Internet Taxation: Controversy Likely to Continue

Less than a month after the Advisory Commission on Electronic Commerce (ACEC) delivered its report to Congress, the House Judiciary Committee has passed a bill that would extend the Internet Tax moratorium for five more years. It is now scheduled for a full-House vote this Wednesday. The proposal is a step in the right direction, but it may not put an end to the debate surrounding sales taxes on the Internet.

H.R. 3709, introduced by Representative Christopher Cox (R-CA), would prohibit special and discriminatory Internet taxes through October, 2006, and would do away with the previously grandfathered Internet taxes that a few states were able to impose before the original act passed. Additionally, H.R. 3709 would limit the ability of states to tax remote sales made over the Internet.

The Nexus Test. A 1992 Supreme Court decision mandated that states could collect sales taxes only from companies with a substantial physical presence within that state’s geographical borders.[1] This presence is commonly referred to as “nexus.” Like the original Internet Tax Freedom Act, H.R. 3709 designates a number of Internet-related items as not sufficient to qualify as nexus. These items include a retailer’s Internet service provider, digital data on a server, and the use of telecommunications services, among others. By designating these items as insufficient to meet the nexus test, the bill protects citizens from being taxed by other states on the Internet.

The five-year extension will continue to protect citizens from other states’ exported tax regimes, but Congress may still face debate over the issue of remote sales taxes on the Internet. Just after the bill passed the House Judiciary Committee, Representative Henry Hyde (R-IL) commented, “There appears to be some sentiment that our consideration of today’s bill is a signal that Congress is unwilling or uninterested in addressing these sales and use tax issues,” and then added, “I can assure you that nothing is further from the truth.”[2]

Battle Will Continue. The National Governors Association (NGA) is leading a strong lobbying effort urging Congress to overturn the Court’s rulings and facilitate remote taxation on Internet purchases. If successful, the NGA Internet tax-grab would violate the time-honored principle of “no taxation without representation” and, in many cases, leave politicians and tax collectors accountable to no one.

In a previous proposal, the NGA suggested a so-called Trusted Third Party (TTP) that would be employed for “calculating, collecting, reporting, and paying the tax” instead of the vendor, as is the case in bricks-and-mortar retailers. But unlike traditional retailers, who base the sales tax rate on their location (wisely avoiding the burden of computing different rates for any one of the 6,600 tax jurisdictions of which the walk-in customer could be a resident) these TTPs would have to gather enough information about a customer to calculate the appropriate tax for his home jurisdiction.

Privacy Threatened. Obviously, making this divulgence of information mandatory has some alarming implications for consumer privacy. Presumably it was with this political liability in mind that the NGA recently abandoned the TTP plan and is now making vague reference to a “technological solution” that would both calculate the correct tax rate and protect the privacy of online shoppers. No word on what exactly that technology might be or even if it currently exists.

Tax Accountability. Nonetheless, the NGA continues to lobby (with taxpayer money) for the opportunity to tax those to whom they are not politically accountable. This would mean a state could collect sales taxes from companies located completely outside of that state’s territory. Taxing officials would have no accountability to those taxpayers and no incentive to keep tax rates at bay. Congress must prevent the states from taxing remote purchases if it wishes to obey the principle of “no taxation without representation.”

The NGA warns that as more sales are conducted over the Internet, sales-tax revenue will soon be insufficient to fund critical state and local services. Currently, tax coffers are awash with funds, but as e-commerce grows it is possible that states will take in substantially less from the sales tax. This scenario need not be the disaster the NGA suggests with its talk of under-funded schools, firehouses, and police departments. States need not be bound to sales taxes to raise revenues, and current taxing schemes are not written in stone.

When these more controversial issues come before Congress, elected officials would be wise to remember that as technology changes the way Americans live, work, and shop, states will need to adjust the way they operate as well. Along with many other functions of states, governors need to give careful consideration to how government can properly raise revenue in the “new economy.” Passing H.R. 3709 is an important step in that direction.

Contrary to the ideas of the NGA, the default answer to tax-revenue concerns is not extending states’ taxing and regulatory regimes beyond their geographical borders. A “one size fits all” approach like the NGA’s plan will force consumers in every state to sacrifice. Better to let those who know their residents and businesses best decide how they will be taxed. This approach promotes tax accountability and tax competition among jurisdictions. The NGA’s tax cartel would do neither.

Jessica Melugin ([email protected]) is an Internet policy analyst at the Competitive Enterprise Institute.


1 Quill Corp. v. Heitkamp, 504 U.S. 298 (1992). 2 “House Panel Backs 5-Year Extension of Internet Tax Moratorium,” Bloomberg News Service, May 4, 2000.