Should Policymakers Apply a Depression-Era Tax System to the Economy of the 21st Century?

Remarks at theÊ Policy Perspectives on the Taxation of Cyberspace Conference on E-Commerce:The Law of E-Business

Denver, CO

Date:
By: 
Orson Swindle, Former Commissioner

It is a pleasure to be with you this morning. As is always the case for a Federal Trade Commissioner, 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 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

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 $507 billion in revenue in 1999 and was responsible for over 2.3 million jobs. These estimates are based on worldwide sales of Internet-related products and services by U.S.- based companies and represent a one year increase of 67% in revenue and 46% increase in job growth over the 1998 numbers.

Let me put those figures in perspective. The Internet economy has become the largest industry in our country eclipsing the automobile industry which stands second at $350 billion. 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

In October 1998, President Clinton signed the Internet Tax Freedom Act which granted a three-year moratorium prohibiting new taxes on the Internet and called for the creation of the Advisory Commission on Electronic Commerce (ACEC) to study the issue and make recommendations to Congress in April, 2000. I was invited by Governor Gilmore of Virginia, the Chairman of the ACEC , to speak before the inaugural meeting of the group in June 1999. 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 issue has been framed by some to suggest that the Internet economy is getting a free ride from taxes--instead of enjoying the Constitutional freedom of interstate commerce. 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 Atlanta area -- a metropolitan area with numerous suburbs, several of which have different local sales tax rates, in addition to Georgia 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 1999 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 1999 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)

My good friend Frank D'Urso sells his mother's gourmet Italian sauce through his website, www.Italianfoodstore.com. In a time where technology finally makes it possible for Frank or virtually anyone to realize the American dream by starting a small business, 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? I worry that states could demand more information about individuals' purchases in order to tax them without offering meaningful protection for that information.

The Lost Revenue Argument

Government has become the ultimate special-interest lobby, always arguing for more government. 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? According to Forrester Research, state and local governments did not collect $525 million in sales taxes in 1999 due to consumer's purchases over the Internet. A study of 1998 data by Ernst and Young indicated that less than $170 million of sales and use tax were not collected on Internet sales. In both studies, the "lost" revenue represents less than 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 ¼ 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.

The Advisory Commission on E-Commerce

The bipartisan commission sought to examine all sides of the Internet taxation issue but in the end was able to achieve only a simple majority for most of the items upon which it voted. The Commission last month recommended:

  • extending the current moratorium on multiple and discriminatory taxation of electronic commerce for and additional five years through 2006;
  • eliminating the three-percent Federal excise tax on telecommunications services originally enacted in 1898 to pay for the Spanish-American War;
  • prohibiting the taxation of digital goods over the Internet thereby preventing the slippery slope of taxing all services, entertainment and information in the economy;
  • making permanent the current moratorium on Internet access taxes, including those grandfathered under the Internet Tax Freedom Act of 1998;
  • establishing "bright line" nexus standards for American businesses engaged in interstate commerce;
  • placing the burden on states to simplify their sales and use tax systems;
  • continuing to press for a moratorium on any international tariffs on electronic transmissions over the Internet; and
  • and last but certainly not least from my perspective--respecting and protecting consumer privacy in crafting any laws pertaining to online commerce generally and in imposing any tax collection and administration burdens on the Internet specifically.

Responses

On his first day back from the campaign trail Sen. McCain introduced S. 2255 to amend the Internet Tax Freedom Act to extend the moratorium through 2006. Representative Chris Cox introduced a similar bill, H.R. 3709, the Internet Non-Discrimination Act. The Cox bill also strips out the grandfather clause that had permitted a handful of states to continue to tax Internet Access. The National Governors' Association introduced a plan to allow state and local governments to collect sales taxes from out-of-state web merchants. Senators Gregg and Kohl introduced S. 2401, the New Economy Tax Simplification Act allowing state and local governments the ability to tax Internet sales if merchants have a "substantial physical presence" in their jurisdictions.

Legislative Outlook

Their seems to be momentum in Congress for dealing this year with three specific recommendations made by the E-Commerce Commission while avoiding the more controversial sales tax issue including nexus and remote sales. The House of Representatives voted Wednesday to extend the moratorium on new taxes applying to the Internet for another five years. There appears to be strong support for legislation permanently banning any tax on Internet access and repealing the three percent telephone excise tax. Even though there are less than 40 legislative days left in this Congress, I expect all three of these bills will pass the House this year. Senate action is less certain.

Conclusion

In his closing remarks at the final meeting of the E-Commerce Commission, Governor Gilmore answered part of my original question by speaking to the role of government. He said, "The 21st Century offers the promise of smaller, more efficient government. The Internet changes everything--including government. Government at all levels must now begin to harness the efficiencies and productivity increases facilitated by information technology and the Internet. Free enterprise is doing it. Government must do it too."

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.