Taxes and the Internet

Conference presented by Sally C. Pipes, President and CEO of the San Francisco Pacific Research Institute, on e-commerce and the tax system.

Taxes and the Internet: Canada and The U.S. Face New Opportunities and Challenges

About a year or so ago, word went out that Canada Post was going to start charging a five-cent fee on every e-mail in order to make up for the loss of business in paper mail. The same message circulated about the American post office. Both were hoaxes but got people fired up, for good reason.

Back in the 1980s, when faxes started to become popular, the United States Postal Service wanted to monopolize those too, just as they do first-class mail. The fax machine would have been in the post office, and you would have to go there to send one or to pick it up. This incredibly stupid idea got shot down right away, which shows two things I want to discuss with you today.

First, ordinary people are very progressive. They like new technology and want to use it to better their lives. The Internet has not only helped people communicate. It’s the flywheel of current prosperity, helping many to launch new businesses, with low start-up costs.

Second, governments tend to be Luddite and reactionary. Their response to the Internet, for example, is not to help expand its use. Rather, they see it simply as another revenue source and seek new ways to tax it. I believe this is misguided and destructive. But Canada might be able to help avert this outcome if Canadians take a cue from what has happened south of the border. Of course, that will take some doing.

Tax worship is a popular religion here and Ottawa has become the Vatican of taxes. In October, 1998, The Organization for Economic Co-Operation and Development (OECD) chose that city to discuss the subject of Internet taxation. That same month, the United States Congress approved the Internet Tax Freedom Act.

That legislation put in place a moratorium on new Internet taxes until October 2001. It also created a federal Advisory Commission on Electronic Commerce or ACEC, a 19-member panel appointed to study whether or not the Internet should be taxed, and if so, how.

The Commission had 18 months to complete its mission, and delivered its report to Congress on April 12, 2000. One of the majority proposals was to extend the current moratorium for another five years. This recommendation led to the passage of the Internet Non-Discrimination Act by the House of Representatives in May 2000, and while that was a step in the right direction, the bill lost support when it reached the Senate.

What does a "moratorium on new Internet taxes mean?" It means no new taxes such as access taxes or data transmission taxes on the Internet – with the emphasis on new. What it does not mean is "no taxes" on the Internet. That’s one of the misconceptions we are battling right now.

You can’t access the Internet without a phone line, and the U.S. federal government charges $3 a month on that line. State and local governments add an additional 37 different types of taxes, which can account for up to 36 percent of the local phone bill. So access to the Internet is already taxed.

Contrary to some media reports, states are currently collecting sales taxes on the Internet, but only on purchases made from vendors that have substantial physical presence in the state. For example, since Amazon. com has no actual stores in California, hence no physical presence, it does not have to collect sales taxes.

Alternatively, The Gap, a clothing chain, has stores in all states and as a result must collect the sales tax on all its Internet sales. This standard, called "nexus," goes back to a 1967 U.S. Supreme Court ruling called National Bellas Hess.

That case involved taxes on the mail order industry and the Court ruled that since the Commerce clause of the US constitution gives authority over interstate commerce to the federal government, "states lack the authority to compel out-of-state firms to collect taxes unless those firms have "nexus" in the state." This decision was reaffirmed by the Supreme Court when applied to sales taxes in the 1992 Quill decision.

It seems to me that Canada has escaped this debate to date because e-commerce is still a minor part of the Canadian economy. But these issues are likely to arise and Canadians stand to gain from watching the U.S. experience.

If taxation were allowed to move across borders, competition between taxing jurisdictions would be stifled. The beauty of federalism is precisely that it allows for the different states or provinces to work with different policies, allowing citizens to see for themselves which policy works best.

That consumers can avoid taxes by crossing an electronic border is no different than residents of Washington State crossing into Oregon to shop tax-free. Such choice expands freedom and disciplines government.

If states were allowed to impose their policies on people outside their states, not only would that be taxation without representation, but the benefits of federalism would disappear. You can see how easily this argument moves to an international model.

The debate over Internet taxes in the U.S. is essentially a debate over the collection of sales taxes. It is quite clear that state governments would like to overturn the Bellas Hess and Quill decisions, and cash in on what many see as the "e-commerce boom."

No doubt, you’ve heard the numbers. In 1998, the "Internet economy generated an estimated $301 billion U.S. dollars in total revenue and was responsible for 1.2 million jobs." By 2003, it’s estimated that business to consumer sales will reach $108 billion dollars or six percent of retail sales currently at two percent, and business-to-business (B-2-B) sales will reach 1.3 trillion.

These are large numbers, and as one commentator said recently, "big numbers with dollar signs attached are irresistible bait for state politicians and tax collectors. Tossing these numbers around is like throwing a bucket of catnip at a bunch of hungry tigers."

So, broadly speaking, the debate is split into two camps: the pro-tax camp and the anti-tax camp and focuses on two specific fights. First, is the notion that a tax-free Internet will cause state and local governments to "lose" tax dollars.

At a time when their treasuries are bursting with surplus cash, many state and local government officials are terrified that the boom in electronic commerce will leave them in the dust, without the ability to provide community services such as schools and police.

For instance, Dallas mayor Ron Kirk who was a member of the Advisory Commission on Electronic Commerce said, "even in the cyberworld, you need police, roads, and bright red fire engines." But contrary to what Kirk and others would have us believe, electronic commerce will not mean the end of local services or communities.

If allowed to flourish, electronic commerce will bring prosperity and economic growth. The problem with the argument put forth by local government lobbyists is that it relies on the myth of the zero-sum game – the idea that growth in one sector is fueled by a loss of growth in another.

The growth of a "tax-free" Internet does not translate into less revenue for local governments. Instead, the opposite is true. Over the last five years, as Internet shopping has grown, so have traditional retail sales taxes collected by local governments. In California, where the zest for on-line buying is astounding, traditional sales-tax revenues have ballooned.

According to Dean Andal, vice chairman of California’s Board of Equalization, "between 1994 and 1998, California’s sales tax revenues have grown at an annualized rate of 5.7 percent for an impressive total of 28.6 percent."

That growth outstripped the state’s inflation and population growth combined. And it happened in tandem with rising e-commerce sales which have doubled every year since 1995. The reason for this impressive performance is clear. The economy is expanding and the economic pie is growing.

It is not a zero-sum game. Internet retailers are reaching out to markets well beyond their local communities, sometimes even beyond the United States and Canada. This success leads to a more robust economy and higher incomes.

People with higher incomes have more cash to spend, and many of them will spend it on local retail or property – both of which lead to increased taxes for local government. But pro-tax lobbyists don’t seem to understand this concept.

Instead, they argue that the pie will remain the same size, thereby predicting that e-commerce will cause them to lose their juicy slice. Of course, it is possible that the pro-tax proponents of state greed do understand that e-commerce will expand the economy, and they are simply attempting to ensure that their piece of the pie grows along with it. But that too would be a myth.

While there is no evidence that on-line purchases have harmed local government coffers, there is ample evidence that taxes are economically destructive. A study by Dean Stansel and Stephen Moore at the Cato Institute demonstrates how taxation affects the economy. They found that following California’s $7 billion tax hike in 1991, "actual revenue growth came in below projections in each of the next three years."

Alternatively, when California cut taxes between 1995 and 1998, income tax revenues rose 48 percent.

Given the evidence, it is clear that the best outcome for consumers, and their governments, is to leave electronic commerce relatively tax-free. Otherwise, both the Internet and the prosperity of the nation will suffer.

The second main fight in the Internet sales tax debate is concerned with fairness. Pro-tax advocates complain that requiring bricks-and-mortar businesses to collect a sales tax that on-line retailers do not collect is unfair. At first blush, this argument for a "level playing field" sounds reasonable.

But the fairness argument only allows for fairness to go in one direction – taxing the Internet. Proponents fail to allow that fairness could also dictate that main-street retailers stop collecting the sales tax. Main-street businesses, it should be noted, do not have the added expense of shipping their goods. Internet businesses do.

Second, many on-line businesses are out of state. It does not seem fair to ask out-of-state businesses to pay sales taxes for government services such as schools and police that they do not use.

Third, taxes of any kind seldom pass a fairness standard like the one proposed. Nothing in the tax system is objectively fair. If you work harder and as a result earn more, you pay a higher tax rate. Some states don’t tax essential goods such as food and clothing. Some don’t tax income. Some have no sales tax.

Dallas mayor Ron Kirk recently gave a $3 million tax break to the Dallas Hyatt Regency Hotel so it could expand. But the other hotels in Dallas did not get this same opportunity. This demonstrates that government control of revenue does not always ensure fairness. Leaving dollars in consumers’ pockets is more likely to ensure fairness for everyone.

When we do spend those dollars, it will likely be in "E-tailing," buying on line, but from familiar businesses known to us in the physical world. Forrester Research predicts that the majority of purely dot. com retailers will be gone by 2001.

So that’s a brief overview of the main arguments for and against expanding the collection of sales taxes on the Internet. Now, I will give you a short summary of a proposal being used as a pilot program in four American states.

The plan, originally put forth by the National Governors’ Association or NGA, was packaged as a plan to streamline and equalize state sales tax collection. Titled "Streamlined Sales Tax System for the 21st Century," the NGA’s plan was basically a new tax scheme in sheep’s clothing.

The plan proposed creating new entities called "Trusted Third Parties" (TTPs) which would act something like private tax collection agencies. These TTPs would create and maintain a technologically-feasible national tax collection system for on-line businesses and offer incentives to businesses to join the system. Incentives for businesses would be needed because, according to the NGA, the new tax regime would be "voluntary" – that’s how they would get around the Commerce clause that was the rationale for the Supreme Court to rule that states can’t tax out-of-state businesses without nexus. Each TTP would then charge each state for these services, passing along the costs to consumers.

Here’s how it would work: Jane would purchase an item on the Internet, and included in the purchase price would be her state’s sales tax, the TTP fee to collect it, and the "incentive" fee for each business that integrates with the TTP. Essentially that amounts to three taxes where previously there was one, or none at all, and hardly what most analysts would describe as fair and streamlined.

The NGA’s proposal was rejected by the Advisory Commission on Electronic Commerce, but the National Governors’ Association has not let it die. Under a program called the Streamlined Sales Tax Project, Kansas, Michigan, North Carolina, and Wisconsin have just signed up for a year-long test run of software that would allow those states to collect sales tax over the Internet from out-of-state vendors.

But does using software firms really make the tax collection process less complex? This is the big question for governments around the globe. The NGA thinks it will, but as R. Bruce Josten, executive vice president of government affairs for the U.S. Chamber of Commerce has argued, "putting new tires on a Model T tax code will not enable it to catch a space-age market."

The NGA is not simplifying the taxing process by enlisting software companies to help create taxation software. They are merely shifting the complexities from government to a third party – a process unlikely to be successful.

So, how is it supposed to work? Taxware’s Transaction Tax Server works by confirming that the address that the consumer has listed as the delivery address exists. If the consumer lives in a state in which the vendor has a physical presence, the system will calculate a sales tax to the purchase. If the consumer is buying from a state in which the vendor does not have a presence, the system will calculate the use tax.

But taxing consumers based upon an address they voluntarily provide is riddled with problems, especially in a market in which digital goods are delivered over the Internet.

When someone buys software off the Internet and loads it onto his or her computer, there’s no way of knowing where the consumer actually is if he or she is using a re-mailer like the Anonymizer or the Freedom software of Zero Knowledge, created in Canada. Since companies selling digital goods use consumers’ addresses for taxation purposes and not for delivery, a customer could easily lie about his or her address in order to get a better tax rate.

This is a problem that Canadian and European governments appear to be particularly concerned with as U.S. international sales of software and digital music rise. That’s because unlike Canadian and European firms, U.S. firms have no national sales tax to collect.

Taxware and other companies also purport to keep track of which products are tax exempt and will charge consumers accordingly. However, this process becomes decidedly chaotic because states exempt different products from the sales tax and change these exemptions often.

In Massachusetts, the first $175 of an article of clothing is tax-exempt. In Connecticut, only the first $50 spent is tax-exempt. In New Jersey, clothing is completely tax exempt. In some states a scarf for decorative purposes is taxable, while a winter scarf intended for warmth is tax-exempt.

Since the software will likely fail to distinguish between tax-exempt and taxable goods, Americans run the risk that governments will attempt to solve the problem by scrapping tax-exemptions altogether, thereby extending taxes even further. The issue of privacy also comes into play.

Currently, businesses have no real need to know where their customers are located. But if they are forced to start charging taxes, they will need to collect that data, and a new electronic database of consumer’s purchases will be created at the government’s behest. This could dampen e-commerce as individuals concerned with their privacy will choose to shop offline.

Company privacy is also at stake in a system in which an outside party has a constant link to the company’s records.

The makers of taxware software claim that their system makes filing taxes easier on companies by calculating the appropriate sales or use taxes and then sending the tax rates to the merchant’s billing system. Taxware’s Transaction Tax Server will electronically report the vendor’s tax liability to the government at the end of the year using information from the Audit File.

Under the NGA proposal, vendors would be required to integrate their business systems with the taxation software systems of the "trusted third parties" to make tax processing simpler.

The NGA plan claims that "system checks" would happen only every once in a while. But the line that divides "system checks" from audits may become blurred over time.

There is no guarantee that a trusted third party won’t use "system checks" as a means of illegally auditing the company. Nor can we be sure that the "trusted third party" isn’t selling consumer profiles to other parties.

The most convincing argument against expanding taxes on the Net is that it would kill jobs. A recent study completed by our policy analysts Sonia Arrison and Naomi Lopez showed that if taxes were applied in California the way that the NGA wants, more than 100,000 California jobs could be permanently destroyed by 2002.

Other groups around the country are currently doing similar calculations for their states, and I can tell you that the total jobs lost for the entire country will be huge.

As you may have heard, California legislators recently passed a bill to expand taxation on the Internet and subsequently that bill was vetoed by Governor Gray Davis.

The bill would have required out-of-state companies with no physical presence to collect the sales tax if they are related to an in-state retailer, such as Barnes and Noble and www.barnesandnoble.com.

If this kind of bill can pass in California where there’s a history of Internet-friendly policies, it is likely to repeat itself all over the country and indeed the world. This should serve as a wake-up call.

Attacks on e-commerce will only continue to grow. And since we are increasingly working in a globalized world, this means that free market voices are going to be in the minority. Consider some of the reports that have come from the Organization for Economic Co-operation and Development. Most have tended against healthy competition and instead promoted tax harmonization. This raises both opportunities and challenges.

The Internet economy is in a rather unique position. E-commerce is starting from a point of few trade restrictions, and the negotiations focus on how to increase them. This stands in stark contrast to what negotiators normally face – talks to bring down trade barriers, for instance NAFTA. So the Internet presents us with the opportunity to reinforce the benefits of free trade.

Canada could have an important role to play in this respect, and we can only hope that the government will continue as they have been – cautious, and according to reports choosing a path of less regulation in order to bolster Canada’s economy.

We would love to see Canada continue on this path of prudence and prosperity. Here is a chance to put people before politics and show greedy American governments how it’s done.

I encourage you to show us that true north, strong and free. And I’d be happy to take any questions you might have.

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