Some Policy Perspectives on the Taxation of Cyberspace

Address to the Federalist Society, Silicon Valley Lawyers Chapter and Corporations Practice Group

Palo Alto, CA

Date:
By: 
Orson Swindle, Former Commissioner

It is a pleasure to be with you this evening. As is always the case for Federal Trade Commissioners, it is important for me to note that my comments today are my own and in no way represent the views of the Commission or of any other Commissioner.

Before addressing the topic of Some Policy Perspectives On The Taxation Of Cyberspace, it might be helpful to share with you some personal thoughts gained from my years of experience as a federal official. First and foremost, our Founding Fathers had it right: government should play only a minimal role in our lives. I believe it was Will Rogers who once observed: AAll government programs have three things in common: a beginning, a middle, and no end."

I mention this because the promises of electronic commerce have those in government excited: the politicians see something to tax and more money to spend, and the regulators see something with endless possibilities to regulate. In their emotion, I fear they will forget some basic rules of a society built upon private enterprise.

Given the tremendous benefits that typically flow from private markets, government intervention in these markets should be undertaken only when it is clearly necessary. We in government, responsible for regulation and for economic and tax policy, should be ever mindful of the Hippocratic Oath -- "First, do no harm." Before embarking on any type of government activity, asking ourselves, "Does this make sense?" might serve us all well.

Taxation is a form of regulation. The history of taxation seems to be that every time a new product, a new industry, a new form of social organization, or even a new economic concept of income or wealth has arisen, governments have moved to tax it. As President Reagan said, AThe government=s view of the economy could be summed up in a few short phrases: If it moves, tax it. If it keeps moving, regulate it. And if it stops moving, subsidize it.@

The Internet Economy

Earlier this year, the University of Texas, backed by Cisco Systems, introduced a study of the current status of electronic commerce -- one of the very first attempts to measure the Internet economy. According to the UT/Cisco study, the Internet economy generated an estimated $301 billion in revenue in 1998 and was responsible for over 1.2 million jobs. Last week the authors of the study projected that the Internet Economy will grow to $507 billion this year and produce over 2.3 million jobs. That=s a projected 67% and 46% increase respectively in one year my friends. (These estimates are based on worldwide sales of Internet-related products and services by U.S.- based companies.)

Let me put those figures in perspective. In 1998, it meant that the Internet economy was the second largest industry in the United States, second only to the automobile industry at $350 billion. For 1999, if the projections hold, it means the Internet Economy has become the largest industry in our country. And what is even more impressive is that the Internet is still in its infancy. Recall that the browser programs, such as Netscape, which make the Internet so consumer-friendly did not arrive on the scene until 1993.

The Question To Consider

As you may know, I spoke before the inaugural meeting of the Advisory Commission on Electronic Commerce this past summer. The question I posed that day is worth repeating today. AShould policymakers apply a Depression-era tax system to the economy of the 21st Century@? The answer to that question will have an enormous impact on economic growth -- the creation of wealth, jobs and prosperity -- throughout our country and the world. The question of imposing new taxes on the Internet is more than just an ideological debate. The economic consequences of government actions in e-commerce will be profound and serious. Any missteps will injure our country gravely, and diminish our position as the leading world economy.

The Internet is a competitive advantage for the United States: more than one-third of all current Internet usage is by Americans. The Internet advances the causes of free trade and improvement of living standards by creating a comparative advantage for people and firms that produce competitive, high-quality services and goods. Internet-specific taxes and taxes on Internet access threaten to choke the Internet at a critical early stage of its development. Unwarranted taxes and regulation at a time when the technology is still rapidly evolving threaten to lock in or limit the Internet to specific technologies and modes of service that fall far short of its likely potential. Tomorrow=s tax policy will have an enormous impact in shaping the future of this burgeoning new industry of electronic commerce supported by the Internet.

The Complications of Taxing Internet Commerce

The issue of taxing the Internet is complicated by several factors:

The Internet is inherently susceptible to multiple and discriminatory taxation in a way that commerce conducted in more traditional ways is not. With approximately 30,000 taxing jurisdictions, compliance becomes a significant obstacle. Double taxation would be inevitable because the borderless nature of the Internet makes taxation very tricky. If we simply required that merchants collect the relevant tax for the jurisdiction into which the product is being delivered, such legislation would produce a world that is anything but Asimple.@

Can you imagine the confusion that would arise in the case where a small business owner from New Hampshire (a state without sales tax) is required to collect the tax on a purchase made by a consumer living in the Dallas area-- a metropolitan area with numerous suburbs, several of which have different local sales tax rates, in addition to Texas state tax? Or even more bizarre, consider Internet sales of shoes-- a product that is tax exempt in some states but not others, depending on such factors as whether the footwear in question is tennis shoes, sneakers, or cleated athletic shoes.(1)

How can we know how to tax it? Since Internet commerce is so new, we do not know what the basic business model will look like in a few years. There are likely many adverse unintended and unanticipated consequences lurking in the future.

How would the taxes be collected? One of the main benefits of Web-based businesses is that the ability to reach such a large potential universe of customers cheaply provides an opportunity for small one- and two-person companies to thrive without a tremendous amount of start-up capital. The cost of compliance and tax collection alone for these small businesses could be enough of a deterrent to keep them from participating in the marketplace.

Clearly, compelling retailers to collect tax under the current jurisdictional regime would place a significant burden on merchants; and such a burden would likely not be uniformly felt across all retailers. If a recent study by the Washington State Department of Revenue is any indication of things to come, small businesses would be hit hardest with respect to the costs of compliance with multi-jurisdiction tax rates. More specifically, a recent study by one of the Big 5 accounting firms, Ernst and Young, has estimated the costs of compliance of small businesses to be close to 87 percent of the sales tax they collect--a far greater percentage than the 14 percent of the tax collected that it would cost large businesses to comply. While these costs might be eased by employing various software packages, such software can cost well over $ 20,000.(2)

In a time where technology finally makes it possible for virtually anyone to realize the American Dream by starting out on his or her own and creating a business from scratch, do we really want to place one more barrier to entry in the form of heavy compliance costs in front of these potential entrepreneurs that might otherwise fuel our economy?

Who has taxing and regulatory jurisdiction? Identifying the state, country or countries that have tax jurisdiction over income generated by electronic transactions may be a problem with no solution. Electronic commerce permits a foreign person to engage in multiple business transactions with customers in the United States without ever having entered the country.

And lastly, what about personal privacy? Do we want to enact a taxation scheme that, to be effectively implemented, will likely have to systematically undermine our privacy by amassing a comprehensive database of our online purchases so that some government agency can be certain that we paid our relevant taxes? What guarantees do we, as consumers, have that such an agency, upon learning of our buying habits, will not either sell that valuable information to third parties or use it in a way that undermines our personal security?

The Lost Revenue Argument

Throughout this debate on taxing Internet use and commerce, the argument has often focused on the claim that failing to create a suitable Internet commerce tax will lead to the steady decline of state revenues, perhaps as much as $20 billion a year, significantly hindering the development of state infrastructure.(3) While such arguments conjure up a frightening vision of what could occur, are such predictions accurate? Another recent study by Ernst and Young has shown that less than $170 million of sales and use tax were not collected in 1998 on Internet sales -- only 1/10 of one percent of total state and local tax revenues. This small effect is due to a number of factors, two of which should be noted. First, an estimated 80 percent of current e-commerce is business-to-business sales that are not subject to sales and use taxes. Second, an estimated 63 percent of current e-commerce business-to-consumer sales are services such as travel and financial services that are not subject to state and local sales and use taxes.

These estimates are similar to another study by scholars at the University of Chicago and Harvard who have estimated the loss to be close to 1/4 of one percent.(4) Considering the future growth of electronic commerce, these scholars have predicted that even after five years, the average loss in sales tax revenue to states will amount to only two percent of potential tax revenues. This is a mere fraction of the $20 billion loss that has been predicted by the proponents of Internet taxation.(5) Is retaining this minor loss in tax revenue worth crippling potential entrepreneurs as they strive to find a place for themselves in this dynamic new marketplace?

Those advocating taxation of the electronic marketplace are also operating on the basis of expectations: they are hungrily anticipating revenue to spend as a result of taxes collected on new products or services. What they may lose sight of, however, is that inappropriate government intrusion in the form of regulation and taxation may in fact chill the development and marketing of new products and services.

Recommendation

Let me offer a proposal that I favor for your consideration. Senator John McCain has introduced legislation to permanently ban Internet sales taxes by specifically outlawing any future attempts to impose a sales tax structure on Internet sales. In addition, Senator McCain=s bill calls for WTO adoption of a global moratorium on Internet taxes. As Senator McCain said on the Senate floor, AThis bill would make permanent the moratorium on sales and use taxes for e-commerce, and would encourage the Administration to urge our world trading partners to do the same.@

I could not agree more with Senator McCain. While some Members of the Advisory Commission on Electronic Commerce seem more focused on how to tax the Internet, only Congress can authorize one state to compel sellers in another state to collect Internet taxes. It is important to move forward to ensure that the default position is not to lift the moratorium on Internet taxation, but to place the burden of proof on those advocating taxation of e-commerce that new taxes are a good idea.

Thank you.

Endnotes:

1. Both of these examples were taken from Cline, Robert J., and Thomas S. Neubig. AMasters of Complexity and Bearers of Great Burden: The Sales Tax System and Compliance Costs for Multistate Retailers,@ Ernst and Young Economics Consulting and Quantitative Analysis, September 8, 1999.

2. Harry Tennant and Associates, (1997), ASales tax, use tax and Internet Transactions@ cited in Lukas, Aaron, ATax Bytes: A Primer on the Taxation of Electronic Commerce@ (CATO Institute, typescript, 1999).

3. The estimate of $20 billion has been offered by the National Governors= Association. AGovernors fear tax loss from Internet; States= surpluses treated cautiously,@ Boston Globe, December 31, 1998.

4. Cline, Robert J. and Thomas S. Neubig, AThe Sky is Not Falling: Why State and Local Revenues Were Not Significantly Impacted by the Internet in 1998," Ernst and Young Economics Consulting and Quantitative Analysis, June 18, 1999 Cline and Neubig have offered the figure of 1/10 of one percent loss. (Goolsbee, Austin and Jonathan Zittrain, AEvaluating the Costs and Benefits of Taxing Internet Commerce@( University of Chicago Graduate School of Business, typescript 1999.) have estimated the loss to be closer to 1/4 of one percent.

5. Goolsbee and Zittrain, supra n. 4.