Closing the Net Tax Debate (Part 3): Taxing Digital Downloads


As parts 1 and 2 of this TechKnowledge series haveargued, applying sales taxes to out-of-state Internet purchases-atleast in the manner that's currently being discussed-would beill-advised. The attempt to coordinate tax collections through theStreamlined Sales Tax Project is unconstitutional, unfair, andanti-competitive.

Most of the debate surrounding Internet taxes has focused ontangible products-items like clothing or stereoequipment-that are ordered online and delivered by common carrier.But electronic commerce also includes the sale ofintangible digital products-things like music, software,or medical consultations-that are delivered directly over theInternet. When it comes to those digital downloads, the antitaxcase is even stronger.

In general, taxes on digital downloads should be the same astaxes on regular goods; the means of delivery shouldn't govern taxtreatment. Such "technologically neutral" taxation would not treatthe sale of a paperback book any differently from the sale of, say,a digitized book. Operationally, however, there are good reasons todiverge from that rule.

For starters, determining which products are functionallyequivalent is a tricky proposition. Is text that's displayed on acomputer screen really the same as a printed book? Is a moviethat's downloaded to a hard drive really the same as a rentedvideo? The answers aren't obvious. Building on that point, there'sno reason for downloads, which after all are only information, tobe classified 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 downloads, which remain a minisculecomponent of consumer spending.

Besides, even if technological neutrality is desirable, itdoesn't override due process and interstate commerceconsiderations; therefore, only firms with substantial ties to thestate should be expected to collect taxes. Some revenue authoritieshave suggested that because the Supreme Court's Quill v. NorthDakota decision, which governs sales taxes applied toout-of-state businesses, dealt specifically with the sales oftangible personal property, it doesn't apply to sales of productsor services delivered online

The language of Quill, however, doesn't explicitlyrefer to tangible products, which suggests that it also applies toinformation purchased over the Internet. Unless Congress acts tooverturn Quill, any state level sales taxes on digitaldownloads will likely be unconstitutional. Of course, if Congresspreempts the states' ability to tax digital downloads-as Rep. CliffStearns's (R-Fla.) H.R. 2421 would do-that legal question will bemoot. But even assuming such legislation failed and a statesuccessfully made its case in court, the victory would be illusory.The fluid nature of digital commerce means that states may havetrouble collecting taxes even on downloads from in-state firms,much less on remote transactions.

Which brings up a final point: taxing the online sale ofintangibles is problematic because of intractable enforcementissues. Many online shoppers don't feel comfortable givingunnecessary personal information to a Web site. Consequently, theymay refuse to type the information in, choose to shop at a sitethat doesn't require it, or simply lie. It's remarkably easy forbuyers to misrepresent their location or to have a third party inanother state purchase the product or service and simply forward itwith the click of a mouse. It's also possible for sellers ofdigital products to locate in foreign jurisdictions that would notenforce tax collection requirements. It would be very difficult,for example, to collect tax on the transmission of content sentfrom abroad 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 hypothetical. MasterCard andMondex have been testing "smart cards" for several years, whilepayment systems such as PayPal and E-gold already boast millions ofcustomers. The offshore gambling industry-which is illegal in theUnited States-thrives using digital payment systems provided bycompanies in Canada and elsewhere. Given the near impossibility ofenforcing compliance in the face of these technologies, the revenuepotential of taxing digital products is probably small.

In short, taxing digital downloads would be more trouble thanit's worth. Even some state agencies that support taxingout-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 and the ease withwhich the taxes could be avoided.

Critics of untaxed digital downloads argue that because mostpurchases are made with a credit card, the billing address could beused to determine tax jurisdiction. But with the rise of digitalcash, that argument will no longer hold. In any case, reliance oncredit card companies would be impractical for other reasons.Services purchased with a credit card are typically billed directlyto the credit card company address rather than to the consumer'slocation. The only information available to tax authorities wouldbe the billing address on file with the credit card company. Butthat address need not have any connection to where a digitalproduct or service was actually downloaded and consumed. Itwouldn't work for corporate cards, for instance.

In addition, individuals could avoid taxes by establishing abilling address in another state by using a post office box, theaddress of friends or relatives, a second home, or a business. Taxadministrators could seek to verify such 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 cardholder 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 hands 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 thinks that sales taxes should be appliedmore uniformly online, the unique nature of digital sales makesthem a poor tax target. The biggest effect of allowing states totax them would probably be an unwillingness on the part ofe-tailers to set up shop in the United States.