The Fundamental Internet Tax Debate

The growing debate on taxing electronic commerce (e-commerce) underscores the obsolescence of our current federal and state tax systems and the need to fundamentally overhaul them. Properly taxing the commerce resulting from rapidly changing technology is a special challenge to a federal form of government with a national tax structure and 50 state tax systems, which at times can overlap and compete.

Moreover, the problems that result from trying to tax e-commerce via a traditional transaction-based sales tax also underscore the continuing shortcomings of the existing income-based tax structure. Thus the perennial (and accurate) criticism that the current Internal Revenue Code is convoluted should serve as a constant reminder to avoid making federal--as well as state--tax structures even more complex.

The current focus on e-commerce taxation also brings up the larger question of how to deal with the major economic inadequacy of the dominant income tax--the heavy tax burden on saving in an economy that generates so little of the saving necessary to finance the nation's investments. If the conventional--and admittedly regressive--sales tax is not up to the task of efficiently collecting revenue from e-commerce, what alternative is available?

Putting aside the intricacies that inevitably accompany any major tax legislation, what is needed is a modern tax system that can both relate effectively to the dynamic and global economy of the new century while meeting the needs of federal and state governments, and support progress toward a high-tech Internet-oriented society. This is a tall order and some analysis is necessary to develop a workable and fair response.

Taxing Cyberspace

Should the tax collector simply ignore the special characteristics of e-commerce, specifically Internet transactions? Surely trying to subject sales on the Internet to conventional sales taxes will run into practical problems, such as the ability of businesses to shift transactions across state lines and national boundaries. These obstacles to the work of the sales tax collectors of today stem from the continually advancing technology used by this new form of marketing and its complex interaction with numerous governmental rules and regulations.

Using income and estate tax experience as a guide, taxpayers can expect a substantial expansion in the existing regulations issued by state tax systems facing companies doing business in a variety of states. It seems unlikely that state legislatures will be able to design sales taxes that effectively and fairly cover e-commerce. The standard response--merely adding complexity to the existing tax structure--is neither efficient nor sustainable in the case of rapidly changing technology.

Another concern has been raised by the high-tech community. Taxing business on the Internet during its formative period could reduce the prospects for its ultimate widespread use. Although the infant industry argument has been abused over the centuries, it is not totally without merit. In view of the cross-border nature of e-commerce, a race by state governments to maximize their revenues from this new economic activity will be particularly disruptive.

Taxing e-commerce can be viewed differently--that is, from the viewpoint of the taxpaying business. On reflection, it does seem unfair to base the decision to tax a purchase solely on whether it is made through a conventional sales outlet. Bricks-and-mortar retailers have a point when they object that their electronic competitors enjoy a lower tax burden. On average, sales taxes generate one-third of a state's total revenue. Therefore, if a rising portion of business transactions is exempt from existing sales taxes, state governments will attempt to meet their revenue needs by taxing other businesses and individuals more heavily. It is cavalier to ignore these concerns.

There is a way out of this dilemma. It requires a critical examination of the government's entire revenue structure. The controversy over the tax status of e-commerce provides an excellent opportunity to consider tax policy more broadly. The shortcomings of the existing U.S. revenue system [End Page...