All Commentary
Thursday, June 1, 2000

Internet Commerce Should Be Taxed?

Taxing Online Sales Would Restrict Intergovernmental Competition

Virginia Governor James Gilmore, chairman of the Advisory Commission on Electronic Commerce, hoped that the group would act quickly to make permanent Congress’s 1998 three-year moratorium on new Internet taxes. But faced with a Clinton administration policy statement objecting to any move that would ban the collection of sales taxes on online purchases, a letter signed by 49 economists contending that Internet taxes are necessary to restore “neutrality” to the sales tax code, and the testimony of mayors and other public officials lamenting the billions in revenue state and local governments stand to lose if the tax moratorium is extended, the commission adjourned its recent meeting in San Francisco without reaching agreement. Given the strength of pro-tax forces being mobilized, it is doubtful that the two-thirds majority required for the commission to make a recommendation preserving the Internet tax haven can ever be achieved.

Economist Paul Krugman has joined the chorus clamoring for closing the e-tax loophole. Writing in the February 12 New York Times, he likens today’s tax-free Internet to a kind of default “industrial policy” for the Digital Age. He ought to know better.

That new taxes on e-commerce are being pushed when the economy is booming, sales tax receipts have swollen, and most state government budgets are awash in black ink undercuts most of what passes for serious analysis of Internet tax policy. Indeed, the palpable absence of a budgetary justification for taxing electronic commerce suggests that the moratorium was enacted, not on the basis of principle, but rather because the tax writers in Congress have not yet figured out how to structure and administer e-taxes so as to maximize the Internet tax take—or found a politically acceptable way for the federal government to share in the loot.

Of course, the pro-tax forces contend that closing the loophole would not impose a new tax but simply eliminate existing distortions in the sales-tax code, that is, ensure that the tax laws do not favor one segment of the retail trade over another. Consumers buying products online currently enjoy the same immunity from state and local sales taxes the U.S. Supreme Court has carved out for mail-order catalog sales. The Court ruled earlier this decade that requiring retailers located in one state to collect sales taxes from consumers in another unconstitutionally burdens interstate commerce. Hence, sales taxes are due on mail-order and Internet purchases only if the retailer has a substantial “physical presence” in the customer’s state of residence. Although buyers in every state with a sales tax are obliged to report and pay “use” taxes on items purchased elsewhere, few consumers voluntarily comply.

As a result, local retailers are supposedly placed at an unfair competitive advantage relative to Internet and mail-order retailers, and including such purchases in the tax code would merely restore a level retail playing field. But the economists who support taxing the Internet to eliminate perceived distortions are living in a fiscal fantasyland. Except insofar as “reform” generates more revenue or confers benefits on key electoral constituencies, government has no interest in designing a neutral tax code, nor in benevolently broadening the tax base so that tax rates can be lowered. Rather, the flesh-and-blood politicians who function in a world light years distant from the policy prescriptions of public-finance textbooks are motivated by more narrowly self-interested objectives.

Barrier to Tax Abuse

Fiscal federalism is a stubborn constitutional barrier to the parochial politics of taxing and spending. As is the case in ordinary markets, competition among the nation’s 30,000 separate state and local tax jurisdictions helps hold tax rates down to their cost-effective minimum. If one jurisdiction imposes a sales-tax rate that is too high compared with the quantity and quality of public services those taxes help finance, its tax base will tend to shrink as businesses and consumers relocate to other jurisdictions with lower taxes, better roads and schools, or both. But moving is costly. The ability to avoid high local taxes by making purchases over the Internet or through mail-order catalogs supplies an alternative margin of competition that forces governments to be more fiscally responsible.

Access to the Internet allows every consumer to live on a “virtual border,” thereby making it economical to exploit even small differences in price. The ability to avoid high local taxes by making purchases online is particularly beneficial to low-income consumers because sales taxes are among the most regressive ways of raising revenue: poor people consume greater percentages of their incomes than those who are financially better off.

Opposition to e-taxes is not, as Krugman puts it, based on a “slash-taxes-to-starve-the-bureaucrats theory.” Tax competition instead promotes a situation in which taxes will tend to mirror interjurisdictional differences in the demands for government services. Policies that promote tax rate “harmony” make it easier for governments to ignore these heterogeneous taxpayer preferences and to levy taxes that are excessively high.

Retailer Response

Local bricks-and-mortar retailers that are placed at a competitive disadvantage by high local sales taxes do not have to stand idly by. They can get business lost to catalog sales or to the Internet back by providing services consumers value—and are willing to pay for. The opportunity to see and touch items on display, to try them on, to take advantage of product demonstrations and other point-of-sale assistance in making their selections, and to accept immediate delivery are options not available to online shoppers. Traditional retailers can also respond to Internet competition by lowering their prices so that, inclusive of sales tax, the prices they charge are equal to or less than those charged by out-of-state retailers, which normally add hefty shipping and handling charges to their customers’ orders.

That is how competition is supposed to work. When the playing field is instead leveled by forcing Internet companies to raise their prices by collecting sales taxes and remitting them to the treasury of the state where the purchaser resides, the competitive market process is short-circuited and taxpayers become more vulnerable to exploitation by big government. Paul Krugman apparently thinks that a tax-free Internet has a harmful effect on retail competition, but he ought to be more concerned with the damage done to intergovernmental competition if the loophole is closed.

—William F. Shughart II
University of Mississippi

  • William F. Shughart II is Research Director and Senior Fellow at The Independent Institute, the J. Fish Smith Professor in Public Choice at Utah State University, and past president of the Southern Economic Association. A former economist at the Federal Trade Commission, Professor Shughart received his Ph.D. in economics from Texas A&M University, and he has taught at George Mason University, Clemson University, the University of Mississippi and the University of Arizona.