The Coming Internet Tax Quid Pro Quo?

October 7, 2003 • TechKnowledge No. 61

The ongoing debate over the taxation of the Internet‐​or, more specifically, the application of sales tax collection obligations to all interstate vendors‐​is coming to a head. The Internet Tax Freedom Act of 1997, which didn’t deal directly with sales taxes but imposed a moratorium on taxes on Internet access or “multiple or discriminatory” taxes on electronic commerce, is due to expire on November 1, 2003. The Internet Tax Nondiscrimination Act was introduced in the House (H.R. 49) and in the Senate (S. 150) to make the existing ITFA moratorium permanent. The measure already has already passed the House and is advancing through the Senate.

In the other direction, Rep. Ernest Istook (R‐​Okla.) and several cosponsors recently introduced H.R. 3184, the Streamlined Sales and Use Tax Act, which would eliminate existing federal barriers to state and local taxation of interstate commerce and Internet sales. Specifically, the Istook bill would give congressional blessing to the Streamlined Sales and Use Tax Agreement (SSUTA), an ongoing effort by many state and local leaders to enter into a formal compact that would simplify and harmonize sales tax administration among the states to get around constitutional hurdles to taxing interstate vendors.

Now that the ITFA appears to be sailing toward easy passage, state and local officials are starting to grumble about how it might cut into their future tax revenues if “Internet access” comes to include some of the old telecom services they tax so heavily. But state and local officials have continued to go along with the ITFA extension and kept their eyes squarely focused on the bigger prize: Congressional termination of the 30 years’ worth of Supreme Court jurisprudence that has limited their ability to impose sales and use tax collection obligations on interstate activities and vendors. This is what the Istook bill would accomplish.

Thus, despite some complaints about the ITFA’s prohibition on Internet access taxes, SSUTA supporters have long understood the benefit of allowing the ITFA to exist, and even be extended. It provides them with a potential legislative quid pro quo that roughly reads as follows: We gave you the ITFA moratorium on Internet access taxes, now give us your consent on the SSUTA compact so we can start collecting sales taxes on e‐​commerce transactions.

By way of background, in a string of Supreme Court decisions over the past 30 years, the Court held that states could only require firms with a physical presence‐​or “nexus”-in their jurisdictions to collect sales taxes on their behalf. State and local tax officials have worked to eliminate or water down these restrictions on their tax reach but thus far have not been able to get around them or convince Congress to give them the authority to tax interstate vendors. Simply stated, these Supreme Court rulings embodied the timeless principle of “no taxation without representation” and sought to apply sensible Commerce Clause protections to interstate activities since Congress had been silent on the matter.

Section 3 of the new Istook bill would effectively end these protections for interstate vendors by noting, “It is the sense of the Congress that the sales and use tax system established by the Streamlined Sales and Use Tax Agreement… provides sufficient simplification and uniformity to warrant Federal authorization to States that are parties to the Agreement to require remote sellers, subject to the conditions provided in this Act, to collect and remit the sales and use taxes of such States and of local taxing jurisdictions of such States.” That language would send a clear message to the Courts during future interstate tax policy or nexus controversies: Congress now cedes to the States‐​or, more specifically, the “Governing Board” of the SSUTA‐​authority over interstate commerce for cross‐​border sales tax collection activities.

Will SSUTA supporters now demand that the price of their general acceptance of the ITFA extension is the Istook bill’s congressional blessing on the creation of a multistate compact and the elimination of existing Supreme Court jurisprudence? That’s the proverbial million (or perhaps multibillion) dollar question. But such a quid pro quo is a steep price to pay for the mere extension of the ITFA’s ban on Internet access taxes. Congress would be wise to think twice before casually disposing of 30 year’s worth of sensible Supreme Court nexus jurisprudence, which not only embodied and extended the Founding Fathers’ “no taxation without representation” vision but nurtured a vigorous interstate marketplace free from extraterritorial tax and regulatory meddling by state and local officials.

Supporters of the SSUTA are essentially proposing to abandon true federalism and jurisdictional tax competition in exchange for the power to potentially recoup a small amount of tax revenue from interstate sales via a uniform system of third‐​party tax collection. Sadly, it appears the many state and local officials would prefer tax collusion over a “laboratories of democracy” model of competition between the states. Real federalism, as envisioned by the Founders, is about a friction and tension between competing units of government, not cooperation and harmonization in the name of extending tax burdens. That’s the European Union model of federalism, not the U.S. model. Congress should be wary of collusionary tax compacts such as the SSUTA that would grant the states such open‐​ended tax authority over the channels of interstate commerce. Preserving or enhancing tax competition should be a guiding theme of this ongoing debate.

Finally, some state leaders will claim that they need to tax the Net and interstate sales to curtail their current fiscal policy crisis. But that crisis is of their own doing, brought on by their profligate spending habits particularly at the end of the 1990s. Total state general fund spending grew by 7.7 percent in FY1999, 7.2 percent in FY2000, and 8.3 percent in FY01. Even as economic growth slowed and budget gaps appeared, state spending still increased 1.3 percent in FY02 and will increase further in FY03. And how much money do they really think they’re going to squeeze out of the Net sector? Internet business represents a minuscule portion of aggregate retailing activity in the United States. According to the U.S. Department of Commerce, e‐​commerce activity accounted for just 1.3 percent of all aggregate retail sales in 2002. Some fear the Internet will grow larger, like mail order and catalog, but in reality those sectors represent breadcrumbs compared to the rest of the economy. Do we really want to justify a burdensome and potentially unconstitutional multistate tax compact and taxes on interstate activities on the grounds that the states need more cash in the short term?

After they cut spending, state and local leaders can explore other tax reform options to solve whatever problems they feel they are experiencing. But in doing so, they must abide by the constitutional protections and sensible nexus guidelines that have protected the channels of interstate commerce in previous decades. It would be foolish for members of Congress to abdicate their responsibility to safeguard the national marketplace by giving the states carte blanche to tax interstate commercial activities via a collusionary multistate tax compact.

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