaccept such a system. At best, it would encourage consumers to maketheir digital purchases from companies outside the UnitedStates.

In conclusion, there is no compelling reason to tax digitaldownloads. Even if one believes that sales taxes should be appliedmore uniformly online, the unique nature of digital sales makesthem a poor tax target. The biggest effect that Iowa would see fromattempting to tax them would probably be an unwillingness on thepart of e-tailers to set up shop here.

Thank you for your time and I look forward to yourquestions.

Aaron Lukas

Iowa Legislature's Electronic Commerce Task Force