Don’t Tax the Net: Fred Smith in Economic Affairs

Published in Economic Affairs, the journal of the Institute of Economic Affairs<?xml:namespace prefix = o ns = “urn:schemas-microsoft-com:office:office” />

Edited by Julian Morris

Volume 20, No. 1

March 2000


The Internet is one of the most promising developments in the world economy. Electronic commerce, by eliminating space and time, has the potential drastically to reduce transaction costs, that is, the costs incurred in bringing buyer and seller into agreement.  It offers great hope for the expansion of wealth and choice for all mankind.  That hope is perhaps greatest for the citizenry of the developing world because information technologies do not require the massive investments that were necessary for earlier technological revolutions. Amongst other possibilities, the Internet opens the way for an Indian or a Chinaman to compete directly in the American labour market without ever leaving India or China. The anonymity offered by the Internet also offers special hope to those pariah groups throughout the world who are today most threatened by loss of civil and economic liberties.  The Internet is a truly democratizing technology.


Or rather, it has the possibility to 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, they argue, impose taxes on electronic commerce – lest our tax system suffer undue “leakage.”  This article is an attempt to address those concerns.


Taxing “Frontier” Sectors is Foolish

As I write this article, I recall the opening scene from the great Kurosawa movie, The Seven Samurai. In that scene, a bandit gang rides to a hillside and looks down on a small village; one bandit urges that they ride down immediately to rob, rape and pillage; but he is restrained by the leader, who argues for patience. The rice is not yet ripe, he notes, wait till the harvest and then we’ll attack.


Certainly, the governments of the world should display at least this level of restraint. The world of electronic commerce is the most dynamic sector of the world’s economy. In scope and scale, this field is changing daily. Changes in the way the industry is structured, information is formatted and transmitted, the way in which exchanges are created and financed, the way in which individuals ensure that an exchange will go forward, that their privacy will be protected. All these and a myriad number of other key features of this emerging industry 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 one might conceive that some small group of brilliant individuals might be able to design a system that would 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. Amongst other things, it is not clear where such a tax should be levied, how compliance would be monitored, what record keeping would be required, or how sales links would be followed. For these and myriad other reasons, restraint is wise in the area of taxing the Net.


Whatever the wisdom of eventually imposing taxes on electronic commerce, it is clear that we should wait till this sector matures and stabilizes. To do otherwise would be 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.


Privacy Concerns

Taxes on remote sales entail large and invasive monitoring, enforcement and collection costs. As a result, most states seek to collect such taxes, only when the costs of doing so are reasonable.  Normally, sales taxes will be collected on retailers in the state. States also seek bi-lateral tax “treaties” with neighboring jurisdictions on occasion, acting as tax collectors for other jurisdictions. Even these tax collection activities are often viewed as threatening and inequitable.


The more serious problems with extending taxes to electronic commerce are already foreshadowed by the experiences of using financial transaction data as a way to “improve” law enforcement. Consider, the U.S. “money laundering” laws – these laws essential presume that all Americans engaging in large dollar transactions are guilty until proven innocent. This perverts all normal notions of justice. Moreover, as electronic commerce becomes more sophisticated, such “large” denomination transactions can be electronically divided into numerous small transactions. That led to FDIC efforts (under the proposed Know Your Customer rule) to extend this presumption of guilt to all depositors. As most of you know, that proposal created a firestorm of protest and resulted in the regulation being withdrawn.


This experience is highly relevant to proposals to tax the Internet. Such tax proposals would pose severe threats to the evolving privacy protections (encryption and digital money) now becoming available. The Internet is a liberating force; Internet taxation threatens to create a 1984 Big Brother regime instead. Consider as one example of how one European government has sought to tax one early form of electronic commerce – television. The UK system of “licensing fees” to support the BBC is enforced by TV inspectors going around with electronic monitoring devices to see whether an individual might be evading the tax. Does America want this type regime?


Civil Rights, Civil Liberties

One of the great potentials of the Internet is that it provides new protections to oppressed minorities around the world. The ability to bypass official channels via the Internet increases their ability to engage in economic exchange on an anonymous basis. Race, creed and political ideology – all are invisible over the Internet, expanding the range of economic opportunities available to such groups. Moreover, that same Internet allows them to transfer and shelter their economic earnings. Internet taxation policies – especially if enacted at the global level – would strip away these privacy protections, making it all too easy for oppressive or populist governments to seize or tax away their savings. The Internet cannot create a world of Good Neighbors but it can reduce the costs of individuals acquiring Good Neighbors and of Bad Neighbors doing you harm – but only if anonymity is preserved. That anonymity will be far harder to achieve in a world that sees such privacy provisions as threatening tax revenues. Thomas Sowed has written eloquently about the contributions – and subsequent risks – to which enterprising minorities – Indians in Africa, Chinese in Asia, Jews throughout the world – are exposed. Legitimizing government rights to pierce that veil of privacy is immoral.


Extending Taxation to Remote Locations is Unjust

The role of taxes is to support those functions carried out by that jurisdiction. To tax remote firms is to lay claims on activities far less likely to obtain any benefit from the taxing jurisdiction. Moreover, the likelihood that a careful analysis of the burdens created by these higher taxes is offset by the benefits achieved by the programs thereby funded is far less likely when these burdens are imposed on foreigners – whether these are overseas or next door. Public choice research suggests we move very carefully before weakening any further the restraints which have, to date, kept Leviathan minimally in check.


Are More Taxes Needed?

The proposed new taxes on electronic (or even remote sales) commerce would almost certainly not be offset by tax reductions elsewhere. Thus, these would be new burdens on the citizenry. With the United States and most state governments experiencing massive tax over-payments already, there is certainly no urgency or rationale in considering tax increases at this time. 


Bad Tax Policy is Good Tax Policy; Good Tax Policy is Bad Tax Policy (And the only good tax is an Old Tax)

In my early work on pollution taxes, an older analyst suggested that I be careful of accepting uncritically the virtues of “efficient” taxation, that is taxes that minimized the dead weight 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, 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 – and they are also new taxes.


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 in moving capital and economic activities around the globe offered by the Internet make 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.


Are Taxes Even Appropriate for an Informational Resource?

To these concerns must be added the high costs of enforcement and the even higher risks of evasion unavoidable in seeking to translate the rules applied to a world of physical entities to the virtual world of the internet. Indeed, taxation of the Internet raises many of the same concerns expressed in taxing intellectual property more generally. Informational resources are not subject to the same scarcity concerns that affect real goods – a flick of a toggle and data can be distributed to thousands of individuals around the world. As the late Ithiel de sola Poole noted Information wants to be free and that fact makes it possible to envision a much faster rate of growth in the developing world than was possible in a world limited by the scarcity, the rivalry, inevitable in a world of physical resources. Should we weaken the hopes of the peoples of the developing world by raising the costs of such resources artificially by taxation?


Summary Thoughts

Neither Europe nor the United States need additional tax revenues at this time. In both societies, tax revenues are already excessive, government is already far larger than that justified. Moreover, 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. 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. There are far less invasive ways of moving toward rational tax policies than that considered by this Commission. One example might be to move toward a Consumed Income Tax (a tax based on income adjusted for savings). Such a tax would address the concerns expressed by some proponents of such a tax without the distortions discussed here.