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December 17, 1999 No.

9

Tax Bytes
A Primer on the Taxation of Electronic
Commerce
by Aaron Lukas

Executive Summary
Electronic commerce conducted over If current state tax systems disadvan-
the Internet has exploded over the past tage local retailers, states already have it
several years. In 1998 online shopping rev- within their power to address the problem.
enues in the United States alone totaled Although reform may be difficult, states
approximately $13 billion, and they are are in no immediate danger of going
projected to reach $108 billion by 2003— broke, nor do they lack alternatives to the
nearly a tenfold increase. Such potentially current system of sales and use taxes. The
astonishing growth has many governments role of the federal government should be to
worried that they are not adequately pre- ensure that states do not unfairly export
pared to tax this flood of new commerce. their tax collection burden, thereby imped-
State and local governments in the ing interstate commerce.
United States have sensibly begun to exam- At the international level, the United
ine how electronic commerce will affect States has a special role to play in design-
their tax systems. Contrary to the claims of ing online tax policy. With more com-
those governments, however, the current puters than the rest of the world com-
federal rules do not exempt electronic com- bined, America is unquestionably the
merce from taxation; they simply prohibit home of the Internet. It is therefore nat-
certain means of collection. The federal ural that other countries look to
government should continue to prohibit Washington for leadership on the taxa-
states from imposing tax collection duties tion of electronic commerce. Thus, it is
on out-of-state businesses by establishing a vital that the United States stand up for
uniform national jurisdictional standard for important principles such as tax compe-
taxing electronic commerce based on the tition by rejecting proposals to draft
substantial physical presence test. Such a American businesses as tax collectors for
standard would reaffirm traditional princi- foreign governments. In addition, the
ples of tax fairness, preserve rate competi- United States should aggressively pursue
tion among states, and avoid years of con- an Internet free-trade agreement in the
tentious litigation. World Trade Organization.

Aaron Lukas is an analyst at the Cato Institute’s Center for Trade Policy Studies.
State and local Part I Wyden (D-Ore.) introduced the Internet Tax
governments are State and Local Taxation Freedom Act, which threatened to permanent-
ly limit states’ authority to tax Internet com-
subject to congres- State and local governments in the United merce. The legislation was a wake-up call to
sional and constitu- States currently impose a variety of taxes on state and local governments, who were just
businesses and consumers, including sales and starting to think about ways to tax online eco-
tional limitations use taxes, telecommunications taxes, income nomic activity.
on the means by taxes, and franchise fees. Electronic commerce One of the first opponents of the ITFA to
which they may is not specifically exempt from such levies, nor lobby Congress was Harry Smith—the mayor
should it be. However, state and local govern- of Greenwood, Mississippi, and a college
tax cross-border ments are subject to congressional and consti- friend of Senate Majority Leader Trent Lott
commerce. tutional limitations on the means by which they (R-Miss.)—who argued that the ITFA was a
may tax cross-border commerce, including serious threat to the financial future of state
much Internet-based commerce. Those limita- and local governments.4 The National
tions, many observers believe, will seriously Governors’ Association and the U.S.
undermine future tax revenues as more people Conference of Mayors, led by NGA vice chair-
conduct online business across state lines. The man Gov. Michael Leavitt of Utah, took up the
continuing fight to overturn federal impedi- cause and attacked the bill as detrimental to
ments to extraterritorial taxation will thus be states’ financial health. Those efforts eventually
the focus of this section. paid off, as Senate leaders vowed to block any
Federal restrictions on the authority of state bill that failed to take states’ concerns into
and local governments to force out-of-state account. In the final version of the ITFA,
telephone and mail-order companies to collect passed in October 1998, the moratorium on
taxes have long irritated supporters of expan- new Internet taxes had been cut from six years
sive government. In recent years, the rapid to three, existing taxes were exempted from the
growth of Internet-based retail sales has creat- ban, and local government had been given
ed a new sense of urgency and has prompted stronger representation on the Advisory
dire warnings from high-tax advocates of the Commission on Electronic Commerce, formed
impending erosion of state and local tax bases. by the ITFA to study Internet tax issues.5
As early as 1995, for example, a paper pub- State efforts to tax electronic commerce did
lished by the Center for Community not die with the passage of the ITFA. The
Economic Research warned that “state and Multistate Tax Commission, for example,
local government finances are being undone by recently issued its Draft Resolution on Interstate
rapid changes in global commerce and technol- Sales Tax Collections that calls for a system that
ogy, particularly the rise of the Internet.”1 The would require sellers above a certain threshold
Center on Budget and Policy Priorities agreed, to collect use taxes on all taxable items.6 The
saying that “if state and local sales taxes are to NGA remained active on the issue by pressur-
survive as a means to support government pro- ing Congress to include participants friendly to
grams and services in the future, a means must state and local tax concerns, most notably
be found to treat all sales to consumers in a Governor Leavitt, on the Advisory
comparable manner.”2 And a 1997 article in the Commission on Electronic Commerce.7
National Tax Journal, which illustrated the Dissatisfied with the commission’s final make-
thinking of many state tax policy specialists, up, the National Association of Counties and
concluded that “the sales tax must and will be the U.S. Conference of Mayors filed suit in
applied increasingly to electronic transac- federal court in March to block the commis-
tions.”3 sion from meeting. That lawsuit was eventual-
Hearing such talk, state and local officials ly dropped when Netscape CEO James
became increasingly alarmed. Then in 1997 Barksdale stepped down from the commission
Rep. Christopher Cox (R-Calif.) and Sen. Ron and was replaced by Delna Jones, the county

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commissioner from Washington County, tant not to overstate the immediate fiscal sig-
Oregon.8 nificance of electronic commerce. Merchants
The most recent report on fiscal year 1999 of all kinds, not just online vendors, reported
state budget activity released by the NGA and strong holiday sales last year.16 Total revenues
the National Association of State Budget from online business-to-consumer retailing in
Officers accurately sums up the long-term fears 1998 were estimated at between $13 billion
of state and local officials: and $20 billion—or from approximately two-
to three-tenths of 1 percent of total consumer
In future years, state revenues are like- spending.17
ly to be affected by the growth of sales Several estimates have been made of how
over the Internet. As more and more cross-border sales translate into uncollected
transactions occur online without the state and local taxes. The United States
collection of existing sales or use taxes, Advisory Commission on Intergovernmental
state revenues from sales taxes, which Relations has said that about $3.3 billion in
provide almost 50 percent of total state state and local sales taxes remains uncollected
and local funding, will erode.9 annually.18 The Internet is expected to rapidly
increase that figure. The NGA has speculated
An Internet Tax Drain? that states could unwillingly be leaving up to
The estimated sales
A brisk holiday retail season in 1998 $20 billion per year in taxpayers’ hands by the and use tax not col-
marked electronic commerce’s emergence as a middle of the next decade because of online lected in 1998
serious retail medium. Online holiday sales sales alone.19 Those estimates may be mislead-
topped $2.3 billion, which prompted ing, however, because they include business-to- because of the
Newsweek to declare the nation’s first “e- business transactions, as well as many services increase in remote
Christmas.”10 And U.S. News & World Report that normally go untaxed.
noted that “[Internet] shoppers from east to A more recent—and more realistic—analy-
sales over the
west seem determined to avoid traffic jams at sis of state revenue losses was published by Internet was less
the mall, long lines at the post office and last- Ernst & Young in June. In that analysis, than $170 million,
minute dashes to the supermarket.”11 Both arti- according to Robert J. Cline and Thomas S.
cles speculated on the threat that electronic Neubig, the estimated sales and use tax not col- or one-tenth of
commerce could pose to local retailers. lected in 1998 because of the increase in remote 1 percent of total
Electronic commerce has stayed in the sales over the Internet was less than $170 mil- state and local gov-
media spotlight, and how to tax such business lion, or one-tenth of 1 percent of total state and
has become a subject of popular debate. For local government sales and use tax collections.20 ernment sales and
instance, one New York Times article by tech- A somewhat higher estimate was presented by use tax collections.
nology commentator James Ledbetter economist Austan Goolsbee of the University
denounced restrictions on Internet taxation as of Chicago and Jonathan Zittrain of Harvard
“unfair” to those who shop in stores.12 A simi- Law School in a recent article for the National
lar story in December accused Internet vendors Tax Journal, which concluded that states lost
of enjoying a “free ride” and warned that local about $430 million in 1998, or less than one-
retailing could eventually cease to exist.13 More quarter of 1 percent of their total tax take.
recently, the Internet-friendly magazine Upside Goolsbee and Zittrain calculated that over the
weighed in with a May cover story titled “Are next five years revenue losses will likely equal
We Stealing from Our Schools? The High less than 2 percent of total state and local sales
Price of Tax-Free E-Commerce.”14 The emerg- tax revenues.21
ing conventional wisdom, as expressed by Those numbers do not suggest, of course,
Internet pundit Bob Metcalfe, seems to be that that state tax collections will never be affected
“Internet purchases will not long be exempt by electronic commerce. With an estimated
from taxes.”15 32.7 percent of Americans already connected
Despite all the hype, however, it is impor- to the Internet, it is possible that future revenue

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erosion could be substantial for states that rely on electronic commerce. Thus, states can
on high sales tax rates.22 Nevertheless, state and impose taxes on products or services purchased
local finances are apparently secure for the online only when similar goods are taxed
foreseeable future while the Internet is still a offline. For example, the ITFA would preclude
relatively new way to conduct business. It is in a tax on access to an online magazine if the sale
that context that Congress acted last year to of magazines from a newsstand is not taxed.
forestall state and local efforts to tax electronic Moreover, states cannot tax electronic com-
commerce. merce at a discriminatory rate. If magazines
from a newsstand are taxed at 6 percent, access
The Internet Tax Freedom Act to an online magazine could not be taxed above
By far the most interesting development in 6 percent. The ITFA also bars new taxes on the
the world of state and local taxation last year sale of Internet-unique goods or services, such
was the ITFA. It was passed as part of the as e-mail or search-engine services.
Omnibus Appropriations Act of 1998 and is in Finally, the ITFA provides some guidance
force from October 1, 1998, until October 20, on the application of sales and use taxes to out-
2001. The ITFA has four major components: of-state vendors engaged in electronic com-
(1) a moratorium on new federal Internet or merce. As the following section of this paper
Internet-access taxes, (2) a declaration that the will discuss, states generally cannot require an
Internet should be free of international tariffs out-of-state seller to collect taxes unless that
and other trade barriers, (3) a three-year prohi- seller has a physical presence in the taxing state.
bition on new taxes imposed on Internet access The ITFA specifies that the ability to access
and on multiple or discriminatory taxes on the Web site of an out-of-state business does
electronic commerce, and (4) the establishment not, in itself, constitute a sufficient level of
of the Advisory Commission on Electronic physical presence to enforce tax collection.
Commerce to study international, federal, Although possibly redundant under Due
state, and local tax issues pertaining to the Process and Commerce Clause protections,
Internet. that clarification might at least dissuade states
The ITFA moratorium on new Internet from initiating pointless litigation.
taxes applies only to taxes that were not gener- For the most part, the ITFA will not have a
ally imposed and actually enforced prior to significant short-term impact on firms current-
October 1, 1998. State income and franchise ly engaged in electronic commerce. It will,
taxes, for example, were in widespread use however, forestall immediate efforts of state
before that date and thus remain in force in all and local governments to extend their
The history of state states that impose them. Other taxes, such as taxing authority. Ultimately, the proposals of
sales taxes on Internet access charges, were not the Advisory Commission on Electronic
and local taxation uniformly collected and thus will be subject to Commerce may have a greater impact on the
of remote com- the federal tax ban in some cases.23 (The ques- future of Internet taxation than will any other
merce has been tion of when Internet access charges are taxable component of the ITFA.
is likely to generate much controversy, especial-
characterized by ly in relation to the “bundling” of Internet Current Trends in Electronic Commerce
ceaseless efforts to access with other taxable telecommunications Taxation
services. However, because it is not directly The history of state and local taxation of
circumvent federal related to cross-border electronic commerce, remote commerce has been characterized by
restrictions on who the taxation of access charges will not be cov- ceaseless efforts to circumvent federal restric-
may be taxed. ered in this paper.) The ITFA includes rules for tions on who may be taxed. The results of those
determining which state levies are allowed, efforts have been mixed and often conflicting.25
although there is bound to be some confusion Early indications suggest that the same pat-
on this issue.24 tern will apply to electronic commerce, but that
The ITFA prohibits discriminatory taxes scenario is not inevitable. Taxation of content

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transmitted over the Internet is not yet wide- state and local governments. The only prohibi- States prefer to
spread and is restricted for three years by the tion facing the states, which can lead to a de avoid internal
ITFA. In addition, states are limited in their facto tax advantage for remote sellers, is on
ability to enforce tax collection on out-of-state their means of collecting transaction taxes. reform by expand-
purchases under the Due Process and States have it within their power to remedy ing their authority
Commerce Clauses of the U.S. Constitution. that situation, but they prefer to avoid internal
Although the Supreme Court in Quill v. North reform by expanding their authority over out-
over out-of-state
Dakota (discussed in more detail below) mini- of-state businesses. businesses.
mized the legal protection offered by the Due
Process Clause, the issue of whether the Sales and Use Taxes
imposed responsibility for tax collection on an Sales taxes are excise taxes (i.e., taxes based
out-of-state business is an unjust deprivation of on the amount of business done) that are
property—taken without the opportunity to be imposed on retail transactions. Sales taxes are
heard—remains valid. Congress should not generally levied by a state or locality on sales of
tolerate states’ engaging in taxation without tangible property and specified services that
representation, even if the Court has given occur within the relevant jurisdiction.
Congress an opening to do so. In addition, by Purchases made by businesses—either for
exporting their tax collection obligations, states resale or as inputs to production—are (in theo-
are effectively projecting their lawmaking ry if not always in practice) exempt from sales
power beyond their borders, thereby impeding taxes in order to avoid double taxation.
the flow of commerce. Congress thus has the Sales taxes are charged to sellers who then
power under the Commerce Clause to prohib- pass those taxes on to consumers. Although
it that activity. consumers are the ultimate taxpayers, there are
Because the ITFA tax moratorium expires real economic costs borne by businesses that
after three years, Congress has only a limited collect sales taxes. First, there are the adminis-
window of opportunity to head off state and trative costs of registering with multiple state
local policies that will interfere with the growth and local agencies, of collecting taxes, and of
of electronic commerce. The question facing remitting the funds (a cost that is higher for
lawmakers is this: should interstate electronic remote than for local sellers). Second, business-
commerce be permanently governed by the es may not always be able to pass on the entire
same rules that now apply to mail-order sales amount of the tax to consumers. For example,
among states? if Amazon.com is required to collect an average
Before that question is addressed, it should tax of 5 percent, it may decide to lower its
again be stressed that the online world does not prices slightly to maintain sales volumes. Even
escape taxation. Telecommunications chan- if it holds prices steady, it will sell fewer books
nels—telephone lines, wireless transmissions, at the after-tax price, thus suffering a loss of
cable, and satellite—are taxed in most states; sales revenue.
electronic commerce companies pay income Every state with a retail sales tax also levies
and other direct taxes; sales taxes are collected a “compensating use” tax, usually referred to
on in-state purchases; and use taxes, though simply as the use tax. The use tax is a supple-
rarely enforced, cover most cross-border trans- ment to the sales tax and is intended to cover
actions. In addition, state income taxes capture the purchase of products and services that
a generous share of the personal wealth gener- would have been subject to sales tax if pur-
ated by the growth of electronic commerce. In chased within the buyer’s home state. Out-of-
short, electronic commerce does not enjoy any state sellers are sometimes required to collect
legal tax advantage; all existing taxes that are and remit the use tax to the buyer’s state, but if
applied to traditional businesses are also regu- not, it is the consumers’ legal obligation to pay
larly applied to online businesses. Those exist- the tax themselves. The use tax is meant to
ing taxes are a significant source of revenue for ensure that all sales to residents are taxed,

5
regardless of where the transaction takes place, It should be noted that Complete Auto is
and also to deter consumers from making pur- usually applied to income, not use, taxes. But
chases in competing tax jurisdictions on a there is no reason why its logic should not
lower- or no-tax basis. apply equally to transaction taxes. Finally, the
Federal law and the U.S. Constitution pro- Court reaffirmed Bellas Hess in 1992 with
hibit states from requiring many out-of-state Quill, which said that states have no authority
firms to collect sales or use taxes. Three cases to tax cross-border mail-order sales absent
in particular provide guidance on tax collection express permission from Congress.31 Quill was
requirements on out-of-state vendors. In 1967 a partial departure from the Court’s earlier rul-
the Supreme Court ruled in National Bellas ing in that Quill considered the nexus question
Hess v. Illinois that a mail-order company separately under the Commerce and Due
could not be required to collect use taxes if the Process Clauses. Regrettably, the Court held
company’s only in-state activity consisted of that due process is satisfied whenever the
shipping catalogs and goods from out of state remote seller’s efforts are “purposefully direct-
by common carrier, such as the U.S. Postal ed”32 toward the residents of another state.
Service or Federal Express.26 The Court held Purposeful direction essentially entails any
that, under both the Due Process and effort, such as the purchase of advertising in a
Federal law and the Commerce Clauses, sellers can be required to local newspaper, to solicit orders from the resi-
U.S. Constitution collect use taxes only for states where they dents of a state. In other words, under Quill,
prohibit states from maintain a level of physical presence known as physical presence is not necessarily required to
“taxable nexus.”27 For transaction tax purposes, satisfy due process considerations as a precon-
requiring many nexus generally requires substantial physical dition for a state to impose responsibility for
out-of-state firms presence: property, equipment, or employees use tax collection.
based in a state.28 A vendor without a physical Although the Court overturned the physi-
to collect sales or presence in the state can also create nexus cal-presence standard for due process, the
use taxes. through a contractual relationship with a busi- physical-presence standard for the Commerce
ness that is in the state. For example, a compa- Clause was left intact. The distinction is signif-
ny based in state A that hired the services of a icant. Because the Due Process Clause is a con-
sales firm in state B to market products there stitutional limitation on the power of govern-
could be liable for tax collection in state B if ment, reducing the level of protection that the
the activities performed on behalf of the seller clause affords would require a constitutional
are necessary for it to establish and maintain amendment; however, the Commerce Clause is
market share.29 an affirmative grant of power to the federal
In a 1977 case, Complete Auto Transit, Inc. v. government. Accordingly, Congress can alter
Brady, the Court attempted to clarify what Commerce Clause requirements by statute.
level of nexus would satisfy the requirements of Many observers have thus concluded that the
the Commerce Clause but did not revisit due Quill decision was an invitation by the Court to
process. The Court constructed a four-pronged Congress to exercise its power to clarify the
test that can help determine when a tax will standards for remote-commerce taxation.
meet Commerce Clause requirements. The result of the Supreme Court’s jurispru-
According to the test, any state tax must dence has been that the use tax, as currently
applied, is not an effective alternative to sales
1. be applied to an activity with “substantial taxes. Although they have it within their
nexus” in the taxing state, authority, most states make little or no effort to
2. be fairly apportioned, directly collect use taxes from consumers.
3. not discriminate against interstate com- Moreover, most consumers are unaware of the
merce, and tax and thus do not voluntarily remit payment
4. be fairly related to the services provided (though most businesses do). As a 1996 survey
by the state.30 by the Software Industry Coalition found,

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“With a few exceptions, state collection of use constitute taxable nexus.37 Furthermore, when
tax from buyers is largely non-existent.”33 an ISP’s server is located in another state, sec-
According to Neal Osten of the National tion 1104(2)(B)(ii) prohibits states from classi-
Conference of State Legislatures, some states, fying that provider as the nexus-creating agent
such as Maryland, actually audit taxpayers who of a remote seller.38
voluntarily pay use tax on the theory that peo- Recent court decisions also seem to confirm
ple seemingly so honest must have something the status of Internet providers as common car-
to hide.34 riers. In December 1998, for example, an inter-
mediate appellate court in New York dismissed
Nexus and the Internet a libel suit brought by a 15-year-old Boy Scout
Because of a reluctance to tackle thorny col- against Prodigy (an OSP) for offensive state-
lection problems—coupled with a growing fear ments transmitted via the Prodigy system. In
of future revenue losses—states have been con- dismissing the action, the court likened the
structing novel theories for extending their tax- online service provider to a telephone company,
ing authority to cover remote online sellers. stating that Prodigy should not be held respon-
Some tax officials have speculated that an sible for the content of communications sent
Internet service provider (ISP), which connects over its network.39
consumers to the Internet, acts as an agent of Even if some states successfully attribute
online sellers and therefore creates nexus for nexus to companies that house Web sites on in-
virtually every firm. That would certainly be in state computer servers, the probable result will
line with the increasingly broad approach some be to drive site hosting and related services out
states have taken to finding nexus. A contro- of state. Thus, because most online vendors
versial 1995 Multistate Tax Commission bul- have substantial nexus in only one or a few
letin, for example, takes the position that con- jurisdictions, much electronic commerce will
tracting with a third party to provide in-state continue to be exempt from use tax collection
warranty repair services creates sales and requirements when purchases of tangible prop-
income tax nexus for remote sellers.35 Although erty are made across state lines.
the bulletin does not deal directly with Internet Other approaches to taxing remote com-
services, its logic could, as an Arthur Andersen merce have been equally problematic. In 1997,
paper pointed out, “conceivably apply to ser- for example, Nebraska passed legislation
vices other than repair services.”36 That argu- (which was later vetoed) that would have
ment is perhaps plausible for online service required out-of-state companies with no in-
providers (OSPs) that give technical or mar- state physical presence to report all purchases
keting assistance to vendors on a proprietary by Nebraska citizens. The state would then use In 1998 the ITFA
network; however, it is clearly inapplicable to that information to collect use taxes directly
ISPs whose connection to the seller is inciden- from its citizens—an approach that raises seri- instructed states to
tal only. ous logistic and privacy concerns. apply the same
States that decide to adopt a broader inter- rules to products
pretation of taxable nexus are on shaky legal Tangible versus Intangible Products
footing. In 1998 the ITFA instructed states to The bulk of electronic retailing involves the sold over the
apply the same rules to products sold over the sale of tangible products—like clothing or Internet and
Internet and delivered by common carrier as stereo equipment—that are ordered online
are applied to mail-order sales. The definition and then delivered by common carrier.
delivered by
of “discriminatory tax” in section 1104(2)(B)(i) Electronic commerce also includes the sale of common carrier
of the ITFA makes it clear that Congress con- intangible digital products—like music and as are applied to
siders the creation or maintenance of a site on software—that are delivered directly over the
the Internet to be so insignificant a physical Internet. In addition, the Internet makes it mail-order sales.
presence that the use of an in-state computer possible to provide services that are “produced”
server in this way by a remote seller does not at one location and “consumed” somewhere

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Even if technologi- else, such as medical or legal consultations. Consequently, they may refuse to type the
cal neutrality of It is generally accepted that tax rules that information in, choose to shop at a site that
govern the sale of intangible products and ser- does not require that information, or simply lie.
taxation is vices should be the same as the rules for other That behavior may prompt states to argue that
desirable, it does goods—namely, that means of delivery should because vendors cannot prove that buyers are
not govern tax treatment. Such “technological- not local, the vendors are liable for tax collec-
not override due ly neutral” taxation would not treat the sale of a tion on all sales. However, that approach would
process and paperback book any differently from the sale of lead to multiple taxation and place on sellers an
interstate a digitized book, to use one oft-cited example. impossible burden that would effectively
However, determining which products are undermine the intent of Quill.
commerce functionally equivalent is a tricky proposition. Even if a state successfully made that case,
considerations. Is text that is displayed on a computer screen the victory would be illusory. The fluid nature
really the same thing as a printed book? Is a of digital products means that states may have
movie that is downloaded to a computer hard trouble collecting taxes even on in-state sales,
drive really the same as a video that is rented? much less on remote transactions. It is relative-
The answer is not obvious. Moreover, most ly easy for buyers to misrepresent their location
states do not apply comprehensive taxation to or to have a third party in another state pur-
services, and few states tax intangible products chase the product or service and simply for-
aside from basic utilities, which are subject to ward it with a click of a mouse. It is also possi-
special taxes. There may be many valid policy ble for sellers of digital products to locate in
reasons for such exemptions, and sovereign foreign jurisdictions that would not enforce tax
states should be free to decide what will be collection requirements. It would be very diffi-
taxed, even when neutrality—taxing identical cult, for example, to collect tax on the trans-
goods at the same rate—suffers.40 mission of content sent from abroad and paid
Even if technological neutrality of taxation for by digital cash or smart card—untraceable
is desirable, it does not override due process encrypted “virtual money” that is spent exactly
and interstate commerce considerations; there- like cash and leaves no paper trail. Given the
fore, only firms with substantial nexus should near impossibility of enforcing compliance, the
be expected to collect taxes. Some states will revenue potential of taxing digital products is
undoubtedly play games with the taxonomy of probably small.
digital products in hopes of circumventing that Some state agencies that support allowing
requirement. For example, a state might decide the states to enforce tax collection on out-of-
to treat the sale of intangible goods either as a state sellers of tangible goods recognize the all
sale of taxable services or as the lease of prop- but insurmountable hurdles to taxing network-
erty and then insist that taxes are due on the delivered intangible products and services.
basis of the contention that the Quill decision California’s Electronic Commerce Advisory
dealt specifically with the sales of tangible per- Council, for instance, has recommended that
sonal property and thus does not offer a safe “the status quo be maintained for taxing the
harbor for sales of products or services deliv- interstate sale of intangibles and provision of
ered electronically. The language of the Quill services.”42 Its report cites both the difficulties
decision, however, does not explicitly refer to associated with establishing a buyer’s identity
tangible products, which suggests that it will and location as well as the ease with which the
also apply to sales of services and digital con- taxes could be avoided as reasons not to
tent over the Internet.41 attempt the taxation of digital commerce.
Taxing the online sale of intangibles is also Critics of that approach note that at present
problematic because the location of customers most purchases are made with a credit card, the
cannot be known with certainty. Many online billing address for which could potentially be
shoppers do not feel comfortable giving unnec- used to determine which state had jurisdiction
essary personal information to a Web site. over a sale.43 But with the likely rise of digital

8
cash and other unaccounted payment systems, such State in the name of or for
avoidance problems would, at best, be only the benefit of a prospective cus-
postponed. The problems with using credit tomer of such person, if orders
cards for tax collection purposes are discussed by such customer to such person
further in the section on international taxation. to enable such customer to fill
orders resulting from such solic-
Income Taxes itation are orders described in
In contrast with sales and use taxes, paragraph (1).45
Congress has actively exercised its power under
the Commerce Clause to limit the authority of It seems that P.L. 86-272 places clear limits
state and local governments to collect income on state and local taxing authority, but the
tax from out-of-state firms. In the 1950s, states extent of that protection has been hotly con-
routinely applied disparate principles to deter- tested. In 1992 the Court, in William Wrigley,
mine when a corporation was subject to tax in Jr. Co. v. Wisconsin, attempted to settle what
their jurisdictions. After the Supreme Court constitutes taxable activity. According to that
gave states a favorable ruling, Congress in 1959 decision, nontaxable activity includes “not
passed Public Law 86-272. Under that law, if a merely the ultimate act of inviting an order but
company’s contact with a state is limited to the entire process associated with the invita-
The fluid nature of
solicitation for the sale of tangible goods and tion.”46 However, according to a recent analysis digital products
the goods are delivered from out of state, the by KPMG Peat-Marwick, “Since Wrigley, a means that states
state may not impose a net income tax on the line of state cases and rulings have whittled
company. When P.L. 86-272 does not apply, away at the foundation of those activities that may have trouble
states are still subject to the constitutional the Court deemed to be ‘protected’ and half- collecting taxes
nexus requirement of substantial physical pres- heartedly applied the de minimis exception set
ence of the business in-state.44 out in Wrigley.”47
even on in-state
P.L. 86-272 should be sufficient to block Although P.L. 86-272, in conjunction with sales, much less
states and localities from collecting income Wrigley, suggests that online merchants that on remote
taxes from most out-of-state firms engaged in solicit orders via a Web site would be protected
electronic commerce. Specifically, the law says: from income taxes, states can be expected to try transactions.
to circumvent the federal barriers. In particular,
No state, or political subdivision there- states might argue that the law’s reference to
of, shall have power to impose a net “tangible personal property” means that firms
income tax on the income derived selling intangible digital products and services
within such state by any person from are liable for income taxes wherever their cus-
interstate commerce if the only busi- tomers live. That approach has at least two
ness activities within such state by or inherent flaws. First, it would place a substan-
on behalf of such person during such tial burden on interstate commerce, thwarting
taxable year are either, or both, of the the original intent of P.L. 86-272, which did
following: not anticipate the importance of intangible
(1) the solicitation of orders by such products. Second, the nature of network-deliv-
person, or his representative, in ered digital products makes a buyer’s location
such State for sales of tangible per- impossible to credibly establish. That could
sonal property, which orders are lead to serious problems with apportionment
sent outside the State for approval and multiple taxation, as states compete for the
or rejection, and, if approved, are same income.
filled by shipment or delivery from Given those difficulties, Congress should
a point outside the State; and consider amending P.L. 86-272 to explicitly
(2) the solicitation of orders by such include the delivery of intangible products and
person, or his representative, in services over the Internet.

9
Other Taxes require out-of-state sellers to collect a national
Use and income taxes will have the greatest sales tax, or both. Congress should reject all
impact on electronic commerce, but there are such advice and instead maintain and clarify
other taxes that bear watching. Expansive use the existing limits. At a minimum, Congress
of telecommunications taxes, for example, should make clear that current tax restrictions
could expose ISPs to double taxation by taxing on mail-order sales will also permanently apply
them once for leasing phone lines and again for to online commerce. The alternative—aug-
access to those lines. For the most part, howev- menting states’ taxing authority—is ill-advised
er, states cannot be precluded from imposing for several reasons.
damaging taxes on electronic commerce unless Tax Competition Is Beneficial. At first glance,
those taxes are extraterritorial. It is to be hoped, the case for extending use tax collection
of course, that states will not impose harmful or requirements to out-of-state sellers sounds rea-
needless taxes on electronic commerce without sonable. After all, why should identical items
careful consideration. be taxed differently depending on how they are
purchased? Neutrality is the core principle of a
The Case against Expanded Taxation tax system designed to minimize economic dis-
The Advisory Commission on Electronic tortions. Other things being equal, neutrality of
Commerce, which held its first meeting in June taxation is highly desirable.
1999, may be the most important part of the Neutrality, however, is not the only determi-
ITFA. Its mandate is far ranging, including the nant of economic efficiency. Indeed, all taxa-
study of taxation of Internet access, remote tion is distortionary because it shifts resources
commerce across national borders, and the from the private to the public sector. High tax
advantages and disadvantages of authorizing rates, even when administered on a neutral
state and local governments to require remote basis, are detrimental to economic growth and
sellers to collect and remit use taxes. The com- development. Thus, unequal taxation at a lower
mission includes a large number of state and average rate may be superior to tax neutrality at
local representatives who are eager to tax a higher rate. If electronic commerce grows and
remote commerce, both electronic and mail tax competition intensifies, forcing states to cut
order.48 (or not raise) sales tax rates, overall economic
The commission should be cautious in efficiency will likely be enhanced.
making recommendations. Imposing use tax A study by Cato Institute economists Dean
collection responsibilities on remote sellers is Stansel and Stephen Moore confirms that
unlikely to generate significant tax revenue but lower tax rates, which are promoted by tax
Given the near could negatively affect the growth of electronic competition, lead to healthier state economies.
sales. A recent study by Austan Goolsbee esti- They compared the performance of 10 states
impossibility of mates that taxing remote electronic commerce that raised taxes between 1990 and 1996 with
enforcing compli- would reduce the number of online buyers by that of 10 states that decreased taxes. On aver-
ance, the revenue 25 percent and total spending on Internet age, the economies of tax-cutting states grew
transactions by more than 30 percent.49 33 percent over the five-year period compared
potential of taxing Furthermore, those sales would not necessarily with only 27 percent for tax-hiking states—a
digital products is shift to traditional retailers because, as variance of nearly 20 percent. Tax-cutting
Goolsbee and Zittrain suggest, the Internet is states also had healthier budget balances; their
probably small. probably a net trade creator—generating busi- reserves averaged 7.1 percent of state outlays
ness that would not have otherwise occurred. compared with 1.7 percent in tax-raising
Nevertheless, pressure by state and local states.50
officials may be substantial, so proposals by the Several misguided plans to expand state and
commission to expand subfederal taxing power local taxation are already being debated. Most
are a possibility. The recommendations could recently, at its July 1999 annual meeting, the
involve legislation to loosen nexus standards or National Association of Counties unanimously

10
approved a resolution urging Congress to collection will not stop states from taxing resi- Congress should
impose a sales tax on all online purchases.51 A dents at the level required to fund government make clear that
similar plan, advanced by Texas’s former tax services, but it may force those states to cut
director Wade Anderson, would create a uni- waste or make the total cost of government current tax restric-
form national sales tax for cross-border pur- more apparent. A more visible tax burden tions on mail-order
chases.52 Similar legislation that would estab- would help people make better decisions about
lish a 5 percent national sales tax on most where to live, which would put additional
sales will also
cross-border purchases has already been intro- downward pressure on tax rates. Over the past permanently apply
duced by Sen. Ernest F. Hollings (D-S.C.).53 15 years, an average of 1,000 people a day have to online
The proceeds of such a tax, based on sales vol- moved from the 10 highest-tax states to the 10
ume or some other formula, would be collected lowest-tax states.55 Given those facts, states commerce.
by merchants and remitted to the states—with may determine that economic development
a possible detour through Washington. goals take precedence over revenue-raising
Others have proposed loosening the sub- concerns and explicitly choose not to tax online
stantial nexus requirement that currently pre- sales.
vents states from imposing use tax collection Electronic commerce gives everyone the
duty on out-of-state sellers. For example, opportunity to live on a virtual border—to take
Harley T. Duncan, executive director of the advantage of the fact that no state, although it
Federation of Tax Administrators, says, is free to do so, currently taxes its exports or
“Congress should use its authority under the voluntarily collects use taxes for other states.
Commerce Clause to authorize states to Like a real border, the Internet can be a potent
require sellers without a physical presence in safety valve that guards against excessive taxa-
the state to collect use taxes on goods and ser- tion. Moreover, because the capital used in
vices sold into the state.”54 In exchange for this many electronic businesses is more mobile than
new authority, a single tax rate would be set for the capital used in traditional ventures, firms
each state, making it somewhat easier for busi- are often able to shop around for the lowest tax
nesses to calculate how much they are sup- rates. Electronic commerce allows consumers
posed to collect and for whom. State officials who have found it difficult to travel out of
reason that such a deal would bring more busi- state—the poor, the elderly, and the infirm—to
nesses into the pro-tax camp. Some large take advantage of tax-free commerce for the
online sellers, for example, support the plan first time.
because they already collect taxes and believe In addition, political pressures to keep tax
mandatory collection would disadvantage rates down would be lessened if the Quill stan-
smaller competitors. That might be a win-win dard were overturned. The Internet will likely
situation for big business, state, and local gov- lead to an expansion of interstate commerce for
ernment, but taxpayers and small businesses nontax reasons, such as shopping convenience.
would lose. If states are allowed to force out-of-state busi-
Because such schemes would effectively nesses to collect use taxes, an increasing share
reduce interstate tax competition, Congress of state tax collections will be conducted by
should reject all of them. Differentiated tax businesses that have no voice in the local polit-
rates encourage cross-border shopping, a ical process. Consequently, there will be fewer
healthy form of tax competition that helps keep businesses that are able to lobby against pro-
local rates under control. Such competition posed rate hikes, making it easier for states to
regularly occurs in the offline world. For exam- raise tax rates in the future.
ple, some residents of New York drive to Fortunately, some states are voluntarily tak-
Delaware to avoid sales taxes—an option that ing a hands-off approach to online taxation.
has undoubtedly curbed the profligate fiscal The California Assembly passed its own ver-
habits of Big Apple politicians. Maintaining sion of the ITFA that was enacted on January
the current restrictions on extraterritorial tax 1, 1999. In addition to a three-year ban on new

11
Internet taxes, the law exempts online firms the Advisory Commission on Electronic
from collecting sales tax on goods sold in Commerce, has noted, “There was a time in
California if those firms have no physical pres- the early 1980s when mail order was growing
ence there.56 Virginia and New York have at rates comparable to today’s Internet sales.
adopted similar legislation, and several gover- During those years, the same pro-tax lobby
nors have announced their support for the fed- who is now beating the drums to tax the net
eral ITFA.57 Undoubtedly, the reason that those was calling to tax mail order sales.”60
states have chosen to restrain their taxing Recent state budget data reveal no hint of a
impulses is because competition for business revenue crisis. In an era of almost no inflation,
has convinced them that it is in their best eco- state budgets grew by 5 percent in FY97 and
nomic interest to do so. Even supporters of nearly 6 percent in FY98. Over the past four
allowing states to tax cross-border sales have years, state tax collections have exceeded expec-
recognized that competition is often the driving tations by about $25 billion.61 It appears that
force behind good tax policy. As Charles E. there will be a sizable revenue windfall this year
McLure of the Hoover Institution has noted, as well. Furthermore, states will receive money
“Exemption for business purchases has from last year’s mammoth tobacco settlement.
occurred not because it is the right thing to do, All 50 states and some cities will collectively
Unequal taxation at as a matter of principle, but grudgingly, in receive $246 billion from the settlement over
a lower average rate response to fears that to do otherwise might the next 25 years.62 With revenues pouring in
may be superior to damage a state’s business climate.”58 so rapidly, it cannot credibly be argued that
A nondistortionary state tax system is a sen- electronic commerce is currently undermining
tax neutrality at a sible ideal and a worthy long-term goal. state tax collections or that states are in need of
higher rate. However, allowing states to force use tax col- new funds.
lection by out-of-state sellers would not signif- Overflowing state coffers reveal that the
icantly further that goal and would unfairly fears of tax administrators are at best prema-
burden many businesses. By broadening the tax ture, and may never be realized. A comprehen-
base without lowering rates, and thereby sub- sive report produced by Ernst & Young and the
jecting more transactions to uneven rates, National Retail Federation indicates that elec-
numerous loopholes, and multiple exemptions tronic commerce does not constitute a signifi-
that typify state tax codes, it is doubtful that cant percentage of retail activity. Only about
any efficiency would be gained. State and local one-third of consumers with online access has
governments already have within their power a purchased products or services over the
better option to reduce unequal taxation: cut- Internet. That means that only 10 percent of
ting taxes, not scheming to collect more. American households have ever made a pur-
Neither Traditional Retailers nor State chase online. And of that group, only 4 percent
Budgets Face a Crisis. Because local stores cater make more than 10 purchases a year.63
to a customer’s desire for a hands-on experi- Sales predictions for electronic commerce
ence, offer immediate gratification, and do not routinely overlook the Internet’s role in driving
charge for shipping, they will probably always consumer purchases to other channels of distri-
dominate retailing. In addition, shopping is for bution. Sixty-four percent of those households
many people a pleasurable social experience with Internet access research products online
that cannot be duplicated online. Thus, and later buy them through traditional chan-
Internet sales won’t destroy “real” retailers, just nels—double the percentage of consumers who
as catalog sales haven’t. Certainly the revenue research and order the same products online.64
crisis that many state officials predicted with As a Greenfield Online survey notes, “The
respect to mail-order sales has never material- human factor still drives shopping, and the vis-
ized (catalog sales were only $52.3 billion com- ceral experience is still the principal shopping
pared with $2.7 trillion for sales in traditional driver. While stores and malls remain the place
stores in 1998).59 As Dean Andal, a member of for buying, online has become the ‘window-

12
shopping’ experience to the world.”65 advantage of sales tax collection.
Moreover, a vast amount of electronic com- If states are concerned about equity, they
merce could not properly be subject to use taxes can address the issue by harmonizing tax rates
even if nexus requirements were completely downward for local retailers. Policymakers in
eviscerated. Approximately 80 percent of both Minnesota and California have raised
online commerce is conducted between busi- that possibility, proposing to eliminate the sales
nesses.66 Those transactions do not translate tax on products that are easily acquired online.
into lost tax revenue because they are tax Specifically targeted are intangible goods that
exempt, or, if not, the funds are voluntarily can be downloaded, such as software, music,
remitted by the buyer. and books.68 Another positive move would be
It is inaccurate to say that restricting the to push for privatization of the U.S. Postal
taxation of remote commerce is fundamentally Service, which unfairly benefits mail-order
unfair to traditional retailers, since the “loop- companies through postage rates that do not
hole” is available to everyone. Indeed, existing fully cover costs for catalogs or shipping.69
businesses are often the ones taking advantage Out-of-State Companies Should Not Collect
of the Internet by setting up Web sites and tak- Taxes. Out-of-state companies that sell online
ing orders. At the national level, many success- do not use the same services as local business-
ful electronic commerce firms are in fact tradi- es, so those companies should not be taxed to
tional retailers that have gone online—Barnes pay for such services. When a business pays
& Noble and Macy’s are two prominent exam- income or remits sales taxes to the state in
ples. The trend is not surprising, since estab- which it is located, there is a plausible linkage
lished businesses have a customer base, a distri- among the taxes paid, the services provided,
bution network, an inventory system, and so and legislative representation. After all, local
on. Electronic commerce is as much a new way firms benefit from police and fire protection,
for existing firms to market their products road construction, waste collection, and other
more widely as it is a source of new competi- services provided by the taxing authority, so it
tion. To the extent that such efforts are suc- is proper that they help cover the costs.
cessful, state and local governments will also Moreover, local firms can make their voices
benefit from greater tax revenues. heard in government through lobbying, voting,
Online sales are also within reach of strictly and membership in local interest groups, such
local establishments. Grocery stores, restau- as the Chamber of Commerce.
rants, and florists are already using the Web to The circumstances are different, howev-
take orders that are delivered the same day. er, for a company that markets goods over
Even independent booksellers—the poster the Internet and delivers them via common Allowing states to
children for retailers savaged by Internet com- carrier. In that case, the remote seller does
petitors—are learning to use the Web to their not benefit from most of the services that force use tax collec-
advantage. In March, the American distant state or those local governments tion by out-of-state
Booksellers Association, which is made up of provide. That does not mean that no one is sellers would not
independent bookstores from around the paying: telecommunications carriers pay
country, announced the formation of Book taxes on income earned from building and significantly further
Sense (www.booksense.com)—an online store maintaining the Internet’s physical infra- tax neutrality and
that combines the stocks of independent stores structure; common carriers pay for services
nationwide. The stores will set their own prices they use in the form of income taxes, fuel
would unfairly
and recommend specialty titles.67 The ability to taxes, and similar levies—in short, no one burden many
offer the convenience of Internet shopping, unfairly benefits from the use of public ser- businesses.
coupled with rapid delivery at minimal costs, vices while conducting electronic com-
should allow local merchants to compete with merce. Electronic commerce firms should
remote sellers. Those benefits could, at least in help pay for services only in states in which
areas with competitive rates, overcome the dis- they are physically located and actually use

13
No one unfairly those services. Use taxes are fine, but they process concerns were satisfied in part because
benefits from the should not be collected by businesses that the petitioner had “purposefully directed its
have no significant contact with the taxing activities at North Dakota residents.”73
use of public state. Specifically, the Quill corporation had mailed
services while con- The case against remote taxation is at least catalogs to, and purchased advertising in,
as strong for sales of intangible products over North Dakota—activity suggesting that the
ducting electronic the Internet. Clearly, network-delivered prod- company was actively availing itself of the
commerce. ucts do not impose any additional marginal North Dakota marketplace. Many, though not
cost on state-provided services. To the extent all, Web-based businesses do not target distant
that digital products substitute for tangible markets that way. The mere existence of a Web
products, the demand for state-provided ser- site (especially on an out-of-state computer
vices might even decline. Fewer trips to the server) is no more purposeful, regular, or per-
video store or the newsstand, for example, sistent solicitation of customers in a foreign
mean less wear on roads and less need for state than is a listing in the local telephone
police protection. book, which, like a Web site, is available
Early decisions by the Court concerning nationwide. On the Internet, customers often
due process established a standard of fairness actively seek remote businesses instead of the
for remote taxation that is still valid today. In a reverse. If taxpayers can drive across state lines
1940 case, Wisconsin v. J.C. Penney Co.,70 that to make purchases from a store that has done
standard was described as follows: nothing to target them, and that business can-
not be compelled to collect use taxes for the
[The] test is whether property was buyer’s home state, then there is no reason to
taken without due process of law, or if hold Web-based firms to a different standard.
paraphrase we must, whether the tax- The Commerce Clause also prohibits states
ing power exerted by the state bears from imposing taxes on businesses that do not
fiscal relation to protection, opportu- benefit from state services. The four-pronged
nities and benefits given by the state. test from Complete Auto, which can help deter-
The simple but controlling question is mine when a tax will pass constitutional
whether the state has given anything muster, requires that any state tax “be fairly
for which it can ask in return.71 related to the services provided by the state.”74
Although Quill effectively abandoned the
More recently, in a 1996 Internet-related physical-presence requirement for due process,
case—Bensusan Restaurant Corp. v. King—a it upheld the Complete Auto test that requires a
federal district court in New York recognized tax to be fairly related to services provided by
limits on a state’s jurisdiction on due process the state. As it considers the question of
grounds. The district court held that the defen- whether to protect the Internet from unfair
dant, based in Missouri, did not purposefully taxation, Congress should recognize the funda-
avail himself of the benefits of New York mental disconnect between remote electronic
through the mere creation of a Web site. In the commerce and state-provided services.
court’s opinion, “Creating the site, like placing The aggressive manner in which many states
a product into the stream of commerce, may be are attempting to draft out-of-state firms as tax
felt nationwide—or even worldwide—but, collectors suggests that new revenue, not equi-
without more, it is not an act purposefully tably sharing the cost of services, is their real
directed toward the state forum.”72 goal.75 State officials regularly speak of “lost” tax
If that conception of a Web site is upheld, revenues to which they are entitled. Their words,
the Due Process Clause is possibly sufficient to however, ring hollow. State and local tax rates
protect many electronic commerce businesses were set in a world where restrictions on cross-
from tax collection duties imposed by distant border tax collection were the norm. The rev-
states. The Court concluded in Quill that due enue such taxes were expected to raise took that

14
reality into account. It is impossible to lose rev- nationwide retailers, but for small Internet sell-
enue that was never anticipated; however, allow- ers it could be prohibitive. In addition to calcu-
ing states to tax remote commerce would raise lating how much tax is owed to whom, firms
new revenue—a de facto tax increase that would be required to register with and remit
escapes voter scrutiny. Congress should thus be taxes to a bewildering array of local agencies
aware that any federal legislation intended to and to collect and store information about their
authorize remote taxation could have the practi- customers.
cal effect of allowing state revenue agencies to Complying with a multitude of state and
expand taxation by fiat. As the American local tax laws would disadvantage Internet
Legislative Exchange Council recently pointed retailers—whose business is inherently inter-
out: “The authority to levy a tax, expand tax state—relative to their traditional competitors.
obligation—including tax collection obliga- Brick-and-mortar retailers are tasked only with
tion—or broaden the tax base in any way is vest- collecting sales taxes for the state where they
ed solely in the legislature. A state revenue are located, regardless of where their customers
administrative entity should have no authority ultimately use their purchases. Instead of “lev-
to levy, increase, or in any way expand a tax, a tax eling the playing field,” as its proponents claim,
obligation, or a tax collection obligation.”76 a policy that allows states to enforce out-of-
If equity were the primary consideration, state tax collection would merely shift any de
The aggressive
states should be proposing to lower tax rates facto tax advantage from remote to local sellers. manner in which
and broaden the tax net simultaneously. With A recent paper published by Ernst & Young many states are
most state budgets in surplus, taxpayers should estimates that small firms selling and collecting
reasonably expect any reforms to be, at a mini- tax nationwide would face compliance costs of attempting to draft
mum, revenue neutral. For example, if current 87 percent of the taxes remitted as opposed to out-of-state firms
retail sales within a state are $1 billion, and the just 7.2 percent for local businesses.80 Faced
tax rate is 5 percent, sales tax receipts would be with that disadvantage, many small- and medi-
as tax collectors
$50 million. If the ability to tax interstate sales um-sized firms would likely choose not to sell suggests that new
increased the tax base to $1.25 billion, then the online, a result that suggests an impermissible revenue, not equi-
tax rate could be lowered to 4 percent to yield burden on interstate commerce.
the same $50 million in revenues..77 Along If allowed, use tax collection and remission tably sharing the
those lines, California’s Electronic Commerce could realistically take place only at the state cost of services, is
Advisory Council has recommended that each level. That would entail either a uniform their real goal.
state “review the tax-base-broadening revenue national tax rate, such as the 5 percent federal
impact of the new system and consider reduc- sales tax on all remote sales proposed by
ing its sales tax rate,”78 but such advice is rarely Senator Hollings, or at least a single rate for
followed in state tax circles. each state. Both of those options, however,
Use Tax Collection by Remote Sellers Would Be would undermine much of the beneficial tax
Burdensome. If remote sellers were required to competition that now takes places among juris-
collect use taxes, the result would be an dictions. Hollings’s proposal is especially anti-
inequitable redistribution of income. State and competitive because it removes altogether the
local tax laws are not uniform, which could possibility for states to set their own tax rates
make compliance costly for remote vendors. on cross-border sales. It would also give con-
With a patchwork of more than 6,500 (and sumers in states with sales tax rates lower than
potentially over 30,000) state and local taxing the national rate an incentive to avoid shopping
jurisdictions currently levying taxes, sorting out online, further discriminating against Internet
competing tax claims would be challenging, businesses.
particularly for small businesses. Although Although it is true that allowing states to
software that can calculate tax liability current- enforce collection requirements on remote sell-
ly exists, it is expensive—often more than ers under a one-rate-per-state system would
$20,000.79 This amount may be trivial for large preserve tax competition among states, that

15
competition would be much less intense than to the transaction itself, nor would any use or
under current rules. Prior to the Internet, the consumption take place there. In such cases,
only meaningful behavioral constraints on sales the collection requirement of the taxing state
tax rates were driving across state lines and would have a sweeping extraterritorial effect
ordering from catalogs. Few people, however, not permitted under prevailing due process
are fortunate enough to live near a state with a jurisprudence, which precludes the application
lower tax rate, and catalogs are limited in both of a state statute to commerce that takes places
capability and availability. Electronic com- wholly outside its borders.
merce gives the option of cross-border shop- Limiting States’ Taxing Authority Is a Crucial
ping to people for whom it never before exist- Component of American Federalism. In 1998 a
ed and expands the range of products that they report published by the National League of
can buy. That is a useful check on the ability of Cities asserted, “One of the virtues of federal-
state and local governments to raise sales taxes ism is that states are able to choose for them-
beyond a reasonable level. selves how to design their own tax systems,
Proposals to require remote sellers to collect whether to tax information services, and
use taxes assume that the location of the cus- whether to tax or exempt on-line providers
tomer will be known. That knowledge cannot from state sales taxes.”82
be taken for granted, however, especially for Although state and local governments are
purchases of digital products and services. As free to set their own tax policies, their authori-
the use of anonymous digital cash becomes ty does not extend beyond their geographic
widespread, sellers may not even have billing borders. There is something inherently unset-
addresses to use in calculating tax charges. A tling about states’ exercising legal authority
uniform national tax rate would not solve that outside their jurisdictions. Unquestionably,
problem, because tax receipts could not be fair- states have the legal right to levy use taxes on
ly apportioned among the states. The Hollings their own citizens. But imposing a collection
bill, for example, does not even attempt to obligation on out-of-state businesses is a fun-
remit funds to states based on the location of damentally unfair government activity. By what
taxpayers; instead, the bill relies on a redistrib- right can New York force a firm in Florida to
utive formula based on poverty rates and act as its tax collection agent? Even if it were
school-age populations. Even if states managed constitutionally permissible, it would set a dan-
to allocate the taxes among themselves, it gerous precedent with enormous potential for
would be extremely difficult for them to fairly conflict.
apportion tax revenues to the localities where Because Internet commerce by nature can-
Electronic consumers were located, resulting in an even not be locally restricted without imposing costs
more inequitable redistribution of income on other states, it falls into Congress’s sphere of
commerce gives the within states. authority. At least some active federal guidance
option of cross- Lack of knowledge of the customer’s loca- could be useful, because recent state court deci-
border, tax-free tion could also lead to taxation by states that sions relating to jurisdiction and the Internet
have no connection to the transaction in ques- are confusing and often contradictory.
shopping to people tion. Assume, for example, that businesses are Consider Inset Systems Inc. v. Instruction Set Inc.
for whom it never instructed to rely on credit card billing infor- and E-Data Corp. v. Micropatent Corp.83 In
mation for tax collection purposes. Consider Inset, the district court held that advertising
before existed and the common example of a traveler who pur- through use of an Internet site, even though no
expands the range chases a digital product by credit card—say, a purchases or sales could be conducted through
of products that downloaded news article—while staying in a the site, constituted solicitations of a nature
hotel room in another state. The seller would sufficiently repetitive to justify jurisdiction by
they can buy. be required to collect and remit a use tax to the Connecticut, where consumers were exposed to
state where the buyer’s credit card was regis- the ads. However, in E-Data Corp., the same
tered, but that state would have no connection court held that a company engaged in electron-

16
ic commerce and operating an Internet site was losses will be negligible. But even if there is a The Framers of
not subject to personal jurisdiction by negative revenue impact, state and local gov- the Constitution
Connecticut solely by virtue of Connecticut ernments have several policy alternatives avail-
residents’ ability to access the site. Those seem- able. At the federal level, the objective should wisely erected
ingly inconsistent opinions illustrate the uncer- be to maintain a tax system that fosters compe- strong protections
tainty that businesses face when confronting tition among the states.
Internet-related legal issues.84 The idea that state and local governments
of interstate
The overriding priority at the federal level will be unable to find the money to perform commerce and
should be to ensure that states are not allowed legitimate government functions is laughable. empowered
to violate the principle of due process by impos- As taxpayers know too well, politicians will
ing tax collection responsibilities on out-of- always have such options as income taxes, use Congress to
state businesses. Quill minimized the legal taxes, property taxes, gas taxes, hotel taxes, and enforce those
importance of due process considerations and the like. Their insistence on expanding tax col- protections.
apparently gave Congress an opening to autho- lection authority without lowering tax rates
rize states to require use tax collection. But the suggests that the goal is not equity or revenue
fact that Congress has the authority to resolve security but instead a new source of funds that
that dispute does not imply that it should rad- would escape voter scrutiny. If a tax increase is
ically change the status quo. That action would not the intent, then current policy recommen-
be neither prudent nor just; the mere potential dations are misguided. Unfortunately, there is
for a revenue crunch is not a compelling reason little reason to expect a change of course. Given
to impose burdensome duties on out-of-state that several states have enacted voter-approved
firms. tax-limiting initiatives, the taxation of elec-
Other constitutional rationales for main- tronic commerce has apparently become an
taining the federal restrictions on state taxation attractive back-door option for lawmakers who
of remote commerce are available.85 The Quill chafe at such restrictions.
contention that requiring remote sellers to col- Justified or not, state and local officials evi-
lect taxes places an unconstitutional burden on dently believe that erosion of the tax base is on
interstate commerce, for instance, remains the horizon. It is thus likely that they will
valid. attempt to recover uncollected taxes from
The Framers of the Constitution wisely somewhere. Ideally that would be accom-
erected strong protections of interstate com- plished by a combination of budget cutting,
merce and empowered Congress to enforce waste reduction, and tax reform. In reality,
those protections. If states are allowed to make however, the most probable strategies will be to
out-of-state firms, which have no connection raise existing taxes, redefine taxable transac-
to or influence over the taxing authority, act as tions, impose new taxes, and attempt to expand
revenue collectors, those barriers will be signif- the nexus provisions.
icantly weakened. Use taxes may not be uncon- Ultimately, states may be forced to look
stitutional per se, but states should be required beyond such piecemeal reforms. Congress is
to collect such taxes themselves, without already considering the idea of extending the
unjustly extending their authority into other ITFA. At least one bill, introduced by Sen.
jurisdictions. Robert Smith (R-N.H.) in January, would
impose a permanent moratorium on taxation
Options for State and Local Taxation of remote electronic commerce. Such a ban is
Despite claims to the contrary, it is by no likely to have popular appeal—the leading
means certain that the growth of electronic Republican presidential candidates have all
commerce will substantially undermine state endorsed the concept and several bills have
and local tax collections. Online commerce been introduced in Congress—so states should
may generate new business and enhance pro- not ignore the possibility that alternatives to
ductivity to such a degree that any revenue traditional sales taxes might be necessary. A

17
few of the available options are considered sent almost twice the rate of inflation plus pop-
below. ulation growth.93 Noting that apparent return
Lower Taxes—Cut Spending. If electronic to profligacy, the Wall Street Journal published a
commerce eventually contributes to a state story headlined “For Republican Governors,
budget crunch, it will not be because revenues Spending Isn’t a Dirty Word Anymore.”94 The
are inadequate but because states simply spend desire to spend more is leading state officials to
too much. For most of America’s history, the perpetually seek new revenue—and electronic
states consumed roughly 4 to 5 percent of gross commerce is now in the cross hairs.
national product. By 1970 that figure had Budget data show that states have no press-
grown to 7 percent; by 1980, to 8 percent; and ing need to tax remote electronic commerce. If
by 1990, to 8.5 percent.86 At that time, many every state had adhered to a population-plus-
states were facing what the New York Times inflation revenue cap from 1992 to 1998, tax-
called “a fiscal calamity.”87 Then, as now, budget payers would have saved a total of $75 billion,
analysts and state officials tended to blame or $278 per capita, in 1998 alone. Even if states
their problems on a multitude of factors had passed $75 billion in tax cuts in 1998, their
beyond their control. Especially singled out for revenues would still have grown by about 22
blame were the resistance of citizens to new percent, or 3.4 percent per year—the level of
The idea that state taxes in the 1980s and a decline in federal inflation and population growth. Instead, state
and local govern- transfer payments. tax collections climbed by 45 percent, or 6.4
ments will be Although both of those factors likely played percent per year.95
some role in causing the states’ fiscal predica- Consider the case of Nevada, where execu-
unable to find the ments, the primary culprit was a decade of run- tive director of the Department of Taxation
money to perform away state government expenditures. With few Michael A. Pitlock has called Internet com-
exceptions, the states with the most severe merce “a significant concern” for state finances
legitimate govern- deficits early this decade were the ones that saw and has proposed “[putting] a requirement on
ment functions is their economies and tax revenues grow rapidly vendors to collect taxes for all products they
laughable. in the 1980s but allowed spending to grow ship to each state.”96 Again, the real problem is
even faster.88 spending, not revenue. As the Las Vegas
By 1996, however, the states had moved Review-Journal noted while discussing the cur-
dramatically in a fiscally conservative direction, rent legislative session, “There will be plenty of
with most states cutting taxes and holding gen- talk about ‘pain,’ ‘cuts,’ and a ‘shortfall.’ Don’t be
eral fund expenditures at or below inflation in fooled: State spending over the next biennium
1995 and 1996.89 Overall, from 1996 to 1997 will increase by almost 10 percent, to an esti-
state budgets expanded just slightly above the mated $3.186 billion.”97 Such budget battles
inflation rate, as opposed to nearly twice the highlight the need to rein in spending, not beef
inflation rate in the early 1990s. The result of up tax collection.
tax cuts and fiscal restraint was that states accu- Local government is not immune to the
mulated sizable budget surpluses, ending the siren song of runaway spending. As Newsday
budget “crisis” of years past.90 recently observed of New York’s Nassau
Unfortunately, there has been a clear trend County, “Unbelievably, at a time of unprece-
toward more spending at the state level during dented prosperity that has created surpluses for
the past two years. In 1998 many governors governments large and small, one of the nation’s
submitted budget proposals that increased richest counties is drowning in red ink.” The
spending by more than 7 percent, roughly three problem: too much spending. “Nassau has been
times the rate of inflation.91 On average, states living beyond its means for years, offering too
estimate an increase in general fund spending many, sometimes overlapping, services and pay-
of 5.7 percent for FY98 and 6.3 percent for ing too many politically connected employees
FY99, with only two states reducing their more than it could afford.”98
FY98 enacted budgets.92 Those figures repre- State and local officials are naturally

18
inclined to spend an ever-increasing portion of tax system have conceded some of those
the taxpayers’ wealth, but that urge must be important advantages:
resisted. To secure their fiscal futures, states
should lower tax rates and give taxpayers Source-based transaction taxes applied
greater value for their tax dollars by cutting to electronic commerce have clear
back unproductive agencies and privatizing compliance and administrative cost
state services. advantages over their destination
States should also emulate the tax- and based counterparts through the elimi-
spending-limit initiatives that have been passed nation of the use tax problem. A desti-
in recent years. Washington’s Initiative 601, for nation tax requires retailers to account
example, says that state spending can grow by no for sales made in all market states, dis-
more than the rate of inflation plus population tinguish between taxable and exempt
growth. That’s running about 3 percent a year, transactions, and apply the proper tax
less than half the average annual budget growth rate to the transaction. Under the
for the past two decades.99 In addition, the same source alternative, retailers need only
state’s recently passed Initiative 695 requires know the transaction tax system with-
voter approval of all tax and fee hikes. Along in their states of location, an especially
similar lines, some governors—including important advantage for smaller firms
Christine Whitman of New Jersey, Tom Ridge with relatively high compliance
of Pennsylvania, and New York’s George costs.102
Pataki—are pushing bills to require a superma-
jority of lawmakers to raise taxes.100 The primary “problem” with source-based
Alternative Tax Structures. The problems taxation, according to its detractors, is that tax
associated with taxation of electronic com- competition may be so intense that businesses
merce would disappear if states switched to a would locate primarily on the basis of tax crite-
source-based system of sales taxation. Current ria. That argument assumes that tax rate differ-
sales taxes are structured on a destination basis, entials will be great enough to offset natural
with the intent of imposing the tax at the place advantages such as proximity to suppliers and
of consumption. Under a source tax, money is customers, and conversely, that location has a
collected where economic production, not con- significant effect on productivity. Both asser-
sumption, takes place. Businesses are assessed tions cannot be true. If location is a major
taxes based on total sales volume, regardless of determinant of productivity, firms will be
the ultimate destination of their output. unlikely to move unless the tax savings will be
Reform in that direction need not entail a com- very high. If, however, modern transportation Under a source tax,
plete overhaul of state tax systems. As Kaye networks make relocation viable for minimal
Caldwell, public policy director of tax savings, there will be little negative effect on
money is collected
CommerceNet, has noted: “All states exempt the nation’s overall economic efficiency. where economic
local merchants from collecting sales taxes on Finally, states could always decide to broad- production, not
goods that are exported from their states to en the in-state tax base so that services are
buyers in other states. Eliminating that loop- taxed more evenly. In addition to achieving consumption,
hole and setting the export rate to match the greater neutrality, that approach has the advan- takes place.
state rate in the buyer’s state would immediate- tage of intergenerational equity. In most states,
ly resolve the [use tax collection] problem.”101 the growing elderly population will spend a
Source taxes have the advantage of low larger share of its income on services than will
administrative costs and high compliance the working-age population. Taxing all goods
rates; they do not extend a state’s taxing and services at the same rate, the tax burden
authority outside its borders, and they main- would be spread more evenly among all seg-
tain strong incentives for states to engage in ments of the local population.
tax competition. Even critics of a source-based Whether states choose to restrain spending

19
or to restructure their tax systems, an important local budgets for the foreseeable future, and in
benefit of internal reform is that it will force any case, those budgets have been growing too
state legislators to face public scrutiny. Federal fast. States should concentrate on reducing
action, though, would allow local lawmakers to bloated budgets and returning surpluses to tax-
pass the buck—to effectively increase taxes payers, not unfairly expanding their taxing
without having to seek voter approval. jurisdictions.
Like state budgets, traditional retailers will
Domestic Conclusions survive the emergence of electronic commerce
The current federal rules do not exempt and may end up being a source of much inno-
online commerce from taxation; they simply vation in that field. Except for digital products
prohibit one means of collection. Thus, elec- delivered over the Internet, online shopping is
tronic commerce does not enjoy any legal tax not vastly different from the catalog or televi-
advantage. Where current state tax systems sion experience. Those two marketing media
effectively disadvantage local retailers, states have more to fear from the Internet than do
already have it within their power to address brick-and-mortar stores. By lowering rates
the problem. and restructuring their tax systems, states can
Although reform may be difficult, states are address equity concerns without unfairly
in no immediate danger of going broke, nor do burdening out-of-state businesses with tax
they lack alternatives to the current system of collection duties.
sales and use taxes. Furthermore, the federal Congress should firmly refuse to bow to
government should ensure that states do not state demands for new taxing authority. The
unfairly export their tax collection burden, ITFA was a good start in ensuring that tradi-
thereby impeding interstate commerce. A fed- tional principles of remote commerce apply to
eral commitment to that principle will also the online world, but more could be done. If
help guarantee that changes at the state level Congress acts, it should be to unequivocally
do not undermine tax competition—that indi- block the extraterritorial taxation of electronic
viduals and businesses retain the freedom to commerce, in both tangible and intangible
escape punishing tax rates. products. That would entail a clear definition
Reform is not urgent, however, so states and of taxable nexus that requires physical presence
localities will have time to alter their tax sys- by a firm before a state can demand use tax col-
tems as conditions change. Online commerce lection. Such clarification should include spe-
is not likely to significantly constrain state and cific language establishing that Internet activi-
ty and contracts for services are insufficient to
establish nexus.
A positive congressional agenda on electronic com- By acting firmly, Congress can uphold tra-
merce taxation should aim to ditional principles of interstate tax competi-
tion, due process, and fairness, while leaving
• establish a clear nexus standard and definitions—based on electronic commerce free to serve as the growth
physical presence—to determine when companies can be engine for tomorrow’s economy.
required by a state to collect sales or use taxes,
• amend P.L. 86-272 to cover the sale of intangible property
and services, Part II
• reject all international efforts to draft American business- International Taxation of
es as tax collectors for foreign governments, and Electronic Commerce
• pursue an Internet free-trade agreement in the World Although it has received relatively little
Trade Organization.
attention in the United States, a debate over
how international electronic commerce ought
to be taxed has also been raging for several

20
years, and the participants in that dialogue have Electronic payment systems could potentially The United States
often voiced alarm. Governments fret that be used to deposit refunds directly in taxpayer should be careful
because existing international tax rules evolved accounts or to accept electronic payments,
in an industrial and agricultural world, they which would save time, postage, and other not to sign on to
might be inadequate for the Brave New World administrative costs. Streamlined customs pro- any international
of electronic trade and tax revenue may be lost. cedures using new technology could also
Conversely, businesses worry that conflicting improve border-clearing efficiency and thus
agreements that
and overly burdensome tax rules could retard increase transaction volumes. As the Internet will hamper the
the growth of electronic commerce. Taxpayers, becomes more reliable and taxpayers become growth of
as usual, have few advocates. accustomed to new ways of interacting with tax
Both governments and businesses have agencies, the gains from such developments electronic com-
been prone to exaggerate the threat of inaction. can be expected to multiply. merce or undercut
Most of the international tax complications But the growth of international electronic beneficial tax
created by electronic commerce have been dealt commerce will undoubtedly pose real—though
with before. Telephone, fax, telex, Electronic often exaggerated—difficulties for the admin- competition.
Data Interchange, and other new forms of istration of national tax systems as they are cur-
communication between businesses and cus- rently structured. At least four issues have been
tomers have challenged international tax rules the focus of much recent concern and analysis:
during a good part of this century. So tax
authorities are not in entirely uncharted waters. 1. Should Internet content be subject to
Predictions of the rapid growth of Internet- customs duties or new taxes?
based electronic commerce, however, suggest 2. Is the concept of “permanent establish-
that it is time to reexamine the principles that ment” valid in cyberspace, and, if so, is the
govern international taxation. existing definition adequate to ensure
The most important question to ask is, that different jurisdictions do not tax the
What is the difference between the taxation same income?
of an Internet-based international transaction 3. Will electronic commerce increase non-
and of a conventional transaction? The answer compliance with or avoidance of con-
should provide tax administrators with reason sumption taxes? How will the characteri-
for optimism: when a sale results in the phys- zation of intangible products and services
ical delivery of goods, there is generally no affect that behavior?
difference. Shipments must still go through 4. Will the ease of conducting business elec-
customs, are subject to import duties, and may tronically lead to “harmful” tax competi-
be subject to consumption taxes.103 That fact tion among countries?
bodes well for both businesses and govern-
ments. As an early U.S. Treasury Department To some extent, all those questions are
paper on electronic commerce notes, “Careful valid, and governments will be forced to con-
examination may very well reveal that few, if front them. The United States in particular,
any, of these emerging issues will be so however, will not have to radically redesign its
intractable that their resolution will not be tax system. As the world’s largest exporter of
found using existing principles, appropriately both information technology products and
adjusted.”104 services and intangibles such as movies and
It is also encouraging that computer net- music, the United States is in an enviable
works and technologies can increase the effi- position.105 The United States should be care-
ciency of tax collection. Electronic filing, for ful not to sign on to any international agree-
example, already promises to radically cut the ments that will hamper the growth of elec-
costs of administering—and perhaps increase tronic commerce, hinder the development of
compliance with—income tax systems in the new technologies, burden U.S. businesses, or
United States and other developed countries. undercut beneficial tax competition.

21
The question of how international electron- 7. Any tax arrangements adopted domesti-
ic commerce should be taxed is a remarkably cally and any changes to existing interna-
complex one, and the preceding list does not tional taxation principles should be struc-
begin to exhaust the range of possible topics. tured to ensure a fair sharing of the
This paper is not intended to serve as a blue- Internet tax base among countries, par-
print for U.S. tax policy; instead, its purpose is ticularly important as regards division of
to raise some of the more immediate issues fac- the tax base between developed and
ing policymakers and to suggest broad developing countries.106
approaches to dealing with those issues.
Other groups have articulated a similar
Basic Principles of International Taxation vision. The Global Information Infrastructure
There was an early coalescence around the Commission, for example, accepts the “general
Organization for Economic Cooperation and tax principles of neutrality, efficiency, certainty,
Development as the forum best suited to deal simplicity, effectiveness, fairness and flexibility
with the taxation of international electronic as applicable to electronic commerce.”107 The
commerce. Work there has already resulted in World Trade Organization agrees, noting, “In
general agreement on the basic principles that principle, taxation of electronic or non-elec-
Just as competition should govern its taxation. That consensus is tronic commerce should be easy to administer
among businesses perhaps best reflected in the OECD’s Model and should not induce unnecessary distortions
is a welfare- Income Tax Convention and, more recently, in and discrimination.”108
its set of seven criteria for judging proposals to It is one thing to agree on vague principles,
enhancing process, tax the Internet: quite another to translate them into actual poli-
so too is tax cies. Indeed, trade ministers from the top 30
1. The system should be equitable: taxpay- industrial nations failed to make much head-
competition among ers in similar situations who carry out way at an OECD meeting in Ottawa at the
governments. similar transactions should be taxed in end of last year because of deep differences,
the same way. particularly between the United States and
2. The system should be simple: adminis- Europe. And although generally sensible, the
trative costs for the tax authorities and OECD guidelines could easily be stretched to
compliance costs for taxpayers should be justify unwise national tax laws. The guidelines
minimized as far as possible. also do not offer specific suggestions for future
3. The rules should provide certainty for the reforms—nothing about how national tax sys-
taxpayer so that the tax consequences of a tems might eventually be forced to adapt to the
transaction are known in advance: tax- new reality of international electronic com-
payers should know what is to be taxed merce. In short, the OECD principles provide
and when—and where the tax is to be little in the way of concrete guidance to U.S.
accounted for. policymakers grappling with the emerging
4. Any system adopted should be effective: online economy.
it should produce the right amount of tax The OECD principles are deficient in
at the right time and minimize the other ways. As do the arguments made by state
potential for tax evasion and avoidance. and local governments in the United States, the
5. Economic distortions should be avoided: OECD international tax principles recognize
corporate decisionmakers should be the basic common-sense notion that tax sys-
motivated by commercial rather than tax tems should be technologically neutral and easy
considerations. to administer. Also as in the domestic debate,
6. The system should be sufficiently flexible the benefits of tax competition are largely
and dynamic to ensure that tax rules keep ignored. The OECD is an organization whose
pace with technological and commercial membership consists exclusively of national
developments. governments. Tax competition among those

22
governments exerts downward pressure on tax ally been the rule in international tax
rates, so governments tend to favor harmoniza- agreements, but the borderless nature of
tion over competition. As a 1998 OECD electronic commerce will make it increas-
report on “harmful tax competition” noted, ingly attractive for some national govern-
“Pressures of this sort can result in changes in ments—especially those with onerous tax
tax structures in which all countries may be and regulatory structures—to rely on rec-
forced by spillover effects to modify their tax iprocal enforcement arrangements. The
bases, even though a more desirable result United States has little to gain but much
could have been achieved through intensifying to lose by following that path.
international co-operation.”109 The question is, 2. The United States should welcome the
More desirable for whom? more intense tax competition that may
Just as competition among businesses is a result from the growth of international
welfare-enhancing process, so too is tax com- electronic commerce. Europe, by con-
petition among governments. The OECD trast, troubled by this phenomenon, has
report is in part an attempt by countries with been studying ways to kill it since at
high levels of taxation to escape the conse- least 1996, and the OECD has shown
quences of their unwise domestic policies. concern. Its paper on the “harmful”
The United States should reject their argu- effects of tax competition calls for “co-
ments. Because of some unique tax system ordinated action at the international
advantages and a generally hospitable com- level.”111 The United States, by demon-
mercial climate, the United States is well strating the benefits of open markets
positioned to benefit from international tax unburdened by excessive taxation, can
competition. There is nothing harmful or encourage other nations to adopt similar
unfair about the United States’ taking a light- policies.
handed approach to taxation and regulation of 3. The United States must be wary of
electronic commerce; in fact, it is essential international agreements that would
that we do so to ensure that we remain the compromise the privacy of Internet con-
most attractive market for businesses engaged sumers, especially ones that would ban
in electronic commerce. the use of emerging privacy-enhancing
Policymakers in both Congress and the technologies. Some nations have sug-
administration must retain a healthy skepti- gested, for example, that the use of unac-
cism about all schemes that undercut tax counted digital cash should be restricted
competition and recognize that international because of its potentially negative impact
cooperation among governments to achieve on their tax systems. That is a wrong- The United States
“revenue stability” could undermine the poten- headed approach. In addition to losing
tial of electronic commerce. But if allowed to privacy, the suppression of new tech-
must be wary of
flourish, electronic commerce will significant- nologies will slow the advancement of international agree-
ly improve the efficiency of economies, electronic commerce and leave govern- ments that would
enhance their productivity, improve resource ments with less revenue to tax. The tech-
allocation, empower consumers, and increase nological shape of the marketplace compromise the
overall long-term growth. should drive the design of tax systems, privacy of Internet
In charting our course in this area, policy- not the reverse.
makers should be guided by three key con-
consumers.
cerns: All proposals relating to the taxation of
international electronic commerce should take
1. The United States should refuse to act as into consideration the preceding criteria. The
a tax collector for other nations—an idea remainder of this paper discusses a few of the
currently under consideration by the most immediate issues that are likely to face
OECD.110 National autonomy has gener- U.S. policymakers. Those issues are grouped

23
The real goal of into three categories: new and Internet-specif- area. This would provide the base rate
supporters of the bit ic taxation, direct taxation of income, and con- of tax for that local area.114
sumption taxation.
tax is apparently to Apart from its substantial technical hur-
expand government New and Internet-Specific Taxation dles,115 the bit tax is a fundamentally flawed
The first operating rule for policymakers concept that is ill suited to the reality of elec-
rather than create should always be to do no harm. With regard tronic commerce. The chief failing of the bit tax
an efficient tax to the taxation of international electronic com- is that it takes no account of the true value of
system. merce, that means that no new or discrimina- what is being taxed. Thus, the transmission of a
tory taxes should be enacted. newly released novel would be taxed at a far
The Bit Tax. One proposal is the “bit tax”— lower rate—possibly thousands of times
essentially a minuscule tax on each “bit” of dig- lower—than the transmission of an amateur
ital information that flows across global net- video or even a personal photograph. The
works. Proposals for the bit tax date back at incentive would be to avoid any high-band-
least to a 1994 paper by Arthur Cordell and width use of the Internet, regardless of its avail-
Thomas Ran Ide.112 Cordell and Ide argue that ability and price. Some proponents of the bit tax
existing tax bases are no longer appropriate in recognize and applaud that result, noting that
an environment where the major economic the tax would end the “rapidly growing conges-
activity is the transmission of data. It is time, tion and increasing amount of ‘junk’ and irrele-
they write, to move to a more appropriate tax vant information being transmitted.”116 Of
base. Luc Soete, chairman of the European course, one man’s junk is another man’s treasure.
Union’s so-called High Level Expert Group, As with state and local officials in the
and Karin Kamp went further, arguing in a United States, the real goal of supporters of the
1996 paper that additional research on the bit bit tax is apparently to expand government
tax was needed because the “taxing of the dis- rather than create an efficient tax system. Soete
tribution of [physical] goods, which has tradi- and Kamp speak of the “additional bit tax rev-
tionally formed one of the essential bases for enues” that will be collected and how such
national, state or even local government’s tax funds could be used to finance the deteriorat-
revenues is . . . eroding rapidly.”113 ing social security system in Europe,117 while
No detailed plan for implementing a bit tax Cordell has lamented the fact that “govern-
has been drawn up; however, the typical con- ment has not yet figured out a way to tax and
cept is that revenues collected under a bit tax redistribute some of the new wealth created by
would be allocated among various jurisdictions global digital networks.”118 Along those lines,
on the basis of some agreed-on formula. the EU’s High Level Expert Group’s report
Cordell and Ide envision the following “Building the European Information Society
arrangement: for Us All” advocates exploring the “appropri-
ate ways in which the benefits of the
For public long distance lines, the tax Information Society can be more equally dis-
would apply to the actual information tributed between those who benefit and those
or flow of digital traffic. For leased who lose.”119 However, commanding new
lines, a fixed amount would be sources of private wealth should be the last
charged, based on the carrying capaci- thing U.S. policymakers seek. Instead, they
ty of the line measured in bits per sec- should concentrate on redesigning antiquated
ond. Carriers would measure the local public-sector programs—such as our own fail-
flow within a specified area. . . . This ing Social Security system—so that individuals
measurement would produce a statisti- can more easily take advantage of the wealth-
cal average for the designated creating dynamism that characterizes the mod-
region—an amount that would repre- ern high-tech economy.
sent the number of bits flowing in the Fortunately, the bit tax has few supporters

24
these days. It was roundly criticized at the establishing the Internet as a duty-free zone
OECD’s 1998 Ottawa ministerial meeting, will not result in revenue losses for govern-
and both the Clinton administration and the ments (since tariffs are currently nonexistent)
EU Commission have essentially dismissed it and will not interfere with national income or
as unworkable. Also recognizing the inherent consumption tax systems. To guarantee that
shortcomings of the bit tax, the WTO has con- free trade in electronic commerce continues, an
cluded that the bit tax would be “a blunt instru- agreement on the tariff treatment of digital
ment, blind to any subtlety in public policy transactions should be pursued in future WTO
considerations.”120 Despite those encouraging negotiations.
signs, policymakers should remain vigilant so Establishing the Internet as a digital free-
that the bit tax—or other Internet-specific trade zone would also dispense with the need
tax—does not resurface as a serious option in to characterize electronic products as either
future deliberations. The latest human devel- goods or services under the WTO. However, if
opment report published by the United countries decide to apply tariffs to trade in dig-
Nations Development Program, for instance, ital goods, it will be necessary to classify the
calls for a one-cent tax on the transmission of content of data flows to determine whether
every 100 e-mails.121 Similar Internet tax they are to be governed by the General
schemes are certain to be hatched in the future. Agreement on Tariffs and Trade or the General
To guarantee that
Free Trade in Cyberspace. True electronic Agreement on Trade in Services. That would free trade in elec-
commerce—the purchase and delivery of prod- be a difficult task because many online transac- tronic commerce
ucts and services online—already takes place in tions are clearly services, yet no universally
a largely free-trade environment. Whether agreed-on system for classifying those services continues, an
because of prudent restraint or lack of techno- exists. Furthermore, developing such a system agreement on the
logical capability, no nation currently levies would needlessly squander scarce WTO
customs duties on wholly electronic transac- resources.125
tariff treatment of
tions. Given that nations have devoted consid- As the world’s leading producer of electron- digital transactions
erable time and energy to lowering barriers to ic goods and services, the United States has an should be pursued
international trade, it makes sense that those especially strong interest in setting a good
countries work to maintain the beneficial status example by resisting domestic pressures to in future WTO
quo for trade in electronic goods and services. charge customs duties on electronic transac- negotiations.
Free trade in electronic goods and services is tions. As a 1998 paper published by the WTO
a unique situation. Never before have all pointed out: “85 per cent of Internet revenue is
nations started from a free-trade position before generated in the United States while only 62
any negotiations began. Thus, for network- per cent of the users are located there. This
delivered digital content, countries should be suggests that the United States is probably a
able to easily agree to a zero-tariff rating. The net exporter of products through the
Clinton administration’s “Duty-Free Zone” Internet.”126 Moreover, because the U.S.
proposal in “Framework for Global Electronic Treasury derives most of its revenues from per-
Commerce”122 was a commendable starting sonal and corporate income taxes, Washington
point that has helped build international sup- must be careful not to raise barriers to trade in
port for zero-tariff rating, and this past May, digital content that will encourage businesses
132 members of the WTO reached a tempo- to locate elsewhere. Federal income tax receipts
rary agreement on the exemption of electronic will rise to the extent economic activity is
transactions from customs duties.123 The encouraged through a commitment to free
OECD has also endorsed the idea, noting that trade online.
it is not intended to “limit the application of Apart from the sale and electronic delivery
VAT/GST as appropriate by any national tax of digital content, the Internet will also pro-
administration in respect of importations of all mote the flow of low-value shipments of phys-
relevant goods and services.”124 In other words, ical goods directly to consumers. The growth of

25
electronic storefronts on the Web, for example, source of income earned by a foreign citizen or
makes it relatively simple for a customer in one entity, that person or entity is subject to U.S.
country to order a product directly from a for- income taxes. Conversely, residence-based tax-
eign seller. Because the costs of insurance and ation is predicated on the nationality of the
customs administration can equal or even person or entity earning the income. The
exceed the value of a low-dollar shipment, this worldwide earnings of U.S. resident citizens
type of commerce may not reach its full poten- and corporations, for example, are generally
tial unless reforms are instituted. subject to taxation at home.
To facilitate the growth of those transac- To avoid paying taxes on the same income
tions, governments should consider expanding in both the United States and abroad, U.S. res-
tax- and duty-free thresholds, especially when idents are eligible for domestic credits on taxes
the costs of inspection and collection would paid to foreign governments.127 Double taxa-
likely exceed revenues raised. As the country tion is also guarded against through an exten-
with the most commercial Web sites, the sive network of bilateral income tax treaties
United States will benefit greatly if such sales that the United States has with at least 48
are allowed to flourish. And as with any reduc- countries.128 Under those agreements, residents
tion in trade barriers, the U.S. economy will of foreign countries are taxed at a lower rate or
benefit even from unilateral action. are exempt from U.S. income taxes on certain
Consequently, the United States should raise items of income they receive from sources
the threshold for customs treatment on small within the United States. The application of
cross-border purchases—at least doubling the those lower rates and exemptions vary among
current $50 limit—regardless of whether other countries and specific types of income. In
nations initially follow suit. exchange, the U.S. government is granted the
right to tax income earned by American com-
Direct Taxation of Income panies in the treaty partner’s country. The
The expected growth of electronic com- intent is to fairly allocate taxing rights between
merce raises some important issues relating to nations, as well as to assist in the exchange of
national systems of direct taxation but does information between tax authorities to mini-
not fundamentally challenge existing con- mize the misreporting of income from foreign
cepts. The most immediate problem facing sources.
tax authorities will be attributing to a particu- Such treaty and tax credit safeguards are
lar country the income generated by electron- necessary because source- and residence-based
ic commerce. Although the “permanent estab- taxation are inherently conflicting. Generally,
The expected lishment” standard has been serving that pur- the country where economic activity takes
pose for a long time and will continue for the place (the “source” country) has a right to tax
growth of electronic foreseeable future to assign tax liability in income that is generated within its borders.
commerce raises electronic commerce, eventually, national gov- However, governments also claim the right to
some important ernments could be compelled to think about tax income earned by their citizens and resident
moving toward a residence-based system of corporations abroad. Clearly, one of those two
issues relating to direct taxation. principles must yield, or the same income
national systems of Current Principles of Direct Taxation. would be taxed simultaneously by two govern-
Direct—or income—taxes in the international ments. Tax treaties thus establish rules for “per-
direct taxation but context currently rely on the twin concepts of manent establishment” to determine which
does not funda- source and residence to specify who is liable for principle will govern in a particular case. That
mentally challenge taxes and, for those who are, what income is approach is laid out in Article 7 of the OECD
subject to tax. Source-based taxation is intend- Model Treaty, which states that a country may
existing concepts. ed to limit income tax collection to the juris- tax an enterprise’s business profits attributable
diction where economic activity takes place. to a permanent establishment located in that
Thus, when activity in the United States is the country, regardless of the enterprise’s country

26
of residence for tax purposes.129 In cases where the location of computer file servers: Should The ability to access
no permanent establishment is deemed to the mere presence of a server in a particular a foreign Web site
exist, the general consensus among OECD taxing jurisdiction be considered sufficient to
member countries is that residence-based tax create permanent establishment? Again, the is actually a lesser
principles should govern. best answer is no. In most cases, the existence degree of contact
In the absence of a treaty, source principles of a foreign-owned server does not require
generally govern taxation. Foreign persons employees to be present in the host country—
than the solicitation
from nontreaty countries are thus subject to traditionally a prerequisite for permanent of orders via catalog
U.S. tax on all income connected with the con- establishment. But even when a business main- or telephone.
duct of a U.S. trade or business. For treaty tains its own server through its own employees,
countries, however, Washington usually cedes the level of contact with the host country rarely
its right to tax income earned by a foreign enti- rises above the “storage, display, or delivery of
ty unless that income can be attributed to a goods” standard that exists in the OECD
permanent establishment—a higher standard Model Treaty. Following the OECD’s guide-
than the mere “conduct of a trade or business.” lines, most tax treaties do not consider facilities
Permanent establishment is defined by the that are used in that manner as a permanent
OECD as “a fixed place of business through establishment.
which the business of an enterprise is wholly or There are additional reasons why an in-
partially carried on.” Facilities used solely for country file server should not be defined as a
the purpose of storage, display, or delivery of permanent establishment, not the least of
goods do not meet the permanent establish- which is Article 5 of the Model Treaty. Article
ment threshold.130 5 has generally been interpreted to exclude
What Constitutes Permanent Establishment? mail-order activities as insufficient to create
What constitutes permanent establishment permanent establishment. A Web site that dis-
with regard to electronic commerce may pose plays product information and takes orders
problems that existing tax treaties do not from customers is equivalent to an electronic
address. The most obvious concern is the abili- catalog and should thus receive the same tax
ty to access a Web site from within a particular treatment as postal solicitations.
taxing jurisdiction. Does the fact that con- A more practical problem is that defining
sumers can place orders through a foreign firm’s servers as permanent establishments would
Web site subject that firm to income taxes in render the allocation of income among com-
the country where the customer lives? The peting jurisdictions very complex. It is all but
proper answer is almost certainly no. A Web site impossible to determine the income attribut-
has no physical presence and thus cannot be able to any one server, and many Web sites are
considered as a permanent establishment in any housed on multiple servers located throughout
meaningful sense. To say that the ability to the world. Apart from the jurisdictional
access a Web site, without more substantial headaches, using the location of a server as the
contact, is sufficient to create permanent estab- criterion for determining the place of econom-
lishment is to say that online businesses are ic activity would result in a largely arbitrary tax
liable for income taxes in every country in standard that bears no relation to where eco-
which their customers reside. Such a broad def- nomic activity occurs.
inition would be virtually useless. The ability to Finally, as companies will seek the best
access a foreign Web site is actually a lesser treatment available, countries that do not tie
degree of contact than the solicitation of orders tax strings to the placement of servers within
via catalog or telephone. Under existing tax their borders will clearly benefit. Because the
principles, which should not be abandoned, location of a server is irrelevant from a techni-
mere solicitation does not create a permanent cal standpoint, shifting the location of servers
establishment. would be an irresistible way to minimize liabil-
Another, more complex, question concerns ities. Tax advisers are already telling their for-

27
eign clients that to “avoid the possibility of an in terms of both compliance costs and
inadvertent permanent establishment in the amount of tax paid compared to the
United States, [they should] use a Web server enterprise’s connection to the local
located outside of the United States,” which economy.134
suggests the United States should clarify its
position on the issue.131 Despite that reality, tax Fortunately, Washington appears to have
authorities in several countries and at least one grasped the truth of that situation. The
OECD Discussion Paper have indicated that Treasury Department’s paper on the tax impli-
the presence of a server might be sufficient to cations of electronic commerce indicates that
create permanent establishment.132 the Treasury will regard both the presence of a
Regardless of what individual governments server in the United States and the fact that a
decide to do, the classification of computer foreign person’s Web site may be accessible by
servers as permanent establishments is not computers in the United States as insufficient
likely to survive without an international agree- to be considered either permanent establish-
ment.133 The borderless nature of electronic ment or a U.S. trade or business.135 Certain
commerce means that countries that make tax- court cases also provide hopeful guidance. In
ation contingent on Web server location will Piedras Negras v. Commissioner—a case involv-
The borderless encourage the migration of servers beyond ing cross-border radio transmissions (a reason-
nature of electronic their borders. Few governments would be will- able analogy for Internet communications)—
commerce means ing to adopt such a policy unilaterally. An the United States unsuccessfully tried to tax a
example of such policy competition can be seen Mexican broadcaster that retained 90 percent
that countries that in the United States, where some states have of its listeners and advertisers north of the bor-
make taxation been thwarted from taxing on the basis of serv- der. A federal circuit court held that the United
er presence by other states that have disavowed States did not have jurisdiction to tax the sta-
contingent on Web that tactic. tion, since there was no capital, labor, or estab-
server location will The Adaptability of Current Standards. lishment in the United States. The electronic
encourage the Nothing in the preceding discussion of perma- links between the station and its listeners were
nent establishment is meant to imply that deemed insufficient to give the U.S. govern-
migration of servers online businesses will escape taxation. The ment taxing authority.136
beyond their point is that existing concepts are sufficiently That is also the best policy for electronic
borders. robust to fairly allocate tax revenues without commerce, and it should be formally adopted
resorting to strained definitions of what consti- as soon as possible. The United States enjoys
tutes “presence” in a remote jurisdiction. As a the highest concentration of Internet servers in
recent article in Tax Management International the world and should therefore stake out a
Journal explains: minimalist position on server tax treatment
regardless of what other countries do. In fact,
The fact that no tax liability is cre- the United States will prosper to the extent
ated in the customer state does not that other countries insist on adopting a more
mean that the e-commerce enterprise aggressive server policy, with more U.S.-based
avoids full tax in those places where its electronic commerce resulting in an expanded
physical inputs are deployed. Transfer tax base. Ultimately, however, international
pricing rules will remain available to efforts to tax on the basis of server presence will
allocate income among those jurisdic- almost certainly be abandoned if Washington
tions where capital and labor in fact refuses to go along.
are employed to create wealth. A In addition to a commitment by the United
direct tax obligation arising in the States not to treat computer servers as perma-
country of source when the enterprise nent establishments, the Treasury Department
has no physical presence there would should consider other measures to simplify tax
create a disproportionate tax burden liability for multinational enterprises. One such

28
positive change would be for the United States goods or services from a related or subsidiary
to replace the “conduct of a trade or business” nonresident corporation. Governments are
standard that currently applies to businesses concerned that the prices used in such transac-
based in nontreaty countries with a uniform tions be equal to those that would be charged
permanent establishment standard. That sim- to an unaffiliated corporation in the open mar-
plification would encourage electronic com- ket (known as the “arm’s length” principle).
merce with nontreaty countries by giving them When that is not the case, price manipulation
a clearer picture of when they would be liable may allow firms to shift profits from high- to
for U.S. income taxes. low-tax jurisdictions. Transfer-pricing rules are
Taxation and ISP Obligations. Agency issues intended to ensure that the prices charged by
may also need to be clarified as they relate to related businesses to each other are accurate.
the conduct of electronic commerce. For exam- The increasingly dense electronic networks
ple, some national governments will likely of multinational enterprises present, in theory,
argue that a domestic ISP—by connecting no new problems for existing transfer-pricing
consumers to a foreign business’s Web site— rules. However, the practical effect of the new
acts as an agent for determining the existence communications technologies is a degree of
of permanent establishment. That position integration that has not been seen before.
would be very difficult to defend. Article 5 of Inexpensive computer network communica-
the Model Treaty defines agency sufficient to tions have made it possible for companies to
create permanent establishment as a relation- coordinate previously impossibly fragmented
ship in which the foreign corporation relies on production processes, particularly for intangi-
the domestic agent to conclude binding con- ble products and services. Thus, current report-
tracts in its name. An independent agent that ing rules for transactions involving affiliated
lacked such authority would not be sufficient to companies or divisions may not be sufficient to
create permanent establishment. track electronic transactions and allocate
As business groups have pointed out, in the income and expenses among competing tax
course of normal commercial activity, “the rela- jurisdictions. At the very least, electronic com-
tionship of an enterprise with its Internet ser- merce has the potential to make the current
vice provider is simply a business contract for problems with transfer pricing more common.
services to be provided to the enterprise rather Preliminary analysis by the OECD suggests
than to act on behalf of the enterprise as a legal that the existing Transfer Pricing Guidelines
agent.”137 Thus, the fact that an ISP may facili- for Multinational Enterprises and Tax
tate the conduct of business in the source coun- Administrations are applicable to the special
try—like a local telephone exchange or postal circumstances of conducting business through Tax authorities
service—does not mean that the ISP has an electronic commerce.138 At the least, it is too
agency relationship with the foreign enterprise. soon to tell if significant problems will arise.
should clarify
Tax authorities should clarify that the existing U.S. policymakers should follow the OECD’s that the existing
definition of what constitutes agency for pur- ongoing work in this area and insist that the definition of what
poses of permanent establishment does not business community be included in the process
include the ordinary activity of domestic ISPs. of crafting any new rules. constitutes agency
By contrast, when a U.S. business provides ser- A Residence Alternative? The difficulties in for purposes of
vices that are clearly integral to the primary determining when and where a permanent permanent estab-
business activity of the foreign enterprise— establishment exists may necessitate a greater
such as selling Internet access services on reliance on residence-based taxation. Under lishment does
behalf of a foreign ISP—a taxable agency rela- that system, individuals and corporations not include the
tionship might be appropriate. would be subject to income tax in the country
Transfer Pricing. A transfer price is charged where they reside or maintain the strongest
ordinary activity of
between related parties in international trans- ties. That approach would greatly simplify the domestic ISPs.
actions—for example, when a U.S. firm buys allocation of taxing rights and increase the

29
A residence-based efficiency of administration. In addition, a under a system that does not rely on knowing
tax system would residence-based system would ensure that where income was created. Residence-based
nations will be forced to compete for increas- taxation is well suited to the taxation of elec-
foster competition ingly mobile businesses by maintaining sound tronic commerce precisely because it requires
and could thus lead tax policies and low rates. The Treasury relatively few pieces of information to function
Department, speculating that “source based effectively. As the Treasury Department paper
to lower and more commerce could lose its rationale and be points out, residence principles have already
simplified taxes, rendered obsolete by electronic commerce,” been adopted for certain space- and ocean-
with a consequent suggests that the idea is worthy of further based activities—a borderless situation not
consideration.139 unlike the world of cyberspace.140
increase in world An international tax system based on resi- Most important, a residence-based tax sys-
economic growth. dency is both feasible and potentially desirable, tem would foster competition and could thus
as evidenced by the permanent establishment lead to lower and more simplified taxes, with a
standard present in most tax treaties. consequent increase in world economic growth.
Permanent establishment describes a threshold Under a system of residence taxation, the loca-
below which source-based taxes will not be col- tion of a corporation becomes more important,
lected. As cross-border electronic commerce especially for online companies whose physical
expands, it may turn out that the source of distance from their customers is irrelevant.
income becomes more difficult to reasonably Some companies might set up shop in countries
determine. Residence-based taxation, already that offer low taxes, or alternatively where gov-
in common usage, is the logical alternative. ernments would compete more intensely than
The most obvious benefit of residence taxa- they do now to provide an environment that is
tion is ease of administration—it is not neces- conducive to economic activity.
sary to identify the source of economic activity U.S. policymakers should realize, of course,
when income is subject to taxation only in the that the benefits of low tax rates and unobtru-
country of residence. That tremendously sim- sive compliance procedures are their own
plifies the calculation of tax liabilities for firms reward; they are not contingent on other coun-
engaged in electronic commerce whose income tries’ adopting similar policies. Countries that
may not be attributable to any specific geo- maintain a business-friendly environment rela-
graphical location. Since nearly all individuals tive to their trading partners are likely to bene-
and businesses claim residency somewhere fit at their expense. As former Citicorp chair-
(under U.S. law, all corporations must be estab- man Walter Wriston observed: “Capital goes
lished under the laws of a given jurisdiction), where it is wanted, and stays where it is well
electronic commerce would not escape taxa- treated. It will flee onerous regulation and
tion. The danger of double or overlapping tax- unstable politics, and in today’s world technol-
ation would also be minimized, since countries ogy assures that that movement will be at near
would not need to squabble over the location of the speed of light.”141 Wriston’s observation
the source of income generated in cyberspace. undoubtedly applies equally to sound tax poli-
Moreover, tax authorities are best able to collect cy. Although tax competition is to some extent
taxes from those firms that are unquestionably inevitable, the efficiency of capital allocation
tied to their national jurisdiction. can be enhanced when nations agree to princi-
The residence of the seller is as good an ples of taxation that will avoid double taxation
approximation of where economic activity and refrain from using national tax codes to
takes place as is the location of the buyer— exclude foreign producers.
especially with regard to intangible goods or Problems with Residence Taxation. One
services. The production of intangible property potential unintended beneficiary of residence-
is becoming increasingly difficult to attribute to based taxation would be tax havens—small off-
any specific geographic location, so if such shore financial centers with low or no corporate
activity is to be taxed at all, it will need to be taxation, lax regulation, and strong secrecy pro-

30
tections. Tax havens are already home to some impose a Value Added Tax (or equivalent
Internet-related businesses, most notably, Goods and Services Tax) except for the United
online casinos.142 Nevertheless, it is far from cer- States and Australia.145 In theory, governments
tain that such tax havens would succeed in collect a VAT from taxpayers in the jurisdiction
attracting a significant number of mainstream where consumption takes place. In practice,
companies involved in electronic commerce if however, consumption taxes are usually collect-
residence taxation becomes widespread. Tax ed indirectly, from the final seller of a product
havens lack the facilities and critical mass of instead of from the consumer. That approach
high-technology companies that exist in devel- has allowed governments to shift the burden of
oped countries. Although it is technically possi- collection to private businesses, making tax
ble for firms to shift some amount of the pro- avoidance relatively difficult. The problem fac-
duction of digital content to such places, it is ing governments is that as consumers increas-
unlikely that many of the highly skilled employ- ingly buy from foreign online businesses, tax
ees involved in that process would be keen on collection may suffer.
living permanently abroad. Even if havens do Should U.S. Businesses Collect Europe’s VATs?
begin to undermine tax revenues, governments Unlike the income tax treaties that specify who
of developed countries could respond by mak- is eligible to tax international economic activity,
ing their own tax systems more attractive, there are no agreements or treaties that coordi-
The growth of
through direct negotiation with havens or by nate the collection of indirect taxes. That should international elec-
other means of political persuasion. not overly concern U.S. policymakers, since tronic commerce
Critics have also charged that residence- Washington relies on income rather than con-
based taxation would entail shifts in the inter- sumption taxes. For that reason, the growth of poses much more
national distribution of tax revenues, especially international electronic commerce poses much of a threat to
from developing to developed countries.143 more of a threat to VAT-reliant countries than to
That concern is overstated for two reasons. the United States. Federal officials must there-
VAT-reliant
First, for revenue losses to occur, there would fore be wary of agreeing to a system that would countries than to
have to be significant source income currently burden U.S. businesses with tax collection the United States.
being taxed, which is generally not the case in responsibilities for other governments. After all,
the sale of digital goods and services. Most the American Revolution was fought over
developing countries have very low levels of England’s jurisdiction to tax remote sales in the
Internet connectivity and thus would not see colonies. The rallying cry of America’s Founders
much change in their taxable base.144 Second, as was not “No taxation without representation . . .
developing countries become a part of the or a mutual cooperation agreement.”
information economy, their collections of for- Unfortunately, that possibility is all too real:
eign-source income tax will increase. If one work is already under way at the OECD to
assumes that consumer demand for imported introduce a system of international cooperation
digital content develops at roughly the same among member countries for indirect taxation.
pace as the domestic information economy, “In an era of globalisation and increased mobil-
then tax flows would tend to balance each ity for taxpayers,” the OECD warns, “tradi-
other to some extent. In any case, OECD tional attitudes towards assistance in the collec-
countries should not base their own intramem- tion of taxes may need to change.”146
ber tax system on the revenue fears of countries Specifically, the Committee on Fiscal Affairs of
that account for a relatively small portion of the OECD has been considering including in
world trade. the Model Tax Treaty an article to allow for
assistance by one state in the collection of taxes
Consumption Taxation: VATs and GSTs for another.147 According to Joseph Guttentag,
Taxes on consumption account for an aver- deputy assistant secretary of the Treasury, such
age 30 percent of the revenues collected by assistance would mean that “Norway would
OECD member countries, and all of them collect tax on sales out of California and

31
California would collect on sales out of of many of the major international credit card
Norway.”148 companies, the support of the United States
That scenario is neither inevitable nor in any co-operative arrangement will be
desirable. First, it is important to note that not significant.”151
all electronic commerce seriously threatens The VAT and Digital Content. The main
VAT revenues. A large amount of internation- concern of VAT-reliant countries is not the sale
al electronic commerce is business-to-business over the Internet of tangible goods but of
transactions, which if not tax exempt, enjoy a intangible ones. Such products as books, music,
high rate of voluntary compliance. A 1999 and software have been easy to tax, because
Forrester Research study estimates that in 2001 they have traditionally been sold on physical
taxable business-to-consumer electronic com- media and distributed by local retailers. On the
merce will represent only 7 percent of total other hand, foreign businesses that sell directly
European Internet electronic commerce, or online do not collect the VAT. Under current
roughly 0.25 percent of European GDP. In the rules in Europe, U.S. companies without a fixed
United States that figure is expected to be 8 establishment can invoice EU customers VAT
percent, or 0.58 percent of GDP.149 Most of free, whereas domestic businesses must charge
that commerce is not expected to cross interna- the tax. From the U.S. perspective, any equi-
tional borders: the WTO predicts that by 2001 table system must retain that practice, since as
only $60 billion of international trade will be noted earlier, it would be grossly unfair for
conducted over the Internet, or 2 percent of American businesses to act as tax collectors for
total estimated global commerce.150 European governments in cases where no sub-
Second, consumption taxes will be collected stantial connection exists between the seller
on many international sales. When the and the consumer’s country. That prospect has
Internet is used for taking orders directly from many European businesses worried that they
consumers, with a physical product’s being will be unable to compete with VAT-free sales
shipped to a foreign tax jurisdiction, there is of digital content. As the Times of London has
generally no difference between electronic noted, “With VAT rates averaging nearly 20
commerce and traditional mail-order business. per cent in the EU, domestic businesses risk
Mechanisms are already in place for such com- losing out to overseas rivals.”152
merce, and goods imported from outside a Fears of rampant tax evasion are probably
country are subject to VAT at importation. The unfounded. The Forrester and WTO data sug-
online delivery of digital content to consumers, gest that international sales of digital content,
which is the type of transaction most difficult although growing rapidly, will remain a rela-
The rallying cry of to tax, presents a different set of issues that are tively insignificant percentage of economic
discussed below. If an increasing volume of activity. In fact, digital content sales by 2001 are
America’s Founders low-value transactions makes VAT collection expected to equal only 5 percent of overall elec-
was not “No burdensome, it may be necessary to expand de tronic commerce revenues in Europe and only
taxation without minimis thresholds so that the flow of low- 3 percent in the United States—less than 0.18
value packages is not impeded. and 0.22 percent of GDP, respectively.153
representation or a Finally, no agreement on international tax When an international transaction takes
mutual cooperation collection assistance is likely to be reached place and no VAT is charged, the customers
unless the United States participates, so there themselves are generally required to assess the
agreement.” is little danger of Washington’s missing the appropriate tax. Businesses frequently comply,
international boat. As the Australian Taxation although most individual taxpayers are
Office has observed, “Given the dominant unaware of their obligations in international
place that United States entities play in transactions and are thus unlikely to remit the
electronic commerce, from Internet software appropriate funds. Some governments are
providers, to content providers, to electronic already taking steps to address that problem.
payment system providers and as the home Canada, for example, has proposed a program

32
designed to educate taxpayers on the tax oblig- making a purchase. The imposition of
ations associated with doing business over the The Credit Card Solution? Some tax authori- consumption taxes
Internet.154 To the extent that tax rates are per- ties have suggested relying on credit card billing
ceived as reasonable, governments may find information to locate sales.157 “Along with is inherently
that voluntary compliance by both business advances in Internet technology,” says an article difficult when both
and consumers will render groundless many of in Accountancy Age, “we may expect advances in
the fears of rampant tax evasion. the monitoring of transactions. Customs &
purchase and
Nevertheless, some observers in both gov- Excise should be able to track down what you delivery of a
ernment and business think that the adminis- have spent and collect the [tax] straight off your product take
tration of consumption taxes—particularly a credit card.”158 However, relying on credit card
European-style VAT system—will become information is extremely problematic. Services place online.
increasingly unworkable as electronic sales of purchased with a credit card are typically billed
digital content expand. If consumers regularly directly to the credit card company address
turn to nonresident suppliers in order to avoid rather than to the location where the buyer con-
the VAT, local businesses fear, probably rightly, sumes the service. The only information avail-
that they will lose customers. The European able to tax authorities would be the billing
e-business tax group, for example, has called on address on file with the credit card company.
the European Commission to update its VAT But that address need not have any connection
rules to keep up with the booming electronic to where a digital product or service was actual-
commerce market.155 Governments, as always, ly downloaded and consumed. Moreover, any
want to ensure that electronic commerce does such approach could be easily abused. For
not undermine tax receipts. example, by using a post office box, the address
The imposition of consumption taxes is of friends or relatives, or a second home or busi-
inherently difficult when both purchase and ness, individuals could establish a billing address
delivery of a product take place online. To in a low-tax jurisdiction. That would allow
effectively impose a VAT, tax authorities need them to access and consume digital goods from
at least three pieces of information. First, it inside a high-tax jurisdiction. In addition, ser-
must be known where a transaction takes place vices are available that allow mail to be sent to a
to assign tax revenues to the appropriate juris- private center that forwards the mail to a second
diction; second, a transaction must be classified address. Tax administrators could seek to verify
as the sale of either a good or a service to know each consumer’s address, but enforce-
what tax to apply; and third, a business selling ment would be expensive and produce little
a product or a service must be able to deter- additional revenue.159
mine when it is liable to collect and remit taxes. Assuming a credit card–based identification
system could be made to work, it would raise
Jurisdiction: Where to Tax? some troubling privacy issues. Currently, gov-
On the issue of jurisdiction, tax authorities ernments generally do not have access to cred-
have concluded cross-border electronic trade it card company data unless a particular card-
should be taxed in the jurisdiction where con- holder is suspected of criminal activity. The use
sumption takes place.156 Unfortunately, that is of such data for tax collection purposes would
not always a straightforward proposition. potentially put a detailed record of a person’s
Companies generally have no need to know the buying habits in the hands of government
physical location of their customers to sell elec- authorities—without the normal judicial pro-
tronic products and services to them. Many tections. The possible abuses of that informa-
Internet shoppers place a high value on privacy tion are enormous, and it is doubtful whether
and may avoid doing business with firms that many individuals would easily accept the
insist on collecting such information. unprecedented invasion of their privacy. Thus,
Alternatively, to avoid taxes, online buyers consumers would have an incentive to use
could easily submit false information when credit cards issued by foreign companies that

33
would not surrender personal data. collectors, especially since Washington does
Even if all issuers could be drafted as tax not impose such obligations on foreign busi-
collectors, credit cards are not likely to work for nesses that sell their products here.
long as a means for locating sales, because Countries with national consumption taxes
unaccounted digital cash will take the place of will not be able to enforce collection even with
the cards. Digital cash systems are more than a the help of the United States. It is not possible
theoretical possibility. MasterCard and to track the transmission of digital content
Mondex, for example, have been testing “smart across borders, especially since such transac-
cards” for several years; and in Denmark, a con- tions can be easily encrypted. Some analysts
sortium of banking, utility, and transport com- have suggested that foreign firms could be
panies has announced a card that may replace compelled to collect taxes by technological
coins and small bills.160 A tax system based on means.162 A country might decide to “black
credit cards would only exacerbate the trend out” the Web site of a company that refuses to
toward digital cash: the anonymity it offers register for VAT collection, for example.
would become immediately more attractive if Customers in a country in which a Web site is
governments seek to monitor consumers blacked out would be unable to access that site
through their credit transactions. Governments from their Web browsers and thus unable to
A tax system based may simply be forced to accept that the loca- complete purchases.
on credit cards tion of many consumers may not be available It is questionable how effective such solu-
would only on purchases of digital content. tions would be. Consider that, despite a highly
Permanent Establishment and the VAT. centralized system of Internet service provi-
exacerbate the Another option that has been discussed is an sion, authoritarian governments (such as
trend toward expansion of permanent establishment for China) have been unable to effectively control
digital cash. VAT purposes.161 That concept is identical to access to dissident Web sites. Moreover, the
permanent establishment and direct taxation. censorship of foreign Web sites would likely
Essentially, the idea is to lower the standard for face legal challenges; the fact that someone
what constitutes a fixed (and thus taxable) might avoid taxes is a shallow pretext for an
establishment to include electronic connec- outright ban on the flow of information.
tions—computer servers, telecommunications Finally, a proliferation of alternative means of
links, and so on. The purpose of broadening Internet access—via satellite or cross-border
the definition is, of course, to extend tax collec- dial up—will make it progressively more diffi-
tion liability to nearly every firm that does cult for governments to maintain centralized
business with a person living inside a particular access controls. Even when customers in VAT-
tax jurisdiction. When a consumer in Milan, imposing countries log on through a govern-
for example, orders a book from Amazon.com, ment-monitored channel, they will probably be
the VAT tax would be collected by Amazon able to ship their digital purchases through
and remitted to a collection point in Europe. third parties in non-VAT countries or order
As with direct taxation, stretching perma- from an ever-changing array of mirror sites.
nent establishment to include such a limited The inability of governments to enforce intel-
“virtual presence” would essentially make it a lectual property rights on recorded music
hollow concept. The purpose of limiting taxa- (online pirate sites are ubiquitous) suggests that
tion to businesses that maintain an actual phys- attempting to collect consumption taxes on the
ical connection with a taxing jurisdiction is not international sale of digital content will be a
only to allocate taxing rights among govern- similarly fruitless endeavor. Reducing expendi-
ments but also to recognize that businesses and tures or looking elsewhere for tax revenue
individuals ought not be subject to the author- would be more effective than attempting dra-
ity of governments from which they derive no conian enforcement of consumption taxes
substantial benefits. Foreign governments have online. The Internet is simply too massive and
no right to expect U.S. firms to be their VAT decentralized to police effectively.

34
From the U.S. perspective, the debate over goods and services would result in equal treat-
collection of online consumption taxes interna- ment, of course, but policymakers in Europe
tionally is largely academic. In the absence of and elsewhere would likely attempt to parlay
an international agreement, the onus will be on that into a tax increase by “harmonizing
the countries that impose a VAT to either dis- upward.”
cover effective ways of levying taxes on imports U.S. policymakers have little if any influence
of seemingly untraceable intangible goods or over such domestic reforms, so the only
abandon the attempt altogether. Whether remaining option is to seek common interna-
through reliance on voluntary self-assessment, tional standards for the classification of digital
incentives for foreign sellers to collect, content. Besides violating the principle of neu-
increased use of direct taxes, or exemption of trality, the EU’s move to classify all online
intangibles from taxation, the problem of levy- transactions as the sale of services will poten-
ing taxes should be tackled by the affected gov- tially serve as a trade barrier to U.S. exports.
ernments. Specifically, uneven tax treatment will mean
that European consumers have an incentive to
Classification: What Tax Applies? purchase zero-rated domestic products instead
Another issue—how to classify digital of digital imports.
transactions as either the sale of goods or ser- The U.S. approach, leading presumably to
vices—also poses problems for consumption more neutral tax treatment, is to characterize
taxes. Since differing VAT rates generally apply digital transactions by the rights transferred to
to goods and services, it is necessary to classify the consumer. (The OECD has also endorsed
online transactions as one or the other. There that general methodology).165 The goal is to tax
has already been some controversy over that functionally equivalent transactions in the same
issue. The position taken by the European way. For example, for tax purposes, the pur-
Commission has been that digital products chase of an off-the-shelf software package
should be considered as services.163 The United from a traditional brick-and-mortar retailer is
States, however, suggested that digital products usually classified as the sale of a good. Instead
should be characterized on the basis of the of treating the sale of that software as a service
rights transferred in each particular case. when it is downloaded off the Internet, the
Speaking at the OECD’s Ottawa meeting, U.S. approach would classify that transaction as
Guttentag criticized the European approach, the sale of a copyrighted article because the
saying that “we should resist the temptation to consumer has purchased only the right to use
settle on answers that represent oversimplifica- or copy the software. Customized software or
tions and over-generalizations, such as, for the transfer of copyright rights, however, would Although the EU’s
example, the conclusion that the provision of face different tax treatments. That nuanced
digitized information is in all cases the provi- approach would more accurately capture the
approach provides
sion of services and not the provision of goods essential quality of each transaction than would certainty, it has the
or the right to use an intangible.”164 the one-size-fits-all characterization proposed significant
Although the EU’s approach provides cer- by the EU.
tainty, it has the significant drawback of dis- Although no detailed guidelines for the drawback of
criminating against products delivered online. characterization of digital commerce have been discriminating
Books and newspapers, for example, face a zero presented by the United States, the Internal against products
VAT rate in some European countries. If view- Revenue Service has issued regulations relating
ing the identical newspaper online were classi- to the U.S. internal income taxation of software delivered online.
fied as the sale of a service, it would be taxed transactions.166 Those regulations make it clear
differently from its physical counterpart—a that the IRS will consider the sale of standard-
result contrary to the principle that like prod- ized software over the Internet as the sale of a
ucts should be taxed the same regardless of the digital product, which means the company sell-
means of delivery. Harmonizing VAT rates for ing it would be liable for income taxes only if it

35
Governments must had a permanent establishment in the United zero VAT rate in some European countries.
come to grips with States. In the case of customized software— Given the technical and privacy barriers to
which would be classified as the sale of ser- tracking online transactions, as well as the cur-
the fact that evasion vices—the income would normally be taxed rent incentive for residents in countries that
of VAT taxes will where the service is performed, likely the for- charge VAT taxes to buy from foreign suppli-
eign company’s home country. Where software ers, the best way to level the playing field might
likely always be is sold with a license that allows multiple copies be to forgo taxation. The result would be non-
possible on sales of to be made and then resold, income would be neutral tax treatment of tangible alternatives to
digital products and taxed as royalty income and a permanent estab- digital goods (unless such items were also zero
lishment would not be required. In principle, rated), but that result might be preferable to
services. there is no reason why the software regulations giving remote Internet sellers a de facto tax
cannot serve as the basis for regulations that advantage. In any case, the relatively small
would cover the sale of a broader range of dig- share of international commerce conducted
ital products as well. online is an indication that the tax losses from
exempting digital content will be minimal for
Collection: Who Must Collect and How? the foreseeable future.
As more companies began to sell online, it If exemption is politically unacceptable, a
will become increasingly difficult for them to more palatable option might be to levy con-
know when and where they are liable for tax sumption taxes on digital transactions at the
collection and remission. Even for firms that place of origin—where a good or a service is
wish to comply, the costs of registering and col- produced—instead of where it is consumed.
lecting for hundreds of VAT systems world- The arguments for such a system are similar to
wide could be enormous unless the process is those for residence-based direct taxation, and
greatly simplified. Fortunately, the concept of reform in that direction could potentially
fixed place used for VAT is sufficiently com- improve the prospects for national tax systems,
prehensive to deal with electronic commerce. businesses, and taxpayers as the global infor-
As with direct taxes, companies that do not mation economy develops.
have a physical connection to the taxing coun-
try should not be expected to collect the VAT. VAT and Place of Supply Rules
The United States should work in the OECD Another aspect of consumption taxes that
to reach an agreement to reaffirm and clarify might create uncertainty for businesses is “place
that basic principle as it relates to electronic of supply” rules. VAT systems generally seek to
commerce. charge taxes at the place where goods or ser-
Governments must come to grips with the vices are supplied.167 Unfortunately, that is not
fact that evasion of VAT taxes will likely always always a simple task. The basic rule for goods is
be possible on sales of digital products and ser- that the place of supply is the location from
vices. The ability to route electronic purchases which they are shipped. The situation is more
through low-tax jurisdictions, as well as widely complex for services: place of supply can be
available encryption technology, makes it rela- either where the supplier or the customer is
tively easy to hide transactions from tax admin- located—depending on the specific type of ser-
istrators. Because the Internet is so large and vice being delivered.
fragmented, effective monitoring by any In the EU, most services are taxed accord-
national authority is difficult. Unless funda- ing to where the supplier has a fixed establish-
mental reforms are made, VAT authorities may ment. There are several exceptions to that rule.
be forced to rely on voluntary compliance. Most relevant to the conduct of electronic
One possible alternative would be to simply commerce is that “cultural, entertainment, or
declare that digital transactions will be free of artistic” services are taxed where they are per-
VAT taxes. As noted earlier, books, newspa- formed, and intangible or intellectual ser-
pers, and other similar products are charged a vices—such as copyrights, licenses, financial

36
transactions, and professional consultations— voluntary collection by foreign firms, such as a
are taxed where the customer who receives the flat fee or percentage of the tax that could be
service is established. kept by the firm doing the collecting. Those
However, the Internet makes it possible for measures might be sufficient to entice at least
more intangible goods and services to be the online sellers who do the most business to
delivered to customers by suppliers who have participate in the VAT system.
no physical presence in the country where Once again, the best alternative might be
consumption takes place. As a result, both simply to exempt digital products and services
businesses and consumers may be able to from the VAT when such purchases are made
structure their buying patterns to avoid paying by individuals. For the most part, when the
the VAT. That has prompted governments to customer is an individual, no VAT is currently
look at how place of supply rules might be being collected by either the buyer or the U.S.
reformed to handle online transactions more seller. Instead of dealing with the costs (both
effectively. financial and in lost privacy) that effective col-
One option would be to change the stan- lection would entail, governments could rea-
dards for what constitutes a fixed establish- sonably decide to deal in other ways with the
ment. The drawbacks to that approach are dis- resultant economic distortions and cede the
cussed above, under “Direct Taxation of loss of VAT revenue in this area.
The best
Income.” Similar objections obtain to loosen- alternative might
ing the standard for VAT tax collection respon- Origin-Based Taxation be simply to
sibilities. Furthermore, VAT countries would Like the case for residence-based taxation
be asking the U.S. government to force for direct taxes, the growth of electronic com- exempt digital
American firms to perform a service that merce will necessitate a change in how con- products and
would not be reciprocated. Washington thus sumption taxes are collected. Although there is
has little incentive to agree to that arrange- nothing inherently wrong with charging indi-
services from the
ment; however, unless there is international rect taxes at the place of consumption, it is in VAT when such
cooperation, enforcing VAT collection require- practice far more complex than levying taxes at purchases are made
ments on firms without permanent establish- the place of origin. As the Global Information
ment would be virtually impossible. Infrastructure Commission has noted, “An ori- by individuals.
A better alternative would be to rethink the gin-based system, universally applied, would
rules that govern place of supply. Instead of simplify indirect taxation, would result in more
attempting to fit Internet transactions into a effective enforcement, would reduce opportu-
complex classification system, governments nities for avoidance, and would eliminate dou-
could simplify consumption taxes on services ble taxation.”168
by levying those taxes uniformly at the place Under a destination-based VAT, tax is
where the customer is established. Such a sys- applied to goods imported into the taxing juris-
tem would require customers purchasing ser- diction, and exports from the jurisdiction are
vices over the Internet to assess the VAT if the tax free. Under an origin-based VAT, exports
seller is established abroad and has no presence are subject to tax, and tax is applied only to the
of company personnel or agents in the VAT value that is added after importation.
country. The fear, of course, is that when for- One advantage of an origin-based system is
eign firms sell directly to consumers (as that since the location of the consumer is irrel-
opposed to VAT-registered entities), taxes will evant, that information need not be collected.
not be voluntarily remitted. Instead, taxes would be levied on business sales,
To solve that problem, governments that regardless of where the product or service is
impose a VAT would need to make consumers ultimately enjoyed. For example, if an online
aware of their tax obligations with respect to software company in the United Kingdom
downloaded digital content. Those govern- uploaded a game to a customer in Oregon, the
ments might also decide to offer incentives for software company would be liable for the VAT.

37
The same would be true if the software were level of revenue. In both cases, it does not mat-
uploaded to a customer in London, Moscow, or ter so much how taxes are levied but rather how
an airplane crossing the Atlantic. Under an ori- high the overall tax burden is. Thus, businesses
gin-based system, taxes would be collected on subject to VAT collection responsibilities may
all sales out of the relevant tax jurisdiction, and not suffer any competitive disadvantages under
no businesses would be expected to collect an origin-based system if tax rates are kept at
taxes for a government from which they derive reasonable levels. A Deloitte & Touche paper
no benefits. put it this way:
Since businesses are subject to audit, the
expected compliance rate with origin-based tax A consumption tax without border tax
rules is very high. Mechanisms to enforce adjustments (an origin-principle con-
compliance with tax collection responsibilities sumption tax) . . . at first appears to
for domestic consumption are already in place, create a disadvantage for domestic
so a move to origin-based taxation would place producers relative to foreign producers
no additional burdens on businesses and in overseas markets. Border tax adjust-
little (if any) new burdens on national tax ments, though, may not be the only
administrations. mechanism operating to maintain
A final benefit of origin-based taxation— neutrality. Other self-executing adjust-
although most governments do not see it that ments by the markets, such as reduc-
way—is that an orgin-based system fosters tions in wage rates or in the value of
robust tax competition among governments. the domestic currency, could offset
Critics of origin-based taxation often warn that wholly any potentially detrimental
such tax competition will not be healthy but trade effects of origin-based taxation
instead will be a “race to the bottom” for nations, on exported goods.170
undermining their ability to raise revenue.169
This is identical, of course, to the claims made Even the European Commission has recog-
concerning residence-based taxation. nized the inherent benefits of origin-based
The revenue impact of origin-based taxa- consumption taxes, albeit only on an internal
tion could be limited by applying it only to basis. In its work program for the gradual
electronic commerce in digital content. introduction of a new common VAT system,
Physical commerce—which will certainly con- the commission announced its intention to
tinue to be a major component of internation- advocate a switch from taxation at destination
al trade flows—could continue to be taxed to taxation at origin for sales within Europe.
One advantage of under the existing destination-based standard. The changes being contemplated are anything
Origin-based taxation for digital content but minor. “All transactions giving rise to con-
an origin-based would be preferable to destination-based taxa- sumption in the EU,” a commission paper
system is that since tion, which is difficult to monitor and collect states, “would be taxed from their point of ori-
the location of the because of the nature of the Internet and the gin so that the existing remission/taxation
rise of unaccounted digital cash. mechanism for trade between Member States
consumer is Critics of origin-based taxation have also would be abolished.”171 Origin-based taxation
irrelevant, that argued that it would disadvantage domestic on an international basis would offer the same
producers on their export sales. Although the advantages that it would within Europe. U.S.
information need design of a nation’s tax system can affect export policymakers should thus actively encourage
not be collected. competitiveness, the true burden facing shifting to such a system as a viable option for
domestic producers is the overall level of taxa- dealing with the growth of electronic com-
tion. High income tax rates, for instance, would merce.
damage the international competitiveness of
U.S. firms just as surely as would an origin- Other Issues to Watch
based consumption system that raised the same Tax Rules as Trade Barriers. Uncertainty

38
over how to apply the rules of international tax- “know your customer” rule that would have Tax authorities may
ation to electronic commerce provides an required banks to collect information from cus- attempt to block
opening for nations wishing to use their tax tomers, monitor their accounts, and report
codes as a barrier to trade. Because the United “suspicious” activities.173 The FDIC backed the implementation
States is the leading exporter of electronic down after receiving thousands of complaints of new technologies
goods and services, other countries may some- from outraged customers, but the fiasco illus-
times be tempted to use their tax codes as bar- trates that administration officials cannot be
instead of dealing
riers to digital imports. On a country-by-coun- relied on to safeguard consumer privacy. with their tax
try basis, the WTO is the proper forum to Suppression of New Technologies. Tax con- consequences.
challenge such nontariff barriers to cross-bor- cerns are also used to justify unwise regulation
der electronic commerce, and U.S. trade offi- in other areas. For example, some authorities
cials should not hesitate to challenge illegal in the EU will not allow business-to-business
impediments to our exports. electronic invoicing, one of the most wide-
At the same time, proposed changes to spread forms of electronic commerce in use
international rules should be scrutinized and today.174 More worrisome, however, is the sug-
challenged whenever they pose a threat to the gestion that tax authorities may attempt to
global free flow of information. Seemingly block the implementation of new technolo-
arcane domestic tax regulations, such as the gies instead of dealing with their tax conse-
EU’s decision to classify all network-delivered quences. Currently, the technology that rev-
content as services, can often have the practical enue authorities dread most is anonymous
effect of discriminating against imports and electronic cash.
should therefore be opposed. Trade officials The revolution in electronic payment sys-
should also keep an eye on domestic regula- tems means that banks and other organizations
tions governing electronic commerce. The are now able to create their own digital money
recent proposal by the National Gambling that consumers can use to make purchases both
Impact Study Commission to ban online gam- over the Internet and in retail stores.175 This “e-
bling, for instance, may effectively bar foreign cash” has no physical manifestation; it exists
providers of gambling services from competing only as a set of encrypted data that the issuer
in the U.S. marketplace.172 Such proposed rules promises to ultimately redeem for legal curren-
should be challenged at home, where they vio- cy or other store of value. Like paper money,
late U.S. trade commitments. e-cash can be passed from buyer to seller with
Privacy Implications. U.S. policymakers no automatic record of the transaction. Placed
should also remain alert to the privacy implica- on an electronic wallet or smart card, e-cash
tions of any proposed changes to the interna- can be used to complete a transaction without
tional tax regime. Unfortunately, the EU— the need for a telecommunications link to the
although highly skeptical of private data collec- banking network. Thus, e-cash has the poten-
tion and use—has not shown a great degree of tial to become a secure, private, and widely used
concern over potential governmental privacy medium of exchange.
invasions that could occur in the name of tax Many governments are instinctively hostile
collection. If international trade in intangible to the idea of e-cash, and their response has
digital content grows as rapidly as expected, been to quash it. They fear that it will enable
European governments will undoubtedly seek people to avoid paying taxes, especially con-
new ways to track and tax that commerce. sumption taxes on digital content from abroad
Consumer privacy could easily be viewed as sold over the Internet. The OECD, for exam-
expendable in the quest for revenue. ple, has suggested that revenue authorities
Officials in the United States have also been “press the appropriate bodies to ensure that
guilty of taking a cavalier attitude toward pri- electronic payment system providers operate
vacy issues. The Federal Deposit Insurance their systems in a way that enables the flow of
Corporation recently proposed a controversial funds to be properly accounted according to

39
prevailing legislation. Revenue authorities may American businesses should not be forced to
seek limits on the values attached to unac- collect taxes for foreign governments—then tax
counted electronic payment systems.”176 competition will flourish, as will electronic
Undoubtedly, e-cash will not escape scruti- commerce. The Internet allows the production
ny and regulation, but as law professor David of goods and services to be increasingly disin-
Post has observed, “It is going to take some tegrated and freed from geographic constraints.
serious thinking to design a regulatory scheme That new reality will undoubtedly place down-
that does not fulfill our worst fears about the ward pressure on government revenues over the
personal privacy implications of the new digital short run but will ultimately lead to productiv-
world.”177 Government officials have three ity gains and wealth creation worldwide. It is a
choices: they can monitor the development of future that should be welcomed by U.S. policy-
new technologies and adjust their tax systems makers.
to deal with new realities, they can outlaw The rise of the Internet economy may her-
emerging technologies and financial innova- ald changes for national tax systems. As factors
tions, or they can try to establish a system in of production become more mobile, the tradi-
which every expenditure by individuals is mon- tional methods and levels of taxation may not
itored and scrutinized. In a free society, the lat- stand the test of time. The best course is for
As factors of ter two options are simply unacceptable. governments to embrace lower spending—if
production become Novecon president Richard Rahn put it this not in absolute terms, then as a decreasing
more mobile, the way: “In the new world of monetary freedom share of the overall economic pie. The worst
there is no halfway ground. Either the govern- strategy would be to succumb to the fears of
traditional methods ment will know everything, or the government short-sighted governments that seek to piece
and levels of will only know what is voluntarily revealed.”178 together an international tax cartel designed to
conscript low-tax countries into roles as tax
taxation may not International Conclusions collectors. That approach seeks to achieve the
stand the test Electronic commerce has the potential to ideal of tax neutrality at the expense of the
of time. radically alter the way the world does business, process of tax competition but is likely to leave
serve as an engine of growth and development, us with neither.
and bring people together across borders. To Governments may even find that the
fulfill that promise, however, electronic com- Internet, as the ultimate global marketplace,
merce must not be strangled by burdensome empowers individuals in ways that will make
taxation. As the birthplace and the heart of the them less dependent on state services. An evo-
Internet, the United States has a special role to lution in online financial services, for example,
play in ensuring that revenue-hungry govern- has made it possible for tens of millions of indi-
ments do not kill the goose that may lay the viduals to inexpensively manage their retire-
golden egg. As U.S. Supreme Court Chief ment investments, obtain price and safety
Justice John Marshall observed, the power to information, and communicate with fellow cit-
tax is indeed the power to destroy. izens. The Internet also benefits individuals by
So far, the U.S. government has been a forcing producers to compete for increasingly
responsible leader in this area. It has led the informed and mobile dollars, an act that lowers
fight against customs duties on digital content prices and shifts bargaining power firmly in
and opposed new Internet-specific taxes such favor of consumers. The goal of government
as the bit tax. Both of those were relatively easy officials should be to provide the few public
battles, however, and the real test is yet to goods that the market fails to produce. When
come. The future direction of Internet taxation markets advance to fill new roles, government
depends largely on how the U.S. government should happily recede. Governments should
chooses to approach problems as they arise. seek to tax as broadly and as lightly as possible.
If the United States maintains a commit- The new online economy offers the perfect
ment to tax sovereignty—to the principle that opportunity to move in that direction.

40
Is a new international agreement on 8. Shannon P. Duffy, “Suit Challenging Internet
Tax Group Voluntarily Dropped,” Legal
Internet taxation necessary? Certainly, cooper- Intelligence, April 29, 1999.
ation among governments with the purpose of
avoiding double taxation is useful and in some 9. National Governors’ Association, “50-State
cases necessary. However, there are also dangers Report on Fiscal 1999 Budgets Released,” NGA
Press release, December 30, 1998, http://www.
in international negotiations, and caution nga.org/Releases/PR-30December1998Fiscal. htm.
should be the watchword. The United States
should strive to create an environment in which 10. Steven Levy, “Xmas.com,” Newsweek, Decem-
electronic commerce can reach its full poten- ber 7, 1998, p. 50.
tial—regardless of the path taken by other gov- 11. William J. Holstein, Susan Gregory Thomas,
ernments. Virtue is its own reward, and taxa- and Fred Vogelstein, “Click ’Til You Drop,” U.S.
tion is no virtue. News & World Report, December 7, 1998, p. 42.

12. James Ledbetter, “The Web’s Free Ride,” New
Notes York Times, November 30, 1998.

1. Nathan Newman, “Prop 13 Meets the Internet: 13. Charles Selle, “Santa.com Is Not a Taxing
How State and Local Government Finances Venture,” Copley News Service, December 7,
Are Becoming Road Kill on the Information 1998.
Superhighway,” Center for Community Eco-
nomic Research, University of California at 14. Norm Alster, “Are We Stealing from Our
Berkeley, August 1995. Schools?” Upside, May 1999, p. 74.

2. Michael Mazerov and Iris J. Lav, “A Federal 15. Bob Metcalfe, “The Internet in 1999: This Will
‘Moratorium’ on Internet Commerce Taxes Prove to Be the Year of the Bills, Bills, and Bills,”
Would Erode State and Local Revenues and Shift Infoworld, January 18, 1999, p. 90.
Burdens to Lower-Income Households,” Center
on Budget and Policy Priorities, May 11, 1998, 16. “Online Merchants Enjoyed Strong Sales This
http://www.cbpp.org/512webtax.htm. Holiday,” Wall Street Journal, December 28, 1998.

3. William F. Fox and Matthew N. Murray, “The 17. Low figure taken from Boston Consulting
Sales Tax and Electronic Commerce: So What’s Group, “The State of Online Retailing,” Research
New?” National Tax Journal 50, no. 3 (September report, November 18, 1998, http://www.shop.org/
1997): 573. research/highlights.htm; high figure taken from
Robert J. Cline and Thomas S. Neubig, “The Sky Is
4. Eileen Shanahan, “WWW.TAXFREE.COM,” Not Falling: Why State and Local Revenues Were
Governing Magazine, December 1998, p. 34. Not Significantly Impacted by the Internet in
1998,” in “Ernst & Young Economics Consulting
5. “Taxing Times on the Internet,” Washington and Quantitative Analysis,” June 18, 1998, p. i,
Times, April 10, 1998. The 19-member commis- electronic version.
sion comprises the heads of the Treasury and
Commerce Departments, as well as the U.S. trade 18. Figure cited in Newman.
representative. The other 16 members were cho-
sen by Senate Majority Leader Lott, Senate 19. Laura Loro, “Marketers Look to Stave Off Net
Minority Leader Thomas Daschle (D-S.D.), for- Taxes,” Business Marketing, April 1, 1999, p. 1.
mer speaker of the House Newt Gingrich (R-Ga.),
and House Minority Leader Richard Gephardt 20. Cline and Neubig, p. i.
(D-Mo.).
21. Austan Goolsbee and Jonathan Zittrain,
6. Multistate Tax Commission, Draft Resolution on “Evaluating the Costs and Benefits of Taxing
Interstate Sales Tax Collections, August 7, 1998, Internet Commerce,” Draft article for the National
http://www.mtc.gov/POLICY/98-1.pdf. MTC is Tax Journal, May 20, 1999, http://gsbwww. uchicago.
an umbrella organization of 21 member states edu/fac/austan.goolsbee/research/jzntj.pdf.
and 16 associate member states that formulates
uniform state tax policy. 22. Figure taken from U.S. Department of
Commerce, “Falling through the Net: Defining
7. Robert MacMillan, “Daschle Alters Tax Freedom the Digital Divide,” July 1999, p. 34, http://
Act Selections,” Newsbytes, December 11, 1998. www.ntia.doc.gov/ntiahome/fttn99/fttn.pdf.

41
23. States that are eligible for the grandfather 36. Karl A. Frieden and Michael E. Porter, “The
clause on Internet access charges are Connecticut, Taxation of Cyberspace: State Tax Issues Related
Iowa, New Mexico, North Dakota, Ohio, South to the Internet and Electronic Commerce,”
Carolina, South Dakota, Tennessee, Texas, and Arthur Andersen, 1996, http://www.caltax.org/
Wisconsin. Not all of those states have chosen to andersen/contents.htm.
levy the tax.
37. Section 1104(2)(B)(i) defines “discriminatory
24. For a more detailed analysis, see David tax” as “any tax imposed by a state or political
Hardesty, “Internet Tax Freedom Act,” Tax Adviser subdivision thereof, if (i) except with respect to a
30, no. 1 (January 1999): 53. tax (on Internet access) that was generally
imposed and actually enforced prior to October 1,
25. See an analysis by Fred O. Marcus, “Nexus on 1998, the sole ability to access a site on a remote
the Information Superhighway,” Paper presented seller’s out-of-state computer server is considered
at the National Association of State Budget a factor in determining a remote seller’s tax col-
Officers, Spring meeting, April 1997, http:// lection obligation.” See “Section-by-Section
www.nasbo.org/resource/taxfee/marcus01.htm. Analysis of the Internet Tax Freedom Act,” http://
www.house.gov/cox/nettax/lawsuml. html.
26. National Bellas Hess v. Illinois, 386 U.S. 753 (1967).
38. The ITFA is unclear on this point. See Walter
27. The MTC defines “nexus” as sufficient con- Hellerstein, “Internet Tax Freedom Act Limits
tacts with a taxing state under the Due Process States’ Power to Tax Internet Access and
Clause and the Commerce Clause of the U.S. Electronic Commerce,” Journal of Taxation 90, no.
Constitution in order to support application of a 1 (January 1999).
taxing state’s sales or use tax, including a duty to
collect a sales tax or a use tax from the out-of-state 39. Lunney v. Prodigy Services Company, 1998 WL
business’s customer. Multistate Tax Commission, 909836 (N.Y. 2d Dept., Dec. 8, 1998), cited in
“Nexus Guideline,” Draft, January 25, 1995. Dickerson M. Downing, “Year Ends with Flurry of
Net News; Bugs, Hacks, Laws and the Starr Report,”
28. In defining “substantial nexus,” the Court New York Law Journal, January 25, 1999, p. 34.
adhered to the physical presence bright-line test
contemplated in its 1967 decision in National 40. Ideally, of course, states should subject all
Bellas Hess. It found such a test in the area of state goods and services to taxation at a uniform low
sales and use taxation to be useful to encourage rate. Until such reforms are instituted, however, it
settled expectations and to protect interstate seems reasonable to expect that electronic com-
commerce against undue burdens. merce not be singled out for special taxation.
29. See Scripto, Inc. v. Carson, 362 U.S. 207 (1960); 41. For a detailed analysis, see Interactive Services
and Tyler Pipe Industries, Inc. v. Washington Association, “Logging on to Cyberspace Tax
Department of Revenue, 483 U.S. 232 (1987). Policy,” ISA White Paper, 1998, http://www.
isa.net/policy/whitepapers.html.
30. Complete Auto Transit, Inc. v. Brady, 430 U.S. 274
(1977). 42. “If I’m So Empowered, Why Do I Need You?”
California Electronic Commerce Advisory Coun-
31. Quill Corp. v. North Dakota, 504 U.S. 298 (1992). cil report, http://www.e-commerce.ca.gov/1d_tax.
Quill upheld state tax collection restrictions from html.
earlier decisions such as Bellas Hess and Complete
Auto Transit, although it suggested that Congress 43. Harley T. Duncan, executive director of the
could authorize cross-border sales taxes through Federation of Tax Administrators, made this
legislation instead of constitutional amendment. point in a presentation at the George Mason
University School of Law on April 28, 1999.
32. Quill at 298. Outline of remarks available on request.
33. “Survey Results: State Use Tax Collection,” 44. Taxation of Cyberspace, 2d ed. (San Jose, Calif.:
Software Industry Issues, 1996, http://www. Deloitte & Touche LLP, 1989), pp. 32, 43.
SoftwareIndustry.org/docs-htm/usetaxcl.html.
45. Public Law 86-272 8505, 101(a), codified as
34. Neal Osten, Speech to the Syracuse University amended at 15 U.S.C. 381–84.
Alumni Association, Washington, D.C., May 19,
1999. 46. William Wrigley, Jr. Co. v. Wisconsin, 505 U.S. 214
(1992) at 225.
35. Multistate Tax Commission Bulletin 95, no. 1
(December 1995). 47. “Recent P.L. 86-272 Decisions Reveal States’

42
Attempts to Wriggle around Wrigley,” KPMG 64. Ibid.
Perspectives in State and Local Taxation, June 1998,
http://www.us.kpmg.com/salt/perspectives/ 65. Internet Shopping: A Digital Consumer Study, a
pers698/index.html. Greenfield Online presentation at the Bear
Stearns E-Tailing Conference, April 1999,
48. Hardesty, “Internet Tax Freedom Act,” p. 53. http://www. greenfieldcentral.com.

49. Austan Goolsbee, “In a World without 66. Peter Coy, “You Ain’t Seen Nothin’ Yet: The
Borders: The Impact of Taxes on Internet Benefits to the Economy of E-Commerce Are
Commerce,” National Bureau of Economic Boundless,” Business Week, June 22, 1998, p. 130.
Research Working Paper no. 6863, November
1998, http://gsbwww.uchicago.edu/fac/austan. 67. Bryant Urstadt, “Is the Internet the End of the
goolsbee/research/intertax.pdf. Story for the Little Bookshop on the Corner? Or
Just the Next Chapter?” Yahoo! Internet Life, June
50. Stephen Moore and Dean Stansel, “Tax Cuts 1999, p. 123.
and Balanced Budgets: Lessons from the States,”
Cato Institute Fact Sheet, September 17, 1996, 68. Henry Breimhurst, “Growing Internet Sales
http://www.cato.org/pubs/wtpapers/taxcuts.html. Spark Study of Tax Issue,” City Business Journal—
Minneapolis 16, no. 30 (December 25, 1998): 3. See
51. National Association of Counties, “New Push also “If I’m So Empowered, Why Do I Need You?”
for Taxing E-Commerce,” Wired News Report, July
19, 1999, http://www.wired.com/news/news/ 69. See Edward Hudgins, ed., The Last Monopoly:
politics/story/20819.html. Privatizing the Postal Service for the Information Age
(Washington: Cato Institute, 1996).
52. See “Internet Tax Horror Stories,” http://
www.house.gov/cox/nettax/Web-horror.html. 70. Wisconsin v. J.C. Penney Co., 211 U.S. 435 (1940),
rehearing denied, 312 U.S. 712 (1941).
53. Senator Hollings’s bill is S. 1433, the “Sales
Tax Safety Net and Teacher Funding Act.” 71. J.C. Penney Co. at 444.

54. Duncan. 72. Bensusan Restaurant Corp. v. King, 96 Civ. 3392
(SHS), http://www.loundy.com/CASES/Bensusan
55. “Do State Tax Cuts Work?” Investor’s Business _v_King.html, September 9, 1996. For a detailed
Daily, “Perspective,” November 5, 1996. analysis, see also Taxation of Cyberspace, p. 35.

56. Ken Magill, “CA Governor Passes 3-Year Ban 73. Quill at 298.
on E-Taxes,” DM News, September 7, 1998,
http://www.dmnews.com. 74. Complete Auto Transit at 274.

57. Taxation of Cyberspace, p. 50. 75. For a detailed discussion of questionable state
tax collection efforts, see Kaye Caldwell, “States
58. Charles E. McLure Jr., “Taxation of Electronic Behaving Badly,” CommerceNet Public Policy Report
Commerce: Economic Objectives, Technological 1, no. 6 (June 1999), http://www.commerce.net/
Constraints, and Tax Law,” Draft paper, May 15, resources/work/StatesBehavingBadly.pdf.
1998, sec. VII (b).
76. American Legislative Exchange Council, “A
59. Lorrie Grant, “Stores with Doors Not Passé,” Policy Guide for the Internet and Electronic
USA Today, August 4, 1999. Commerce,” State Factor 25, no. 1 (Winter 1999): 5.

60. Dean Andal, Letter to the Sacramento Bee, April 77. Example taken from “If I’m So Empowered,
1999. Available on request. Why Do I Need You?”

61. National Association of State Budget Officers, 78. Ibid.
“The Fiscal Survey of States: May 1998,”
http://www.nasbo.org. 79. Figure cited in Harry Tennant & Associates,
“Sales Tax, Use Tax and Internet Transactions,”
62. “Glorious Dilemmas,” The Economist, January 1997, http://www.htennant.com/hta/askus/sales
23, 1999, p. 25. tax. htm.

63. Ernst & Young/National Retail Federation, 80. Robert J. Cline and Thomas S. Neubig,
“Internet Shopping Study: The Digital Channel “Masters of Complexity and Bearers of Great
Continues to Gather Steam,” January 1999, pp. 8–9. Burden: The Sales Tax System and Comp-

43
liance Costs for Multistate Retailers,” Ernst & 94. Dana Milbank, “For Republican Governors,
Young, September 8, 1999, http://www.ey.com/ Spending Isn’t a Dirty Word Anymore,” Wall Street
ecommerce. Journal, February 17, 1998.

81. See, for example, Shaffer v. Heitner, 433 U.S. 186 95. Dean Stansel and Stephen Moore, “The State
(1977) at 197. Spending Spree of the 1990s,” Cato Policy
Analysis no. 343, May 13, 1999.
82. Thomas W. Bonnett, “Is the New Global
Economy Leaving State-Local Tax Structures 96. John Simons, “States Chafe As Web Shoppers
Behind?” National League of Cities Report no. Ignore Sales Taxes,” Wall Street Journal, January 26,
3701, January 1998. 1999.

83. Inset Systems Inc. v. Instruction Set Inc., 937 F. Supp. 97. “Now in Session: Nevada Lawmakers Convene
161 (D. Conn. 1996); and E-Data Corp. v. Micropatent in Carson City,” Las Vegas Review-Journal, January
Corp., 989 F. Supp. 173 (D. Conn. 1997). 31, 1999.

84. See “1998 Developments in . . . ,” Connecticut 98. “Gulotta’s Fine Mess,” Newsday, February 4, 1999.
Law Tribune, December 21, 1998.
99. David Ammons, “Spending Limits Law: Still
85. For additional constitutional analyses, see Kickin’ after Five Years,” Associated Press State &
Adam D. Thierer, “Why Congress Must Save the Local Wire, January 23, 1999.
Internet from State and Local Taxation,” Heritage
Foundation Executive Memorandum no. 488, 100. Ben Wildavsky, “The Governors Are on a
June 23, 1997; and Dan L. Burk, “How State Roll,” U.S. News & World Report, February 1, 1999,
Regulation of the Internet Violates the Commerce pp. 28, 30.
Clause,” Cato Journal 17, no. 2 (1998): 147.
101. Kaye K. Caldwell, Letter in Upside, July 1999,
86. Stephen Moore and Dean Stansel, “A Fiscal p. 28. For more on CommerceNet, see http://
Policy Report Card on America’s Governors: www. commerce.net.
1994,” Cato Institute Policy Analysis no. 203,
January 28, 1994. 102. Fox and Murray.

87. Michael de Courcy and Erik Eckholm,“80’s 103. See David E. Hardesty, “Struggling to Tax
Legacy: States and Cities in Need,” New York E-Commerce,” Siliconindia, September 1998.
Times, December 30, 1990.
104. U.S. Department of the Treasury, “Selected Tax
88. For a full analysis, see Stephen Moore, “State Policy Implications of Global Electronic Com-
Spending Splurge: The Real Story behind the merce,” November 1996, http://www.fedworldgov/
Fiscal Crisis in State Government,” Cato Institute pub/tel/internet.txt.
Policy Analysis no. 142, May 23, 1991.
105. The United States leads the world by a wide
89. Stephen Moore and Dean Stansel, “A Fiscal margin in Internet hosts; installed PCs; Web sites;
Policy Report Card on America’s Governors: and spending on IT hardware, software, and services.
1996,” Cato Institute Policy Analysis no. 257, July See World Information Technology and Services
26, 1996, p. 8. Alliance, “Digital Planet: The Global Information
Economy,” Vienna, Virginia, October 1998.
90. Ibid., p. 9.
106. OECD Observer, no. 208 (October 1997): 19.
91. Stephen Moore and Dean Stansel, “A Fiscal
Policy Report Card on America’s Governors: 107. The Global Information Infrastructure
1998,” Cato Institute Policy Analysis no. 315, Commission, “E-Commerce Taxation Principles:
September 3, 1998, p. 7. A GIIC Perspective,” GIIC Focus, http://www.giic.
org/focus/ecommerce/ectax.html.
92. National Association of State Budget
Officers, “The Fiscal Survey of the States: 108. Marc Bacchetta et al., Electronic Commerce and
December 1998,” http://www.nasbo.org/pubs/ the Role of the WTO (Geneva: WTO Publications,
fiscsurv/fs1298.htm. 1998), p. 39.

93. From 1992 to 1998, state tax revenues grew by 109. Organisation for Economic Co-operation
45 percent, while population growth and infla- and Development, Harmful Tax Competition: An
tion rose by a combined 22 percent. Emerging Global Issue (Paris: OECD, 1998).

44
110. Michael Hardy and Frances Horner, more) states on the same taxpayer in respect of
“Billabongs, Dugongs, Internet and Tax,” OECD the same subject matter and for identical periods.
Observer, no. 215 (January 1999): 15.
128. Internal Revenue Service, U.S. Tax Treaties,
111. Organisation for Economic Co-operation and Internal Revenue Service Publication 901, May
Development, Harmful Tax Competition, para. 89. 1998, p. 40.

112. Arthur Cordell and Thomas Ran Ide, “The 129.Organisation for Economic Co-operation
New Wealth of Nations,” Paper prepared for the and Development, “Electronic Commerce: The
Club of Rome, November–December, 1994. Challenge to Tax Authorites and Taxpayers,”
OECD Discussion Paper, November 1997.
113. Luc Soete and Karin Kamp, “The ‘BIT TAX’:
The Case for Further Research,” Draft paper, 130. Ibid.
August 12, 1996, http://www.ispo.cec.be/hleg/
bittax.html. 131. David Hardesty, “Treasury Comments on
International Taxation of Digital Products,”
114. Cordell and Ide. November 11, 1998, http://www.mshb.com/EC/
110998.htm.
115. Soete and Kamp speculate that a bit tax would
require “the introduction of ‘bit measuring’ equip- 132. See the discussion in “Electronic Commerce:
ment on all communications equipment.” The Challenge to Tax Authorites and Taxpayers.”

116. Soete and Kamp. 133. The OECD is reportedly planning to discuss
that possibility in the forthcoming “Commentary
117. Ibid. on the Model Tax Convention.”
118. Arthur J. Cordell, “New Taxes for a New 134. Michael P. Boyle et al., “The Emerging
Economy,” Government Information in Canada/ International Tax Environment for Electronic
Information gouvernmentale au Canada, vol. 2, Commerce,” Tax Management International Journal,
no. 4, http://www.usask.ca/library/gic/v2n4/ June 11, 1999, p. 357.
cordell/cordell.html.
135. U.S. Department of the Treasury, “Selected
119. Quoted in ibid. Tax Policy Implications,” sec. 7.2.5.
120. Bacchetta, p. 41. 136. Michael R. McEvoy, “Feds Suggest Policies
for Internet Commerce,” Rochester Business Journal,
121. Judith Miller, “Globalization Widens Rich- December 13, 1996.
Poor Gap, U.N. Report Says,” New York Times, July
13, 1999. 137. Global Information Infrastructure Commis-
sion, “E-Commerce Taxation Principles.”
122. Office of the President of the United States,
“Framework for Global Electronic Commerce,” July 138. Organisation for Economic Co-operation
1, 1997, http://www.ecommerce.gov/framewrk. and Development, “Electronic Commerce: A
htm. Discussion Paper on Taxation Issues,” OECD,
September 17, 1998, para. 56.
123. “Electronic Commerce: Internet Exempt
from Customs Duties but Not from VAT,” 139. U.S. Department of the Treasury, “Selected
European Report no. 2318, May 27, 1998. Tax Policy Implications,” sec. 7.1.5.
124. Organisation for Economic Co-operation 140. Ibid.
and Development, “Dismantling the Barriers to
Global Electronic Commerce,” OECD Discussion 141. Walter B. Wriston, “Dumb Networks and
Paper, September1997, http://www.oecd.org// Smart Capital,” Cato Journal 17, no. 3 (1998): 342.
dsti/sti/it/ec/prod/dismantl.htm.
142. For an example of an online casino located in
125. For a more complete discussion of this prob- a tax haven, see http://www.omnicasino.com.
lem, see Bacchetta, p. 50.
143. See McLure.
126. Ibid., p. 33.
144. For example, according to the United
127. Double taxation is defined by the OECD as Nations Development Project, “Human
the imposition of comparable taxes in two (or Development Report 1999,” South Asia has 23

45
percent of the world’s population but less than 1 Commerce: Taxation and Planning (New York:
percent of the world’s Internet users. Warren Gorham & Lamont, 1999). For more
information, see http://www.ecommercetax.
145. Bacchetta, p. 15. com.
146. Organisation for Economic Co-operation 163. “Electronic Commerce: Commission Sets
and Development, Harmful Tax Competition, para. Out Guidelines for Indirect Taxation,” EU Busi-
137. ness, June 17, 1998, http://www.eubusiness.com/
finance/980617co.htm.
147. Organisation for Economic Co-operation
and Development, “Electronic Commerce: A 164. Quoted in Hardesty, “Treasury Comments
Discussion Paper on Taxation Issues,” para. 57 on International Taxation of Digital Products.”
148. Joseph Guttentag, Testimony before the 165. See Article 12 of the OECD Model Treaty,
Advisory Commission on Electronic Commerce October 1998.
(independent commission), Williamsburg, Vir-
ginia, June 22, 1999. 166. “Classification of Certain Transactions
Involving Computer Programs,” Internal Revenue
149. April 1998 Forrester Research cited in Boyle. Service Prop. Reg 1.861-18.
150. Bacchetta, p. 33. 167. For a more detailed discussion of VAT place
of supply rules, see Organisation for Economic
151. Australian Taxation Office Electronic Co-operation and Development, “Dismantling
Commerce Project Team, “Tax and the Internet,” the Barriers to Global Electronic Commerce,”
Discussion Report, August 1997, p 85. paras. 58–68.
152. Graeme Ross, “The Revenue Net and the 168. Global Information Infrastructure Commis-
Internet,” Times (of London), October 8, 1998. sion, “E-Commerce Taxation Principles.”
153. Statistics cited in Boyle. 169. McLure used this phrase to describe the con-
sequences of taxing sales at their origin (testimo-
154. “Electronic Commerce and Canada’s Tax ny before the Advisory Commission on Electronic
Administration: A Response by the Minister of Commerce on June 22, 1999).
National Revenue to His Advisory Committee’s
Report on Electronic Commerce,” Ottawa, 170. “Consumption Tax Issues Briefs,” Fun-
September 1998, pp. 15–16. damental Tax Reform, Deloitte & Touche LLP, 1996,
http://www.dtonline.com/TAXREF/trissue.
155. Nick Huber, “Taxation; Euro VAT ‘Not Fit for htm.
Web Age,’ ” Accountancy Age, May 13, 1999, p. 4.
171. Tino Eggermont, “The Commission’s Work
156. Organisation for Economic Co-operation Programme for the Gradual Introduction of the
and Development, “Electronic Commerce: A New Common VAT System,” European Commis-
Discussion Paper on Taxation Issues,” para. 42. sion, 1998, http://www.ecu-activities.be/1998_2/
eggermont.html.
157. For example, the Australian Tax Office dis-
cusses that possibility in “Tax and the Internet.” 172. The National Gambling Impact Study
Commission, Final report, http://www.ngisc.gov.
158. Richard Baron, “Cyberspace’s New Tax For an analysis supporting the legalization of
Conundrum,” Accountancy Age, November 12, 1998. Internet gambling, see Tom W. Bell, “Internet
Gambling: Popular, Inexorable, and (Eventually)
159. Fox and Murray. Legal,” Cato Institute Policy Analysis no. 336,
March 8, 1999.
160. Elinor Harris Solomon, Virtual Money (New
York: Oxford University Press, 1997), p. 70. 173. For more information, see Solveig Singleton,
Testimony before the House Banking and Finan-
161. Organisation for Economic Co-operation cial Services Committee on the Bank Secrecy
and Development, “Electronic Commerce: A Act and Privacy Policy, 106th Cong., 1st sess.,
Discussion Paper on Taxation Issues,” para. 66. April 20, 1999, http://www.cato.org/testimony/
ct-ss042099. html.
162. The idea of blocking Web pages for tax col-
lection purposes was suggested to me in an e-mail 174. Christine Sanderson, “Taxing a Borderless
exchange with David Hardesty, author of Electronic World,” International Tax Review 10, no. 1

46
(December 1998–January 1999): 35. and Development, “Electronic Commerce: A
Discussion Paper on Taxation Issues,” para. 33.
175. For an analysis of how the suppression of digi-
tal cash could impede the growth of electronic com- 177. David Post, “E-Cash: Can’t Live with It, Can’t Live
merce, see Eric Hughes, “Effects of the Regulatory without It,” American Lawyer, March 1995, p. 116.
Suppression of Digital Cash,” in Economic Casualties,
ed. Solveig Singleton and Daniel T. Griswold 178. Richard Rahn, “The New Monetary Universe
(Washington: Cato Institute, 1999), pp. 63–75. and Its Impact on Taxation,” in The Future of
Money in the Information Age, ed. James A. Dorn
176. Organisation for Economic Co-operation (Washington: Cato Institute, 1997), p. 84.

47
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