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Electronic commerce conducted overthe Internet has exploded over the pastseveral years. In 1998 online shopping rev-enues in the United States alone totaledapproximately $13 billion, and they areprojected to reach $108 billion by 2003—nearly a tenfold increase. Such potentiallyastonishing growth has many governmentsworried that they are not adequately pre-pared to tax this flood of new commerce.State and local governments in theUnited States have sensibly begun to exam-ine how electronic commerce will affecttheir tax systems. Contrary to the claims of those governments, however, the currentfederal rules do not exempt electronic com-merce from taxation; they simply prohibitcertain means of collection. The federalgovernment should continue to prohibitstates from imposing tax collection dutieson out-of-state businesses by establishing auniform national jurisdictional standard fortaxing electronic commerce based on thesubstantial physical presence test. Such astandard would reaffirm traditional princi-ples of tax fairness, preserve rate competi-tion among states, and avoid years of con-tentious litigation.If current state tax systems disadvan-tage local retailers, states already have itwithin their power to address the problem.Although reform may be difficult, statesare in no immediate danger of goingbroke, nor do they lack alternatives to thecurrent system of sales and use taxes. Therole of the federal government should be toensure that states do not unfairly exporttheir tax collection burden, thereby imped-ing interstate commerce.At the international level, the UnitedStates has a special role to play in design-ing online tax policy. With more com-puters than the rest of the world com-bined, America is unquestionably thehome of the Internet. It is therefore nat-ural that other countries look toWashington for leadership on the taxa-tion of electronic commerce. Thus, it isvital that the United States stand up forimportant principles such as tax compe-tition by rejecting proposals to draftAmerican businesses as tax collectors forforeign governments. In addition, theUnited States should aggressively pursuean Internet free-trade agreement in theWorld Trade Organization.
Tax Bytes
 A Primer on the Taxation of ElectronicCommerce
by Aaron Lukas
December 17, 1999 No. 9
 Aaron Lukas is an analyst at the Cato Institute’s Center for Trade Policy Studies.
Executive Summary
 
2
State and localgovernments aresubject to congres-sional and constitu-tional limitationson the
means
bywhich they maytax cross-bordercommerce.
Part IState and Local Taxation
State and local governments in the UnitedStates currently impose a variety of taxes onbusinesses and consumers, including sales anduse taxes, telecommunications taxes, incometaxes, and franchise fees. Electronic commerceis not specifically exempt from such levies, norshould it be. However, state and local govern-ments are subject to congressional and consti-tutional limitations on the
means
by which theymay tax cross-border commerce, includingmuch Internet-based commerce. Those limita-tions, many observers believe, will seriouslyundermine future tax revenues as more peopleconduct online business across state lines. Thecontinuing fight to overturn federal impedi-ments to extraterritorial taxation will thus bethe focus of this section.Federal restrictions on the authority of stateand local governments to force out-of-statetelephone and mail-order companies to collecttaxes have long irritated supporters of expan-sive government. In recent years, the rapidgrowth of Internet-based retail sales has creat-ed a new sense of urgency and has prompteddire warnings from high-tax advocates of theimpending erosion of state and local tax bases.As early as 1995, for example, a paper pub-lished by the Center for CommunityEconomic Research warned that “state andlocal government finances are being undone byrapid changes in global commerce and technol-ogy, particularly the rise of the Internet.”
1
TheCenter on Budget and Policy Priorities agreed,saying that “if state and local sales taxes are tosurvive as a means to support government pro-grams and services in the future, a means mustbe found to treat all sales to consumers in acomparable manner.”
2
And a 1997 article in the
 National Tax Journal
, which illustrated thethinking of many state tax policy specialists,concluded that “the sales tax must and will beapplied increasingly to electronic transac-tions.”
3
Hearing such talk, state and local officialsbecame increasingly alarmed. Then in 1997Rep. Christopher Cox (R-Calif.) and Sen. RonWyden (D-Ore.) introduced the Internet TaxFreedom Act, which threatened to permanent-ly limit states’ authority to tax Internet com-merce. The legislation was a wake-up call tostate and local governments, who were juststarting to think about ways to tax online eco-nomic activity.One of the first opponents of the ITFA tolobby Congress was Harry Smith—the mayorof Greenwood, Mississippi, and a collegefriend of Senate Majority Leader Trent Lott(R-Miss.)—who argued that the ITFA was aserious threat to the financial future of stateand local governments.
4
The NationalGovernors’ Association and the U.S.Conference of Mayors, led by NGA vice chair-man Gov. Michael Leavitt of Utah, took up thecause and attacked the bill as detrimental tostates’ financial health. Those efforts eventuallypaid off, as Senate leaders vowed to block anybill that failed to take states’ concerns intoaccount. In the final version of the ITFA,passed in October 1998, the moratorium onnew Internet taxes had been cut from six yearsto three, existing taxes were exempted from theban, and local government had been givenstronger representation on the AdvisoryCommission on Electronic Commerce, formedby the ITFA to study Internet tax issues.
5
State efforts to tax electronic commerce didnot die with the passage of the ITFA. TheMultistate Tax Commission, for example,recently issued its
 Draft Resolution on InterstateSales Tax Collections
that calls for a system thatwould require sellers above a certain thresholdto collect use taxes on all taxable items.
6
TheNGA remained active on the issue by pressur-ing Congress to include participants friendly tostate and local tax concerns, most notablyGovernor Leavitt, on the AdvisoryCommission on Electronic Commerce.
7
Dissatisfied with the commission’s final make-up, the National Association of Counties andthe U.S. Conference of Mayors filed suit infederal court in March to block the commis-sion from meeting. That lawsuit was eventual-ly dropped when Netscape CEO JamesBarksdale stepped down from the commissionand was replaced by Delna Jones, the county
 
3
commissioner from Washington County,Oregon.
8
The most recent report on fiscal year 1999state budget activity released by the NGA andthe National Association of State BudgetOfficers accurately sums up the long-term fearsof state and local officials:In future years, state revenues are like-ly to be affected by the growth of salesover the Internet. As more and moretransactions occur online without thecollection of existing sales or use taxes,state revenues from sales taxes, whichprovide almost 50 percent of total stateand local funding, will erode.
9
An Internet Tax Drain?
A brisk holiday retail season in 1998marked electronic commerce’s emergence as aserious retail medium. Online holiday salestopped $2.3 billion, which prompted
 Newsweek 
to declare the nation’s first “e-Christmas.”
10
And
U.S. News & World Report 
noted that “[Internet] shoppers from east towest seem determined to avoid traffic jams atthe mall, long lines at the post office and last-minute dashes to the supermarket.”
11
Both arti-cles speculated on the threat that electroniccommerce could pose to local retailers.Electronic commerce has stayed in themedia spotlight, and how to tax such businesshas become a subject of popular debate. Forinstance, one
 New York Times
article by tech-nology commentator James Ledbetterdenounced restrictions on Internet taxation as“unfair” to those who shop in stores.
12
A simi-lar story in December accused Internet vendorsof enjoying a “free ride” and warned that localretailing could eventually cease to exist.
13
Morerecently, the Internet-friendly magazine
Upside
weighed in with a May cover story titled “AreWe Stealing from Our Schools? The HighPrice of Tax-Free E-Commerce.”
14
The emerg-ing conventional wisdom, as expressed byInternet pundit Bob Metcalfe, seems to be that“Internet purchases will not long be exemptfrom taxes.”
15
Despite all the hype, however, it is impor-tant not to overstate the immediate fiscal sig-nificance of electronic commerce. Merchantsof all kinds, not just online vendors, reportedstrong holiday sales last year.
16
Total revenuesfrom online business-to-consumer retailing in1998 were estimated at between $13 billionand $20 billion—or from approximately two-to three-tenths of 1 percent of total consumerspending.
17
Several estimates have been made of howcross-border sales translate into uncollectedstate and local taxes. The United StatesAdvisory Commission on IntergovernmentalRelations has said that about $3.3 billion instate and local sales taxes remains uncollectedannually.
18
The Internet is expected to rapidlyincrease that figure. The NGA has speculatedthat states could unwillingly be leaving up to$20 billion per year in taxpayers’ hands by themiddle of the next decade because of onlinesales alone.
19
Those estimates may be mislead-ing, however, because they include business-to-business transactions, as well as many servicesthat normally go untaxed.A more recent—and more realistic—analy-sis of state revenue losses was published byErnst & Young in June. In that analysis,according to Robert J. Cline and Thomas S.Neubig, the estimated sales and use tax not col-lected in 1998 because of the increase in remotesales over the Internet was less than $170 mil-lion, or one-tenth of 1 percent of total state andlocal government sales and use tax collections.
20
A somewhat higher estimate was presented byeconomist Austan Goolsbee of the Universityof Chicago and Jonathan Zittrain of HarvardLaw School in a recent article for the
 NationalTax Journal,
which concluded that states lostabout $430 million in 1998, or less than one-quarter of 1 percent of their total tax take.Goolsbee and Zittrain calculated that over thenext five years revenue losses will likely equalless than 2 percent of total state and local salestax revenues.
21
Those numbers do not suggest, of course,that state tax collections will never be affectedby electronic commerce. With an estimated32.7 percent of Americans already connectedto the Internet, it is possible that future revenue
The estimated salesand use tax not col-lected in 1998because of theincrease in remotesales over theInternet was lessthan $170 million,or one-tenth of 1 percent of totalstate and local gov-ernment sales anduse tax collections.
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