Rush to Tax Could Produce Net Loss

Rush to Tax Could Produce Net Loss

November 23, 1999

In the great Kurosawa Akira movie, The Seven Samurai, a bandit gang rides to a hillside and looks down on a small village. One of the bandits urges that they ride down immediately to rob, rape, and pillage. He is restrained by the leader, who argues for patience. The rice is not yet ripe, he notes, wait until the harvest and then we’ll attack.

Certainly, the governments of the world–not to mention America’s various state governments and municipalities–should display at least this level of restraint when it comes to levying taxes on the Internet. Electronic commerce is the most dynamic sector of the world’s economy.

By eliminating space and time, electronic commerce has the potential to drastically reduce transaction costs, that is, the costs incurred in bringing buyers and sellers together. This technology offers great hope of expanding wealth and choice for all mankind. That hope is perhaps greatest for the developing world because informational technologies do not require the massive investments necessary for earlier technological revolutions. The anonymity offered by this technology offers special hope to those oppressed groups throughout the world most threatened by loss of civil and economic liberties. The Internet is a truly democratizing technology.

Or, that is, it may be. These potential gains are threatened by the concerns of political jurisdictions in the United States and abroad that this new form of commerce will increase the difficulty of collecting a range of current taxes. We must, some argue, impose taxes on electronic commerce–lest our tax system suffer undue “leakage.”

But before acting based on how the Internet might affect taxation, we should consider how taxation would affect something as new, revolutionary, and dynamic as the Internet.

In scope and scale, it is changing daily. There are constant changes in the way the industry is structured, the way information is formatted and transmitted, the way transactions are created and financed, the way individuals ensure that a sale will go forward and that their privacy will be protected. These and a myriad of other key features are in flux. Any effort to assert political control–whether by regulation or taxation–over such rapidly changing activities is fraught with difficulty.

And while some small group of brilliant individuals arguably might be able to design a system that could achieve reasonable and equitable taxation of these activities, it is highly unlikely that such individuals would seek employment as civil servants in the tax bureaucracy. To seek to impose the rigidities of a tax system on this most dynamic part of the world economy is foolish. Where taxes should be levied, how we would monitor compliance, what record keeping would be required, how sales links would be followed–these and other questions suggest that restraint is wise when it comes to the Internet.

Whatever the wisdom of eventually imposing taxes on electronic commerce, it is clear that we should wait until this sector matures and stabilizes. To do otherwise is to build implementation castles in the sand. Applying yesterday’s tax policies to today’s growth industries can only endanger the hopes of a better tomorrow.

One argument routinely put forth by opponents of the move to spare this fledgling industry from strangling taxation is that what we really need is a harmony among tax systems with regard to the Internet–rather than subjecting the Internet to dozens, hundreds, thousands of different taxes and levies from who knows how many government entities, let’s construct a uniform tax system which is efficient and fair.

This argument reminds me of my early work on pollution taxes, when an older analyst suggested I be wary of accepting uncritically the virtues of “efficient” taxation, that is, taxes that minimize the deadweight losses of revenue collection. His point was that such “painless” taxes (those that minimally affected choice) would be raised far too easily by politicians, increasing the overall burden and, therefore, acting as a drain on society. In contrast, a tax that was costly to collect and readily avoided would rarely be raised, reducing the threat to economic growth. Internet taxes are bad taxes on both grounds.

The broader point here is that harmonization of tax policy is not necessarily good policy. Competition is useful in the marketplace, but it is perhaps even more valuable in the political world. Irrational and counter-productive taxing policies are not uncommon.

The flexibility the Internet offers to move capital and economic activities around the globe makes it possible to sharpen those disciplining influences. There has always been great value in encouraging more responsible political action and this has become even more critical in a global economy.

If governments are concerned about the “tax avoidance” made possible by this technology and by other forms of remote sales, then they should re-consider their overall tax systems. The Internet itself is still in an embryonic state. To impose static laws on this dynamic sector can only reduce the gains possible from this innovation.

Fred L. Smith, Jr., is President of the Competitive Enterprise Institute.