Closing the Net Tax Debate (Part 2): Identifying the Real Sales Tax Drain

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The moratorium on state and local government "multiple ordiscriminatory" taxation of the Internet as well as taxes onInternet access is set to expire shortly, and Congress is debatingthe merits of extending or making permanent those restrictions onstate and local taxing activity. The existing Internet Tax FreedomAct (1998) moratorium does not, however, prohibit the states fromattempting to collect sales or use taxes on goods purchased overthe Internet. What pro-tax state and local officials are really atwar with is not the ITFA but 30 years of Supreme Courtjurisprudence that has not come down in their favor. The ultimategoal of the pro-tax crowd is to overturn cases such as NationalBellas Hess v. Illinois (1967), Complete Auto Transit,Inc. v. Brady (1977), and Quill v. North Dakota(1992), in which the Supreme Court ruled that states could requireonly firms with a physical presence in their states to collecttaxes on their behalf.

Ever since those decisions were first handed down, state andlocal tax officials have worked tirelessly to eliminate or at leastwater down their guidelines, largely in an effort to tax catalog ormail order sales. Luckily for companies and consumers, Congress hasso far not allowed the states to set their own ground rules for thetaxation of interstate commerce, which would upset the delicateconstitutional balance by giving the states too much authority overthe interstate marketplace. [See: "Closing the Net Tax Debate (Part 1): DebunkingLevel Playing Field Myths," Cato TechKnowledge#22].

More important, what this effort to tax the Internet reallycomes down to is a classic case of misplaced blame. In their zealto find a way to collect taxes on electronic transactions tosupposedly "level the (sales tax) playing field," most state andlocal officials conveniently ignore the fact that current sales taxsystem is perhaps the most unlevel playing field anyone couldpossibly have designed.

Several politically favored industries and politically sensitiveproducts receive generous exemptions from sales tax collectionobligations or the taxes themselves. Food and groceries,agricultural products and production, and clothing all receivesales tax exemptions in most states and localities. That createsmassive confusion in defining the sales tax base in some states.For example, are marshmallows and granola bars a "food" or a"candy" product? If they are labeled "candy," they are taxed insome states; if classified as "food," they are not. Likewise, thetax treatment of shoes varies widely. Some states exempt all shoesas clothing while others impose taxes on tennis shoes or cowboyboots as luxury items. There are endless debates among taxofficials about product definitions.

Despite the definitional quibbles and the problems brought on bythe growing number of exemptions, sales tax collection remainedfairly effective in the post-World War II period since a sizableportion of the American economy was still subjected to the tax.When the sales tax was first being formulated during the 1930s tosupplement income and property taxes, which were less effectiveduring the Depression, tracing and taxing the sale of commoditieswere a far more rudimentary undertaking, because the Industrial Ageeconomy of the time was primarily goods based. In other words, mostcommodities were tangible goods that typically were sold over thecounter in most business establishments. That made sales taxcollection fairly routine.

But as America began a gradual shift to a service-based economyin subsequent decades, serious strains were placed the sales taxsystem since sales taxes had traditionally been collected on goods,not services. Therefore, the vast majority of "service-sector"industries and professions receive a blanket exemption from salestax obligations. A partial list of the professions exempted fromthe sales tax in most jurisdictions includes business services,banking and financial services, construction and contracting,health services, media services and advertising, and transportationas well as a wide variety of other personal and professionalservices.

The sales tax was not designed to capture those activities and,therefore, as the service sector became a larger portion of theAmerican economy, the overall tax base shrank accordingly. Limitedefforts have been made by some states to expand sales tax coverageto include services, but those efforts have met with staunchcorporate and consumer opposition. Regardless, the combined effectof the service-sector exemptions and exemptions for "special"goods-producing industries such as agriculture and clothing, hasbeen the gradual diminution of the sales tax base in America.

In fact, in a December 2000 study in the National TaxJournal, economists Donald Bruce and William F. Fox of theUniversity of Tennessee Center for Business and Economic Researchestimated that the sales tax base as a percentage of personalincome has fallen from roughly 52 percent in the late 1970s to lessthan 42 percent today. That is just a complicated way of sayingthat the current sales tax system hits only about 40 percent of allindividual consumption. In other words, America's primary method oftaxing consumption - the sales tax - doesn't hit even half theconsumption activity in the economy. Worse yet, as the sales taxbase has been gradually eroding in recent decades, evidencesuggests that average sales tax rates have been going up. In otherwords, we now have a rising average tax rate over a shrinking taxbase. That is the textbook definition of an inefficient tax.Optimally, economists want a low tax rate over a very broad taxbase.

Does this mean that state and local policymakers should scrapthe sales tax system entirely and learn to rely on other tax basessuch as property and income? Not necessarily. It is just to saythat citizens should be cognizant of the deficiencies of thecurrent system and not allow state and local policymakers to trickthem into thinking that the Internet is to blame for the holes intheir sales tax bases. Although state and local officials wouldhave us believe that the Internet and electronic commerce aredriving a bigger wedge into their sales tax bases, the reality issomething much different. Electronic commerce sales constituted asurprisingly low 0.92 percent of aggregate retail sales in thesecond quarter of 2001 according to U.S. Department of Commercedata. This is down from a whopping high of 1.09 percent in thefourth quarter of last year. In light of those numbers, it's hardto see how the Internet is to blame for the declining sales taxbase.

So next time you hear state or local officials pleading forCongress to save them from the massive sales tax drain brought onby the Internet, tell them to first clean up the mess they'vecreated. And if they really want to find a way to "level theplaying field" and tax Internet transactions, an origin-based salestax system would allow them to do so in an economically efficientand constitutionally sensible way. In the meantime, however,Congress would be wise to extend the existing ITFA moratorium onmultiple and discriminatory taxes, as well as Internet accesstaxes, and let beneficial Supreme Court precedents continue togovern the interstate marketplace for electronic commercetransactions.