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 A heated debate is once again under way inCongress over the tax treatment of electronic com-merce and the Internet Tax Freedom Act of 1997.The ITFA imposed a moratorium on state andlocal taxes on Internet access and banned “multi-ple or discriminatory” taxes on electronic com-merce. That moratorium was intended to last only three years but was extended by Congress in 2001for another two years. It will lapse on November 1,2003.The ITFA has been a remarkably misunderstoodor misinterpreted statute and has very little to dowith what really lies at the heart of this debate—theeffort by state and local governments to collect salesand use taxes on remote vendors in interstate com-merce (mail order, catalog, and e-commerce compa-nies). Contrary to press reports and statementsmade by some members of Congress, the ITFAmoratorium does not directly affect the ability of states and localities to impose sales and use taxes onpurchases made over the Internet.What state and local officials are really at warwith is not the ITFA but 30 years of SupremeCourt jurisprudence that has not come down intheir favor. Their ultimate goal is to overturnthose precedents, which held that states couldrequire only firms with a physical presence—or“nexus”—in their jurisdictions to collect taxes ontheir behalf. State and local tax officials haveworked to eliminate or water down these restric-tions on their tax reach but thus far have notbeen able to get around them or convinceCongress to authorize the imposition of collec-tion obligations on interstate vendors. Although extending the existing ITFA mora-torium and continuing to uphold the SupremeCourt’s nexus jurisprudence makes good sense,Congress must also take an affirmative standagainst efforts by state and local governments tocreate a collusive multistate tax compact to taxinterstate sales. Other options exist that stateand local governments can pursue before look-ing to impose unconstitutional tax burdens oninterstate commerce. Of course, getting runaway state spending under control would go a longway toward solving many of their supposedproblems. Merely extending sales tax collectionresponsibilities to electronic commerce—whichconstitutes less than 2 percent of all retail activi-ty in the United States—will not solve the fiscalcrisis that state and local governments have cre-ated through their profligate spending habits.
The Internet Tax Solution
Tax Competition, Not Tax Collusion
by Adam D. Thierer and Veronique de Rugy 
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 Adam D. Thierer is director of telecommunications studies and Veronique de Rugy is a policy analyst at the Cato Institute.
Executive Summary 
No. 494October 23, 2003
 
Introduction
Many policymakers, journalists, and oth-ers view the debate over Internet taxation infairly narrow terms. They believe the debate isreally about whether or not federal, state, orlocal legislators should “tax the Net.”Consequently, the war of words has focusedon competing bumper-sticker slogans suchas “Don’t Tax the Net” and “Level the TaxPlaying Field.”Framing the debate in this manner grossly underestimates the complexity and impor-tance of the issue. For instance, the don’t-tax-the-net side chooses to ignore the fact that theInternet is not really a “tax-free zone.” Although states cannot force remote vendorsof interstate commerce to collect and remitsales taxes, states have a corresponding “usetax” that requires consumers in their jurisdic-tion to remit the tax owed on out-of-state pur-chases. However, those levies are difficult toenforce. In other words, the absence of use taxcollection is what makes the Internet (e.g.,mail order and catalog sales) appear to be taxfree. Anti-tax activists ought to ask themselveswhether this is really the best way to achievelower tax rates and smaller government. It ispossible that states simply offset tax losses onremote sales by raising taxes on other classesof goods or vendors. Finally, there are legiti-mate tax fairness issues at stake. All otherthings being equal, similar goods and servicesshould be taxed in similar ways.The arguments offered by those peoplewho would like to extend the sales tax toInternet purchases seldom prove valid. Inparticular, the level-playing-field argument—the notion that interstate vendors have a sig-nificant tax advantage over Main Street ven-dors—does not hold water. Indeed, to theextent that there is a genuine level-playing-field problem with regard to the sales tax, it isoften one of the states’ own making, becausethe current system is riddled with exemp-tions and special rules. Attempts to blame the rise of the Internetfor a decline in the sales tax base or state andlocal revenues are completely without merit.Internet business represents a minusculeportion of aggregate retail activity in theUnited States and can hardly be fingered asthe culprit for recent state and local govern-ment budget shortfalls. In fact, according tothe U.S. Department of Commerce, e-com-merce activity accounted for just 1.3 percentof all aggregate retail sales in 2002.
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Regardless, as policymakers debate thiscontentious issue, three themes or principlesshould guide the discussion.
Federalism: A Two-Sided Coin
 Although state and local governmentsmust lead reform efforts, Congress has animportant role to play. Although the sales taxis a state and local system, efforts to imposecollection responsibilities on out-of-state vendors automatically warrants some degreeof federal oversight by Congress. Because thedebate is infused with endless talk of protect-ing federalism and states’ rights, it is impor-tant to understand what is meant by thoseterms. Many state and local officials and taxadministrators seem to believe that states’rights means that state and local govern-ments should be free to impose any type of tax or regulatory regime on commercialactivities, even if interstate activities areinvolved. Such an argument shows a misun-derstanding of the federal system that theFounding Fathers set forth in the U.S.Constitution.Federalism is a two-sided coin: one side isstates’ rights and the other is interstate com-merce. The vast majority of tasks undertakenby the federal government since the New Deal have been an unjustifiable usurpationof the powers that the Constitution grantedto the states or the citizenry. But theConstitution was also an explicit rejection of the Articles of Confederation: the disadvan-tages of untrammeled states’ rights weretrade disputes, protectionism, and interfer-ence with the flow of interstate commerce.Consequently, the Founders granted Con-gress the authority to take steps to regulatecommerce among the states—that is, to keep
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Federalism is atwo-sided coin:one side is states’rights and theother is interstatecommerce.
 
open the channels of interstate commerce toensure that free trade would win out overstate protectionism. Applying the Founders’ vision to high-tech markets they could not have foreseen istricky but not impossible. In the debate overthe taxation of e-commerce it means thatCongress will need to oversee state-ledreform efforts to ensure that states do notimpose unconstitutional tax collection bur-dens on remote vendors in interstate com-merce. In addition to extending the currentITFA moratorium on “multiple and discrim-inatory” taxes as well as Internet access taxes,Congress will consider whether to put itsstamp of approval on a multistate tax com-pact or collection agreement called theStreamlined Sales Tax Project.The SSTP is presented as an effort to sim-plify and harmonize sales tax administrationamong the states in order to get around con-stitutional hurdles to taxing remote vendors. Although simplification is a laudable goal,tax harmonization can also have a downside.In particular, even though advocates of theSSTP talk only about harmonizing tax-basedefinitions and collection systems, the nextlogical step may be the harmonization of taxrates. Indeed, many retailers may demandthat Congress force the states to adopt onerate per state to achieve the ultimate form of sales tax simplification.Congress should reject such proposalsand be wary of collusive tax compacts thatwould in the long run grant the states open-ended tax authority over the channels of interstate commerce, not only because of thepotential constitutional issues they raise, butbecause tax competition between and amongthe states might be negatively affected.Preserving or enhancing tax competitionshould be a guiding theme in this debate.
“Fairness” and “Neutrality” Aren’tNeutral Terms
 Although fairness and neutrality animateefforts to extend sales tax collection obliga-tions to Internet vendors, the current salestax system is hardly perfectly fair or neutral,and efforts to extend it to the Internet wouldraise different fairness and neutrality issues. Although state and local officials are rushingto devise a mechanism to tax interstate sales,and e-commerce in particular, they have paidmuch less attention to the fact that constantpolitical meddling and special-interest favor-itism have turned the sales tax base intoSwiss cheese. Countless special rules, exemp-tions, and loopholes have been devised forfavored industries or products.Of course, for those people who desirefewer taxes in general, the fact that many goods and services are exempt offers a cer-tain kind of tax relief. But the downside of such exemptions is that politicians mightuse them as an excuse to raise the rates onother activities or certain groups of taxpay-ers. In fact, as states engaged in a spendingfrenzy in the 1990s, many legislators in-creased sales tax rates. Moreover, the averagestate sales tax rate has increased from 1.2percent in 1950 to almost 5 percent today.The combined state, city, and county rate isnow closer to 6 percent. Despite steady taxrate increases, however, spending has oftenoutpaced revenues and led to claims of bud-get shortfalls.Is the Internet somehow to blame for thecurrent situation? Will taxing e-commercemake up for the perceived tax shortfallsmany governments fear? Unlikely on bothcounts. Even if state and local officials suc-ceeded in devising a sales tax collectionscheme to capture the minuscule portion of retail economic activity generated by the elec-tronic commerce sector, it would likely be a Pyrrhic victory, especially if states keptincreasing spending.Extending current sales tax collectionschemes to the Internet in the name of fair-ness seems particularly hypocritical giventhe many games politicians have playedwith the current sales tax system. Moreover,it would hardly be fair to demand thatinterstate vendors collect and remit salestaxes in jurisdictions where they have nophysical presence and consume no govern-ment services.
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Preserving orenhancing taxcompetitionshould be a guiding theme in thidebate.
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