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Internet Taxation: Which Side Are You On?
The emerging online marketplace has generated debate over the taxation of transactions on the Internet. Policymakers and other stakeholders deliberate on whether cyberpurchases should be subject to the same sales taxes levied on brick-and-mortar retailing. 

by Isabel M. Isidro
Managing Editor


As business activity on the Internet surges, can Uncle Sam be far behind?

The emerging online marketplace has generated debate over the taxation of transactions on the Internet.  Policymakers and other stakeholders deliberate on whether cyberpurchases should be subject to the same sales taxes levied on brick-and-mortar retailing.  At present, online buyers pay no sales taxes. However, the supersonic growth of the sale of goods over the Internet shows that there's plenty of money at stake, and government is scrambling to take part of the sweet Internet pie.

The Government has imposed a 3-year moratorium on any new Internet taxes set to expire in 2001. Pundits, however, say that the Internet’s days as a no-tax zone are numbered.  Outlined below are the key arguments for and against taxation of sales on the Internet.

What's at Stake?

E-commerce is defined as all the commercial transactions that take place over the Internet, including retail sales of products and services, advertising, and business-to-business commerce. For the fourth quarter of 1999 alone, official government estimates show that the U.S. retail e-commerce sales amounted to $5.3 billion, accounting for a miniscule but growing share of the total retail sales estimated at $821.2 billion for the quarter. A January 2000 study by Ernst and Young estimated that 39 million people shopped online in 1999, up from 17 million in 1998.

Certainly, the growth potential of e-commerce is great, as the number of people connected to the Net increases. As of February 2000, NUA estimates that 275.5 million worldwide are online. Forrester Research, on the other hand, estimates that 56.3 percent of households in the U.S. alone will be on the Internet in 2003.

Consumer shopping online is also quickly gaining acceptance worldwide. The Direct Marketing Association says online sales will reach $31.1 billion in 2004 compared with $75.5 billion in catalog revenue, while a few others believe that Internet revenue will surpass catalog revenue by 2004. Though figures and estimates vary widely, one thing is clear: electronic commerce will grow to account for hundreds of billions of dollar a year in sales. E-commerce is poised to take off as consumers take advantage of comparison shopping, niche markets, and, importantly, the tax-free status of goods bought and sold over the Internet.

The debate over Internet taxation started several years ago, when Internet was at its earliest stages. In 1998, the U.S. Congress passed the Internet Freedom Act, which imposed a 3-year moratorium on new Internet taxes. Presently, states can still tax income earned through Internet service providers. States can also apply local business license taxes to a service provider when it is located in the same jurisdiction, and collect sales taxes on products bought over the Internet, if the taxes are imposed in the same manner as taxes on mail order products. The Internet Freedom Act also set up the National Advisory Commission on Electronic Commerce to recommend a course of action for Internet taxation. Pressure is on this group right now, as they must come to a decision by April 21, 2000, whether or not to recommend taxing Internet commerce.

In one side of the fence . . .

E-commerce growth will produce sales-tax numbers that are simply too large to ignore. Due to Internet’s income generating potential, state and local policy makers are hard-at-work opposing any limits on their efforts to reap revenue from the Internet for their treasuries. These groups want to stop the loss of tax revenue through remote sales of items over the Internet and are pushing for a variety of changes to the current tax codes.  The main reason put forward is that the increased acceptance of online retailing could potentially decrease the tax coffers of cities and states.  The potentially taxable e-commerce events include access to the Internet; digitized services sold on the Internet; and tangible goods and services sold on the Internet. 

Advocates claim that America's tax-free e-commerce really amounts to mass tax evasion.  Citing a similar struggle with the mail order industry, they argue that states lose $4 billion in sales taxes annually from catalog sales since states, cities and counties lack the authority to capture sales taxes on catalog sales if the mail-order business is headquartered out of state.

They are concerned that electronic commerce will result in the loss of even more revenue; estimated at more than $10 billion per year by 2003.  The loss of tax base will impair the ability of state and local governments to improve education, roads, public safety, health, low-income housing, and many other essential services. They project that exempting online purchases from taxes could result in 200,000 fewer teachers and police officers across the nation. Either citizens learn to live with a deterioration of these services or they must swallow higher state income and property taxes. Thus, it is up to government to impose a big tax bite on Internet sales to even the odds.

Should the call for Internet taxation fail, some state and local officials have argued that they may be forced to raise other taxes to make up for lost revenue. Or request the federal government to cover for the budgetary shortfall. Sales taxes account for up to 40 percent of state revenues.

Another important argument put forward by pro-tax supporters us the alleged unfair advantages Internet has over traditional retailers. Exempting “e-tailers'' from sales taxes is said to give them a competitive advantage over regular retailers. They point that there is no fundamental reason to provide favored treatment to online transactions over similar types of transactions offline. Since other services that are important to the growth of the economy are taxed, there is no reason to favor Internet access and e-commerce. Thus, calling for the imposition of tax on all Internet sales would ensure the protection of two things: the revenue base, as well as “Main Street” businesses. 

To counter claims that taxing Internet will stunt its growth, the pro-tax side cite the 1999 study by CIO Magazine that 71 percent of consumers say they would e-shop the same amount if Internet taxes were applied. Sixty percent of respondents to a survey by the National Association of Counties and U.S. Conference of Mayors favor the collection of sales taxes on goods acquired through Internet retailers.

. . . and on the Other Side

Opponents fear that the imposition of taxes would slow the growth and opportunity of e-commerce, just before it fully gains a foothold among consumers. They fear that introducing taxes now might seriously impede the Internet’s growth at a critical stage of early development. Extending the moratorium will enable e-commerce, which is relatively new and emerging industry, a chance to develop without the market distortions caused by a haphazard tax structure.

The anti-tax camp argues that the Internet, by its very nature, cannot be regulated or controlled. Policymakers and businesses opposed to Internet taxes argue that the Internet should remain a "global free trade zone," unencumbered by overlapping and discriminatory taxes imposed by the country's 30,000 taxing jurisdictions.  However, if taxes are imposed on Internet commerce, this zone of freedom and opportunity will become enmeshed in government bureaucracies. 

According to research by Austan Goolsbee, an economics professor at the University of Chicago Graduate School of Business, sales of merchandise on the Web could plummet if consumers were forced to pay sales taxes. After examining the purchasing habits of 25,000 online users, Goolsbee estimated that one in four would stop buying on the Web if the sales were taxes in a way similar to those in conventional retail settings, resulting in a 30% drop in online spending. Online buyers are "highly sensitive" to taxes, says Goolsbee, with many of them residing in high-tax areas of the country."

A similar study by the National Bureau of Economic Research in 1999 concluded that applying existing sales taxes to the Internet would slash the number of online buyers by 25 percent and reduce online purchases by 30 percent or more, thereby damaging one of the leading sectors of today's booming economy. A December 1999 study by BizRate.com also showed that nearly 60 percent of consumers would make fewer purchases if they had to pay a sales tax on all Internet purchases.  The tax issue, according to the BizRate.com’s Flash Survey study, would have a greater negative impact on foreign merchants, as 30 percent of the respondents indicated that they would never buy from an online foreign merchant if they had to pay tariffs on online purchases.

Another important contention is the fact that the Internet is inherently non-geographic.  As Representative Chris Cox, author and sponsor of the Internet Tax Freedom Act said: "The decentralized nature if the Internet makes it impossible to establish the precise geographic route or endpoints taken by any single transmission. This makes every Internet transmission vulnerable to multiple taxation that could stop this rapidly growing medium in its tracks."  Although state and local governments enjoy a significant amount of freedom in determining their tax policies, their tax discretion does not extend beyond their geographic boundaries.

Taxing the Internet may also drive away the dot.coms to locations that do not tax them, if we impose taxes that reduce their business. Many of the companies that engage in commerce over the Internet do not have to be physically located in the United States. An exodus of e-commerce companies could impact the growth of Internet-related jobs, a loss that could hurt the economy.  Other opponents argue that compliance with the thousands of differing local tax rates, would be unduly burdensome on out-of-state companies, especially for small businesses or for sellers of information goods that are delivered online and often do not even have a customer’s mailing address.

Some argue that the Internet stimulates purchases at retail stores and through catalogs. One study found that consumers spent $3.3 billion on Internet retail sales in 1997. But they spent more -- $4.2 billion - buying goods and services elsewhere after getting product information online.

What’s the Verdict?

The fate of Internet taxation – whether to prevent blanket taxation, enact a taxpayer alternative plan, or impose the full gamut of taxes – is still unknown.  By April 2000, the Advisory Commission must recommend the best approach to taxation of sales over the Internet.  Should sales over the Internet receive preferential treatment given the fledgling nature of e-commerce and its essential role in the prosperity of the U.S. economy? Or should Main Street be given a chance to compete against cyber-malls and local governments be able to add online sales to their tax bases?

Is the taxman coming on the Internet?  


As of November 28, 2001, President Bush renewed a ban on Internet taxes, ensuring that the country's 130 million Internet users will not face new taxes for at least another two years. Bush said the legislation which he signed into law would ''ensure that the growth of the Internet is not slowed by additional taxation and that holiday shoppers will not be burdened by new taxes on their online purchases.'' Congress passed the original ban in 1998 to prevent states and local governments from imposing new taxes that might discourage growth of the new medium.