Electronic commerce conducted overthe Internet has exploded over the pastseveral years. In 1998 online shopping rev-enues in the United States alone totaledapproximately $13 billion, and they areprojected to reach $108 billion by 2003—nearly a tenfold increase. Such potentiallyastonishing growth has many governmentsworried that they are not adequately pre-pared to tax this flood of new commerce.

State and local governments in theUnited States have sensibly begun to exam-ine how electronic commerce will affecttheir tax systems. Contrary to the claims ofthose governments, however, the currentfederal rules do not exempt electronic com-merce from taxation; they simply prohibitcertain means of collection. The federalgovernment should continue to prohibitstates from imposing tax collection dutieson out-of-state businesses by establishing auniform national jurisdictional standard fortaxing electronic commerce based on thesubstantial physical presence test. Such astandard would reaffirm traditional princi-ples of tax fairness, preserve rate competi-tion among states, and avoid years of con-tentious litigation.

If current state tax systems disadvan-tage local retailers, states already have itwithin their power to address the problem.Although reform may be difficult, statesare in no immediate danger of goingbroke, nor do they lack alternatives to thecurrent system of sales and use taxes. Therole of the federal government should be toensure that states do not unfairly exporttheir tax collection burden, thereby imped-ing interstate commerce.

At the international level, the UnitedStates has a special role to play in design-ing online tax policy. With more com-puters than the rest of the world com-bined, America is unquestionably thehome of the Internet. It is therefore nat-ural that other countries look toWashington for leadership on the taxa-tion of electronic commerce. Thus, it isvital that the United States stand up forimportant principles such as tax compe-tition by rejecting proposals to draftAmerican businesses as tax collectors forforeign governments. In addition, theUnited States should aggressively pursuean Internet free-trade agreement in theWorld Trade Organization.

Tax Bytes A Primer on the Taxation of Electronic

Commerceby Aaron Lukas

December 17, 1999 No. 9

Aaron Lukas is an analyst at the Cato Institute’s Center for Trade Policy Studies.

Executive Summary

2

State and localgovernments are

subject to congres-sional and constitu-

tional limitationson the means bywhich they maytax cross-border

commerce.

Part IState and Local Taxation

State and local governments in the UnitedStates currently impose a variety of taxes onbusinesses and consumers, including sales anduse taxes, telecommunications taxes, incometaxes, and franchise fees. Electronic commerceis not specifically exempt from such levies, norshould it be. However, state and local govern-ments are subject to congressional and consti-tutional limitations on the means by which theymay tax cross-border commerce, includingmuch Internet-based commerce. Those limita-tions, many observers believe, will seriouslyundermine future tax revenues as more peopleconduct online business across state lines. Thecontinuing fight to overturn federal impedi-ments to extraterritorial taxation will thus bethe focus of this section.

Federal restrictions on the authority of stateand local governments to force out-of-statetelephone and mail-order companies to collecttaxes have long irritated supporters of expan-sive government. In recent years, the rapidgrowth of Internet-based retail sales has creat-ed a new sense of urgency and has prompteddire warnings from high-tax advocates of theimpending erosion of state and local tax bases.As early as 1995, for example, a paper pub-lished by the Center for CommunityEconomic Research warned that “state andlocal government finances are being undone byrapid changes in global commerce and technol-ogy, particularly the rise of the Internet.”1 TheCenter on Budget and Policy Priorities agreed,saying that “if state and local sales taxes are tosurvive as a means to support government pro-grams and services in the future, a means mustbe found to treat all sales to consumers in acomparable manner.”2 And a 1997 article in theNational Tax Journal, which illustrated thethinking of many state tax policy specialists,concluded that “the sales tax must and will beapplied increasingly to electronic transac-tions.”3

Hearing such talk, state and local officialsbecame increasingly alarmed. Then in 1997Rep. Christopher Cox (R-Calif.) and Sen. Ron

Wyden (D-Ore.) introduced the Internet TaxFreedom Act, which threatened to permanent-ly limit states’ authority to tax Internet com-merce. The legislation was a wake-up call tostate and local governments, who were juststarting to think about ways to tax online eco-nomic activity.

One of the first opponents of the ITFA tolobby Congress was Harry Smith—the mayorof Greenwood, Mississippi, and a collegefriend of Senate Majority Leader Trent Lott(R-Miss.)—who argued that the ITFA was aserious threat to the financial future of stateand local governments.4 The NationalGovernors’ Association and the U.S.Conference of Mayors, led by NGA vice chair-man Gov. Michael Leavitt of Utah, took up thecause and attacked the bill as detrimental tostates’ financial health. Those efforts eventuallypaid off, as Senate leaders vowed to block anybill that failed to take states’ concerns intoaccount. In the final version of the ITFA,passed in October 1998, the moratorium onnew Internet taxes had been cut from six yearsto three, existing taxes were exempted from theban, and local government had been givenstronger representation on the AdvisoryCommission on Electronic Commerce, formedby the ITFA to study Internet tax issues.5

State efforts to tax electronic commerce didnot die with the passage of the ITFA. TheMultistate Tax Commission, for example,recently issued its Draft Resolution on InterstateSales Tax Collections that calls for a system thatwould require sellers above a certain thresholdto collect use taxes on all taxable items.6 TheNGA remained active on the issue by pressur-ing Congress to include participants friendly tostate and local tax concerns, most notablyGovernor Leavitt, on the AdvisoryCommission on Electronic Commerce.7

Dissatisfied with the commission’s final make-up, the National Association of Counties andthe U.S. Conference of Mayors filed suit infederal court in March to block the commis-sion from meeting. That lawsuit was eventual-ly dropped when Netscape CEO JamesBarksdale stepped down from the commissionand was replaced by Delna Jones, the county

3

commissioner from Washington County,Oregon.8

The most recent report on fiscal year 1999state budget activity released by the NGA andthe National Association of State BudgetOfficers accurately sums up the long-term fearsof state and local officials:

In future years, state revenues are like-ly to be affected by the growth of salesover the Internet. As more and moretransactions occur online without thecollection of existing sales or use taxes,state revenues from sales taxes, whichprovide almost 50 percent of total stateand local funding, will erode.9

An Internet Tax Drain?A brisk holiday retail season in 1998

marked electronic commerce’s emergence as aserious retail medium. Online holiday salestopped $2.3 billion, which promptedNewsweek to declare the nation’s first “e-Christmas.”10 And U.S. News & World Reportnoted that “[Internet] shoppers from east towest seem determined to avoid traffic jams atthe mall, long lines at the post office and last-minute dashes to the supermarket.”11 Both arti-cles speculated on the threat that electroniccommerce could pose to local retailers.

Electronic commerce has stayed in themedia spotlight, and how to tax such businesshas become a subject of popular debate. Forinstance, one New York Times article by tech-nology commentator James Ledbetterdenounced restrictions on Internet taxation as“unfair” to those who shop in stores.12 A simi-lar story in December accused Internet vendorsof enjoying a “free ride” and warned that localretailing could eventually cease to exist.13 Morerecently, the Internet-friendly magazine Upsideweighed in with a May cover story titled “AreWe Stealing from Our Schools? The HighPrice of Tax-Free E-Commerce.”14 The emerg-ing conventional wisdom, as expressed byInternet pundit Bob Metcalfe, seems to be that“Internet purchases will not long be exemptfrom taxes.”15

Despite all the hype, however, it is impor-

tant not to overstate the immediate fiscal sig-nificance of electronic commerce. Merchantsof all kinds, not just online vendors, reportedstrong holiday sales last year.16 Total revenuesfrom online business-to-consumer retailing in1998 were estimated at between $13 billionand $20 billion—or from approximately two-to three-tenths of 1 percent of total consumerspending.17

Several estimates have been made of howcross-border sales translate into uncollectedstate and local taxes. The United StatesAdvisory Commission on IntergovernmentalRelations has said that about $3.3 billion instate and local sales taxes remains uncollectedannually.18 The Internet is expected to rapidlyincrease that figure. The NGA has speculatedthat states could unwillingly be leaving up to$20 billion per year in taxpayers’ hands by themiddle of the next decade because of onlinesales alone.19 Those estimates may be mislead-ing, however, because they include business-to-business transactions, as well as many servicesthat normally go untaxed.

A more recent—and more realistic—analy-sis of state revenue losses was published byErnst & Young in June. In that analysis,according to Robert J. Cline and Thomas S.Neubig, the estimated sales and use tax not col-lected in 1998 because of the increase in remotesales over the Internet was less than $170 mil-lion, or one-tenth of 1 percent of total state andlocal government sales and use tax collections.20

A somewhat higher estimate was presented byeconomist Austan Goolsbee of the Universityof Chicago and Jonathan Zittrain of HarvardLaw School in a recent article for the NationalTax Journal, which concluded that states lostabout $430 million in 1998, or less than one-quarter of 1 percent of their total tax take.Goolsbee and Zittrain calculated that over thenext five years revenue losses will likely equalless than 2 percent of total state and local salestax revenues.21

Those numbers do not suggest, of course,that state tax collections will never be affectedby electronic commerce. With an estimated32.7 percent of Americans already connectedto the Internet, it is possible that future revenue

The estimated salesand use tax not col-lected in 1998because of theincrease in remotesales over theInternet was lessthan $170 million,or one-tenth of1 percent of totalstate and local gov-ernment sales anduse tax collections.

4

erosion could be substantial for states that relyon high sales tax rates.22 Nevertheless, state andlocal finances are apparently secure for theforeseeable future while the Internet is still arelatively new way to conduct business. It is inthat context that Congress acted last year toforestall state and local efforts to tax electroniccommerce.

The Internet Tax Freedom ActBy far the most interesting development in

the world of state and local taxation last yearwas the ITFA. It was passed as part of theOmnibus Appropriations Act of 1998 and is inforce from October 1, 1998, until October 20,2001. The ITFA has four major components:(1) a moratorium on new federal Internet orInternet-access taxes, (2) a declaration that theInternet should be free of international tariffsand other trade barriers, (3) a three-year prohi-bition on new taxes imposed on Internet accessand on multiple or discriminatory taxes onelectronic commerce, and (4) the establishmentof the Advisory Commission on ElectronicCommerce to study international, federal,state, and local tax issues pertaining to theInternet.

The ITFA moratorium on new Internettaxes applies only to taxes that were not gener-ally imposed and actually enforced prior toOctober 1, 1998. State income and franchisetaxes, for example, were in widespread usebefore that date and thus remain in force in allstates that impose them. Other taxes, such assales taxes on Internet access charges, were notuniformly collected and thus will be subject tothe federal tax ban in some cases.23 (The ques-tion of when Internet access charges are taxableis likely to generate much controversy, especial-ly in relation to the “bundling” of Internetaccess with other taxable telecommunicationsservices. However, because it is not directlyrelated to cross-border electronic commerce,the taxation of access charges will not be cov-ered in this paper.) The ITFA includes rules fordetermining which state levies are allowed,although there is bound to be some confusionon this issue.24

The ITFA prohibits discriminatory taxes

on electronic commerce. Thus, states canimpose taxes on products or services purchasedonline only when similar goods are taxedoffline. For example, the ITFA would precludea tax on access to an online magazine if the saleof magazines from a newsstand is not taxed.Moreover, states cannot tax electronic com-merce at a discriminatory rate. If magazinesfrom a newsstand are taxed at 6 percent, accessto an online magazine could not be taxed above6 percent. The ITFA also bars new taxes on thesale of Internet-unique goods or services, suchas e-mail or search-engine services.

Finally, the ITFA provides some guidanceon the application of sales and use taxes to out-of-state vendors engaged in electronic com-merce. As the following section of this paperwill discuss, states generally cannot require anout-of-state seller to collect taxes unless thatseller has a physical presence in the taxing state.The ITFA specifies that the ability to accessthe Web site of an out-of-state business doesnot, in itself, constitute a sufficient level ofphysical presence to enforce tax collection.Although possibly redundant under DueProcess and Commerce Clause protections,that clarification might at least dissuade statesfrom initiating pointless litigation.

For the most part, the ITFA will not have asignificant short-term impact on firms current-ly engaged in electronic commerce. It will,however, forestall immediate efforts of stateand local governments to extend theirtaxing authority. Ultimately, the proposals ofthe Advisory Commission on ElectronicCommerce may have a greater impact on thefuture of Internet taxation than will any othercomponent of the ITFA.

Current Trends in Electronic CommerceTaxation

The history of state and local taxation ofremote commerce has been characterized byceaseless efforts to circumvent federal restric-tions on who may be taxed. The results of thoseefforts have been mixed and often conflicting.25

Early indications suggest that the same pat-tern will apply to electronic commerce, but thatscenario is not inevitable. Taxation of content

The history of stateand local taxation

of remote com-merce has been

characterized byceaseless efforts tocircumvent federal

restrictions on whomay be taxed.

5

States prefer toavoid internalreform by expand-ing their authorityover out-of-statebusinesses.

transmitted over the Internet is not yet wide-spread and is restricted for three years by theITFA. In addition, states are limited in theirability to enforce tax collection on out-of-statepurchases under the Due Process andCommerce Clauses of the U.S. Constitution.Although the Supreme Court in Quill v. NorthDakota (discussed in more detail below) mini-mized the legal protection offered by the DueProcess Clause, the issue of whether theimposed responsibility for tax collection on anout-of-state business is an unjust deprivation ofproperty—taken without the opportunity to beheard—remains valid. Congress should nottolerate states’ engaging in taxation withoutrepresentation, even if the Court has givenCongress an opening to do so. In addition, byexporting their tax collection obligations, statesare effectively projecting their lawmakingpower beyond their borders, thereby impedingthe flow of commerce. Congress thus has thepower under the Commerce Clause to prohib-it that activity.

Because the ITFA tax moratorium expiresafter three years, Congress has only a limitedwindow of opportunity to head off state andlocal policies that will interfere with the growthof electronic commerce. The question facinglawmakers is this: should interstate electroniccommerce be permanently governed by thesame rules that now apply to mail-order salesamong states?

Before that question is addressed, it shouldagain be stressed that the online world does notescape taxation. Telecommunications chan-nels—telephone lines, wireless transmissions,cable, and satellite—are taxed in most states;electronic commerce companies pay incomeand other direct taxes; sales taxes are collectedon in-state purchases; and use taxes, thoughrarely enforced, cover most cross-border trans-actions. In addition, state income taxes capturea generous share of the personal wealth gener-ated by the growth of electronic commerce. Inshort, electronic commerce does not enjoy anylegal tax advantage; all existing taxes that areapplied to traditional businesses are also regu-larly applied to online businesses. Those exist-ing taxes are a significant source of revenue for

state and local governments. The only prohibi-tion facing the states, which can lead to a defacto tax advantage for remote sellers, is ontheir means of collecting transaction taxes.States have it within their power to remedythat situation, but they prefer to avoid internalreform by expanding their authority over out-of-state businesses.

Sales and Use TaxesSales taxes are excise taxes (i.e., taxes based

on the amount of business done) that areimposed on retail transactions. Sales taxes aregenerally levied by a state or locality on sales oftangible property and specified services thatoccur within the relevant jurisdiction.Purchases made by businesses—either forresale or as inputs to production—are (in theo-ry if not always in practice) exempt from salestaxes in order to avoid double taxation.

Sales taxes are charged to sellers who thenpass those taxes on to consumers. Althoughconsumers are the ultimate taxpayers, there arereal economic costs borne by businesses thatcollect sales taxes. First, there are the adminis-trative costs of registering with multiple stateand local agencies, of collecting taxes, and ofremitting the funds (a cost that is higher forremote than for local sellers). Second, business-es may not always be able to pass on the entireamount of the tax to consumers. For example,if Amazon.com is required to collect an averagetax of 5 percent, it may decide to lower itsprices slightly to maintain sales volumes. Evenif it holds prices steady, it will sell fewer booksat the after-tax price, thus suffering a loss ofsales revenue.

Every state with a retail sales tax also leviesa “compensating use” tax, usually referred tosimply as the use tax. The use tax is a supple-ment to the sales tax and is intended to coverthe purchase of products and services thatwould have been subject to sales tax if pur-chased within the buyer’s home state. Out-of-state sellers are sometimes required to collectand remit the use tax to the buyer’s state, but ifnot, it is the consumers’ legal obligation to paythe tax themselves. The use tax is meant toensure that all sales to residents are taxed,

6

regardless of where the transaction takes place,and also to deter consumers from making pur-chases in competing tax jurisdictions on alower- or no-tax basis.

Federal law and the U.S. Constitution pro-hibit states from requiring many out-of-statefirms to collect sales or use taxes. Three casesin particular provide guidance on tax collectionrequirements on out-of-state vendors. In 1967the Supreme Court ruled in National BellasHess v. Illinois that a mail-order companycould not be required to collect use taxes if thecompany’s only in-state activity consisted ofshipping catalogs and goods from out of stateby common carrier, such as the U.S. PostalService or Federal Express.26 The Court heldthat, under both the Due Process andCommerce Clauses, sellers can be required tocollect use taxes only for states where theymaintain a level of physical presence known as“taxable nexus.”27 For transaction tax purposes,nexus generally requires substantial physicalpresence: property, equipment, or employeesbased in a state.28 A vendor without a physicalpresence in the state can also create nexusthrough a contractual relationship with a busi-ness that is in the state. For example, a compa-ny based in state A that hired the services of asales firm in state B to market products therecould be liable for tax collection in state B ifthe activities performed on behalf of the sellerare necessary for it to establish and maintainmarket share.29

In a 1977 case, Complete Auto Transit, Inc. v.Brady, the Court attempted to clarify whatlevel of nexus would satisfy the requirements ofthe Commerce Clause but did not revisit dueprocess. The Court constructed a four-prongedtest that can help determine when a tax willmeet Commerce Clause requirements.According to the test, any state tax must

1. be applied to an activity with “substantialnexus” in the taxing state,

2. be fairly apportioned,3. not discriminate against interstate com-

merce, and4. be fairly related to the services provided

by the state.30

It should be noted that Complete Auto isusually applied to income, not use, taxes. Butthere is no reason why its logic should notapply equally to transaction taxes. Finally, theCourt reaffirmed Bellas Hess in 1992 withQuill, which said that states have no authorityto tax cross-border mail-order sales absentexpress permission from Congress.31 Quill wasa partial departure from the Court’s earlier rul-ing in that Quill considered the nexus questionseparately under the Commerce and DueProcess Clauses. Regrettably, the Court heldthat due process is satisfied whenever theremote seller’s efforts are “purposefully direct-ed”32 toward the residents of another state.Purposeful direction essentially entails anyeffort, such as the purchase of advertising in alocal newspaper, to solicit orders from the resi-dents of a state. In other words, under Quill,physical presence is not necessarily required tosatisfy due process considerations as a precon-dition for a state to impose responsibility foruse tax collection.

Although the Court overturned the physi-cal-presence standard for due process, thephysical-presence standard for the CommerceClause was left intact. The distinction is signif-icant. Because the Due Process Clause is a con-stitutional limitation on the power of govern-ment, reducing the level of protection that theclause affords would require a constitutionalamendment; however, the Commerce Clause isan affirmative grant of power to the federalgovernment. Accordingly, Congress can alterCommerce Clause requirements by statute.Many observers have thus concluded that theQuill decision was an invitation by the Court toCongress to exercise its power to clarify thestandards for remote-commerce taxation.

The result of the Supreme Court’s jurispru-dence has been that the use tax, as currentlyapplied, is not an effective alternative to salestaxes. Although they have it within theirauthority, most states make little or no effort todirectly collect use taxes from consumers.Moreover, most consumers are unaware of thetax and thus do not voluntarily remit payment(though most businesses do). As a 1996 surveyby the Software Industry Coalition found,

Federal law and theU.S. Constitution

prohibit states fromrequiring many

out-of-state firmsto collect sales or

use taxes.

7

“With a few exceptions, state collection of usetax from buyers is largely non-existent.”33

According to Neal Osten of the NationalConference of State Legislatures, some states,such as Maryland, actually audit taxpayers whovoluntarily pay use tax on the theory that peo-ple seemingly so honest must have somethingto hide.34

Nexus and the InternetBecause of a reluctance to tackle thorny col-

lection problems—coupled with a growing fearof future revenue losses—states have been con-structing novel theories for extending their tax-ing authority to cover remote online sellers.Some tax officials have speculated that anInternet service provider (ISP), which connectsconsumers to the Internet, acts as an agent ofonline sellers and therefore creates nexus forvirtually every firm. That would certainly be inline with the increasingly broad approach somestates have taken to finding nexus. A contro-versial 1995 Multistate Tax Commission bul-letin, for example, takes the position that con-tracting with a third party to provide in-statewarranty repair services creates sales andincome tax nexus for remote sellers.35 Althoughthe bulletin does not deal directly with Internetservices, its logic could, as an Arthur Andersenpaper pointed out, “conceivably apply to ser-vices other than repair services.”36 That argu-ment is perhaps plausible for online serviceproviders (OSPs) that give technical or mar-keting assistance to vendors on a proprietarynetwork; however, it is clearly inapplicable toISPs whose connection to the seller is inciden-tal only.

States that decide to adopt a broader inter-pretation of taxable nexus are on shaky legalfooting. In 1998 the ITFA instructed states toapply the same rules to products sold over theInternet and delivered by common carrier asare applied to mail-order sales. The definitionof “discriminatory tax” in section 1104(2)(B)(i)of the ITFA makes it clear that Congress con-siders the creation or maintenance of a site onthe Internet to be so insignificant a physicalpresence that the use of an in-state computerserver in this way by a remote seller does not

constitute taxable nexus.37 Furthermore, whenan ISP’s server is located in another state, sec-tion 1104(2)(B)(ii) prohibits states from classi-fying that provider as the nexus-creating agentof a remote seller.38

Recent court decisions also seem to confirmthe status of Internet providers as common car-riers. In December 1998, for example, an inter-mediate appellate court in New York dismisseda libel suit brought by a 15-year-old Boy Scoutagainst Prodigy (an OSP) for offensive state-ments transmitted via the Prodigy system. Indismissing the action, the court likened theonline service provider to a telephone company,stating that Prodigy should not be held respon-sible for the content of communications sentover its network.39

Even if some states successfully attributenexus to companies that house Web sites on in-state computer servers, the probable result willbe to drive site hosting and related services outof state. Thus, because most online vendorshave substantial nexus in only one or a fewjurisdictions, much electronic commerce willcontinue to be exempt from use tax collectionrequirements when purchases of tangible prop-erty are made across state lines.

Other approaches to taxing remote com-merce have been equally problematic. In 1997,for example, Nebraska passed legislation(which was later vetoed) that would haverequired out-of-state companies with no in-state physical presence to report all purchasesby Nebraska citizens. The state would then usethat information to collect use taxes directlyfrom its citizens—an approach that raises seri-ous logistic and privacy concerns.

Tangible versus Intangible ProductsThe bulk of electronic retailing involves the

sale of tangible products—like clothing orstereo equipment—that are ordered onlineand then delivered by common carrier.Electronic commerce also includes the sale ofintangible digital products—like music andsoftware—that are delivered directly over theInternet. In addition, the Internet makes itpossible to provide services that are “produced”at one location and “consumed” somewhere

In 1998 the ITFAinstructed states toapply the samerules to productssold over theInternet anddelivered bycommon carrieras are applied tomail-order sales.

8

Even if technologi-cal neutrality of

taxation isdesirable, it doesnot override due

process andinterstate

commerceconsiderations.

else, such as medical or legal consultations.It is generally accepted that tax rules that

govern the sale of intangible products and ser-vices should be the same as the rules for othergoods—namely, that means of delivery shouldnot govern tax treatment. Such “technological-ly neutral” taxation would not treat the sale of apaperback book any differently from the sale ofa digitized book, to use one oft-cited example.However, determining which products arefunctionally equivalent is a tricky proposition.Is text that is displayed on a computer screenreally the same thing as a printed book? Is amovie that is downloaded to a computer harddrive really the same as a video that is rented?The answer is not obvious. Moreover, moststates do not apply comprehensive taxation toservices, and few states tax intangible productsaside from basic utilities, which are subject tospecial taxes. There may be many valid policyreasons for such exemptions, and sovereignstates should be free to decide what will betaxed, even when neutrality—taxing identicalgoods at the same rate—suffers.40

Even if technological neutrality of taxationis desirable, it does not override due processand interstate commerce considerations; there-fore, only firms with substantial nexus shouldbe expected to collect taxes. Some states willundoubtedly play games with the taxonomy ofdigital products in hopes of circumventing thatrequirement. For example, a state might decideto treat the sale of intangible goods either as asale of taxable services or as the lease of prop-erty and then insist that taxes are due on thebasis of the contention that the Quill decisiondealt specifically with the sales of tangible per-sonal property and thus does not offer a safeharbor for sales of products or services deliv-ered electronically. The language of the Quilldecision, however, does not explicitly refer totangible products, which suggests that it willalso apply to sales of services and digital con-tent over the Internet.41

Taxing the online sale of intangibles is alsoproblematic because the location of customerscannot be known with certainty. Many onlineshoppers do not feel comfortable giving unnec-essary personal information to a Web site.

Consequently, they may refuse to type theinformation in, choose to shop at a site thatdoes not require that information, or simply lie.That behavior may prompt states to argue thatbecause vendors cannot prove that buyers arenot local, the vendors are liable for tax collec-tion on all sales. However, that approach wouldlead to multiple taxation and place on sellers animpossible burden that would effectivelyundermine the intent of Quill.

Even if a state successfully made that case,the victory would be illusory. The fluid natureof digital products means that states may havetrouble collecting taxes even on in-state sales,much less on remote transactions. It is relative-ly easy for buyers to misrepresent their locationor to have a third party in another state pur-chase the product or service and simply for-ward it with a click of a mouse. It is also possi-ble for sellers of digital products to locate inforeign jurisdictions that would not enforce taxcollection requirements. It would be very diffi-cult, for example, to collect tax on the trans-mission of content sent from abroad and paidfor by digital cash or smart card—untraceableencrypted “virtual money” that is spent exactlylike cash and leaves no paper trail. Given thenear impossibility of enforcing compliance, therevenue potential of taxing digital products isprobably small.

Some state agencies that support allowingthe states to enforce tax collection on out-of-state sellers of tangible goods recognize the allbut insurmountable hurdles to taxing network-delivered intangible products and services.California’s Electronic Commerce AdvisoryCouncil, for instance, has recommended that“the status quo be maintained for taxing theinterstate sale of intangibles and provision ofservices.”42 Its report cites both the difficultiesassociated with establishing a buyer’s identityand location as well as the ease with which thetaxes could be avoided as reasons not toattempt the taxation of digital commerce.Critics of that approach note that at presentmost purchases are made with a credit card, thebilling address for which could potentially beused to determine which state had jurisdictionover a sale.43 But with the likely rise of digital

9

cash and other unaccounted payment systems,avoidance problems would, at best, be onlypostponed. The problems with using creditcards for tax collection purposes are discussedfurther in the section on international taxation.

Income TaxesIn contrast with sales and use taxes,

Congress has actively exercised its power underthe Commerce Clause to limit the authority ofstate and local governments to collect incometax from out-of-state firms. In the 1950s, statesroutinely applied disparate principles to deter-mine when a corporation was subject to tax intheir jurisdictions. After the Supreme Courtgave states a favorable ruling, Congress in 1959passed Public Law 86-272. Under that law, if acompany’s contact with a state is limited tosolicitation for the sale of tangible goods andthe goods are delivered from out of state, thestate may not impose a net income tax on thecompany. When P.L. 86-272 does not apply,states are still subject to the constitutionalnexus requirement of substantial physical pres-ence of the business in-state.44

P.L. 86-272 should be sufficient to blockstates and localities from collecting incometaxes from most out-of-state firms engaged inelectronic commerce. Specifically, the law says:

No state, or political subdivision there-of, shall have power to impose a netincome tax on the income derivedwithin such state by any person frominterstate commerce if the only busi-ness activities within such state by oron behalf of such person during suchtaxable year are either, or both, of thefollowing:

(1) the solicitation of orders by suchperson, or his representative, insuch State for sales of tangible per-sonal property, which orders aresent outside the State for approvalor rejection, and, if approved, arefilled by shipment or delivery froma point outside the State; and

(2) the solicitation of orders by suchperson, or his representative, in

such State in the name of or forthe benefit of a prospective cus-tomer of such person, if ordersby such customer to such personto enable such customer to fillorders resulting from such solic-itation are orders described inparagraph (1).45

It seems that P.L. 86-272 places clear limitson state and local taxing authority, but theextent of that protection has been hotly con-tested. In 1992 the Court, in William Wrigley,Jr. Co. v. Wisconsin, attempted to settle whatconstitutes taxable activity. According to thatdecision, nontaxable activity includes “notmerely the ultimate act of inviting an order butthe entire process associated with the invita-tion.”46 However, according to a recent analysisby KPMG Peat-Marwick, “Since Wrigley, aline of state cases and rulings have whittledaway at the foundation of those activities thatthe Court deemed to be ‘protected’ and half-heartedly applied the de minimis exception setout in Wrigley.”47

Although P.L. 86-272, in conjunction withWrigley, suggests that online merchants thatsolicit orders via a Web site would be protectedfrom income taxes, states can be expected to tryto circumvent the federal barriers. In particular,states might argue that the law’s reference to“tangible personal property” means that firmsselling intangible digital products and servicesare liable for income taxes wherever their cus-tomers live. That approach has at least twoinherent flaws. First, it would place a substan-tial burden on interstate commerce, thwartingthe original intent of P.L. 86-272, which didnot anticipate the importance of intangibleproducts. Second, the nature of network-deliv-ered digital products makes a buyer’s locationimpossible to credibly establish. That couldlead to serious problems with apportionmentand multiple taxation, as states compete for thesame income.

Given those difficulties, Congress shouldconsider amending P.L. 86-272 to explicitlyinclude the delivery of intangible products andservices over the Internet.

The fluid nature ofdigital productsmeans that statesmay have troublecollecting taxeseven on in-statesales, much lesson remotetransactions.

10

Other TaxesUse and income taxes will have the greatest

impact on electronic commerce, but there areother taxes that bear watching. Expansive useof telecommunications taxes, for example,could expose ISPs to double taxation by taxingthem once for leasing phone lines and again foraccess to those lines. For the most part, howev-er, states cannot be precluded from imposingdamaging taxes on electronic commerce unlessthose taxes are extraterritorial. It is to be hoped,of course, that states will not impose harmful orneedless taxes on electronic commerce withoutcareful consideration.

The Case against Expanded TaxationThe Advisory Commission on Electronic

Commerce, which held its first meeting in June1999, may be the most important part of theITFA. Its mandate is far ranging, including thestudy of taxation of Internet access, remotecommerce across national borders, and theadvantages and disadvantages of authorizingstate and local governments to require remotesellers to collect and remit use taxes. The com-mission includes a large number of state andlocal representatives who are eager to taxremote commerce, both electronic and mailorder.48

The commission should be cautious inmaking recommendations. Imposing use taxcollection responsibilities on remote sellers isunlikely to generate significant tax revenue butcould negatively affect the growth of electronicsales. A recent study by Austan Goolsbee esti-mates that taxing remote electronic commercewould reduce the number of online buyers by25 percent and total spending on Internettransactions by more than 30 percent.49

Furthermore, those sales would not necessarilyshift to traditional retailers because, asGoolsbee and Zittrain suggest, the Internet isprobably a net trade creator—generating busi-ness that would not have otherwise occurred.

Nevertheless, pressure by state and localofficials may be substantial, so proposals by thecommission to expand subfederal taxing powerare a possibility. The recommendations couldinvolve legislation to loosen nexus standards or

require out-of-state sellers to collect a nationalsales tax, or both. Congress should reject allsuch advice and instead maintain and clarifythe existing limits. At a minimum, Congressshould make clear that current tax restrictionson mail-order sales will also permanently applyto online commerce. The alternative—aug-menting states’ taxing authority—is ill-advisedfor several reasons.

Tax Competition Is Beneficial. At first glance,the case for extending use tax collectionrequirements to out-of-state sellers sounds rea-sonable. After all, why should identical itemsbe taxed differently depending on how they arepurchased? Neutrality is the core principle of atax system designed to minimize economic dis-tortions. Other things being equal, neutrality oftaxation is highly desirable.

Neutrality, however, is not the only determi-nant of economic efficiency. Indeed, all taxa-tion is distortionary because it shifts resourcesfrom the private to the public sector. High taxrates, even when administered on a neutralbasis, are detrimental to economic growth anddevelopment. Thus, unequal taxation at a loweraverage rate may be superior to tax neutrality ata higher rate. If electronic commerce grows andtax competition intensifies, forcing states to cut(or not raise) sales tax rates, overall economicefficiency will likely be enhanced.

A study by Cato Institute economists DeanStansel and Stephen Moore confirms thatlower tax rates, which are promoted by taxcompetition, lead to healthier state economies.They compared the performance of 10 statesthat raised taxes between 1990 and 1996 withthat of 10 states that decreased taxes. On aver-age, the economies of tax-cutting states grew33 percent over the five-year period comparedwith only 27 percent for tax-hiking states—avariance of nearly 20 percent. Tax-cuttingstates also had healthier budget balances; theirreserves averaged 7.1 percent of state outlayscompared with 1.7 percent in tax-raisingstates.50

Several misguided plans to expand state andlocal taxation are already being debated. Mostrecently, at its July 1999 annual meeting, theNational Association of Counties unanimously

Given the nearimpossibility of

enforcing compli-ance, the revenue

potential of taxingdigital products is

probably small.

11

Congress shouldmake clear thatcurrent tax restric-tions on mail-ordersales will alsopermanently applyto onlinecommerce.

approved a resolution urging Congress toimpose a sales tax on all online purchases.51 Asimilar plan, advanced by Texas’s former taxdirector Wade Anderson, would create a uni-form national sales tax for cross-border pur-chases.52 Similar legislation that would estab-lish a 5 percent national sales tax on mostcross-border purchases has already been intro-duced by Sen. Ernest F. Hollings (D-S.C.).53

The proceeds of such a tax, based on sales vol-ume or some other formula, would be collectedby merchants and remitted to the states—witha possible detour through Washington.

Others have proposed loosening the sub-stantial nexus requirement that currently pre-vents states from imposing use tax collectionduty on out-of-state sellers. For example,Harley T. Duncan, executive director of theFederation of Tax Administrators, says,“Congress should use its authority under theCommerce Clause to authorize states torequire sellers without a physical presence inthe state to collect use taxes on goods and ser-vices sold into the state.”54 In exchange for thisnew authority, a single tax rate would be set foreach state, making it somewhat easier for busi-nesses to calculate how much they are sup-posed to collect and for whom. State officialsreason that such a deal would bring more busi-nesses into the pro-tax camp. Some largeonline sellers, for example, support the planbecause they already collect taxes and believemandatory collection would disadvantagesmaller competitors. That might be a win-winsituation for big business, state, and local gov-ernment, but taxpayers and small businesseswould lose.

Because such schemes would effectivelyreduce interstate tax competition, Congressshould reject all of them. Differentiated taxrates encourage cross-border shopping, ahealthy form of tax competition that helps keeplocal rates under control. Such competitionregularly occurs in the offline world. For exam-ple, some residents of New York drive toDelaware to avoid sales taxes—an option thathas undoubtedly curbed the profligate fiscalhabits of Big Apple politicians. Maintainingthe current restrictions on extraterritorial tax

collection will not stop states from taxing resi-dents at the level required to fund governmentservices, but it may force those states to cutwaste or make the total cost of governmentmore apparent. A more visible tax burdenwould help people make better decisions aboutwhere to live, which would put additionaldownward pressure on tax rates. Over the past15 years, an average of 1,000 people a day havemoved from the 10 highest-tax states to the 10lowest-tax states.55 Given those facts, statesmay determine that economic developmentgoals take precedence over revenue-raisingconcerns and explicitly choose not to tax onlinesales.

Electronic commerce gives everyone theopportunity to live on a virtual border—to takeadvantage of the fact that no state, although itis free to do so, currently taxes its exports orvoluntarily collects use taxes for other states.Like a real border, the Internet can be a potentsafety valve that guards against excessive taxa-tion. Moreover, because the capital used inmany electronic businesses is more mobile thanthe capital used in traditional ventures, firmsare often able to shop around for the lowest taxrates. Electronic commerce allows consumerswho have found it difficult to travel out ofstate—the poor, the elderly, and the infirm—totake advantage of tax-free commerce for thefirst time.

In addition, political pressures to keep taxrates down would be lessened if the Quill stan-dard were overturned. The Internet will likelylead to an expansion of interstate commerce fornontax reasons, such as shopping convenience.If states are allowed to force out-of-state busi-nesses to collect use taxes, an increasing shareof state tax collections will be conducted bybusinesses that have no voice in the local polit-ical process. Consequently, there will be fewerbusinesses that are able to lobby against pro-posed rate hikes, making it easier for states toraise tax rates in the future.

Fortunately, some states are voluntarily tak-ing a hands-off approach to online taxation.The California Assembly passed its own ver-sion of the ITFA that was enacted on January1, 1999. In addition to a three-year ban on new

12

Internet taxes, the law exempts online firmsfrom collecting sales tax on goods sold inCalifornia if those firms have no physical pres-ence there.56 Virginia and New York haveadopted similar legislation, and several gover-nors have announced their support for the fed-eral ITFA.57 Undoubtedly, the reason that thosestates have chosen to restrain their taxingimpulses is because competition for businesshas convinced them that it is in their best eco-nomic interest to do so. Even supporters ofallowing states to tax cross-border sales haverecognized that competition is often the drivingforce behind good tax policy. As Charles E.McLure of the Hoover Institution has noted,“Exemption for business purchases hasoccurred not because it is the right thing to do,as a matter of principle, but grudgingly, inresponse to fears that to do otherwise mightdamage a state’s business climate.”58

A nondistortionary state tax system is a sen-sible ideal and a worthy long-term goal.However, allowing states to force use tax col-lection by out-of-state sellers would not signif-icantly further that goal and would unfairlyburden many businesses. By broadening the taxbase without lowering rates, and thereby sub-jecting more transactions to uneven rates,numerous loopholes, and multiple exemptionsthat typify state tax codes, it is doubtful thatany efficiency would be gained. State and localgovernments already have within their power abetter option to reduce unequal taxation: cut-ting taxes, not scheming to collect more.

Neither Traditional Retailers nor StateBudgets Face a Crisis. Because local stores caterto a customer’s desire for a hands-on experi-ence, offer immediate gratification, and do notcharge for shipping, they will probably alwaysdominate retailing. In addition, shopping is formany people a pleasurable social experiencethat cannot be duplicated online. Thus,Internet sales won’t destroy “real” retailers, justas catalog sales haven’t. Certainly the revenuecrisis that many state officials predicted withrespect to mail-order sales has never material-ized (catalog sales were only $52.3 billion com-pared with $2.7 trillion for sales in traditionalstores in 1998).59 As Dean Andal, a member of

the Advisory Commission on ElectronicCommerce, has noted, “There was a time inthe early 1980s when mail order was growingat rates comparable to today’s Internet sales.During those years, the same pro-tax lobbywho is now beating the drums to tax the netwas calling to tax mail order sales.”60

Recent state budget data reveal no hint of arevenue crisis. In an era of almost no inflation,state budgets grew by 5 percent in FY97 andnearly 6 percent in FY98. Over the past fouryears, state tax collections have exceeded expec-tations by about $25 billion.61 It appears thatthere will be a sizable revenue windfall this yearas well. Furthermore, states will receive moneyfrom last year’s mammoth tobacco settlement.All 50 states and some cities will collectivelyreceive $246 billion from the settlement overthe next 25 years.62 With revenues pouring inso rapidly, it cannot credibly be argued thatelectronic commerce is currently underminingstate tax collections or that states are in need ofnew funds.

Overflowing state coffers reveal that thefears of tax administrators are at best prema-ture, and may never be realized. A comprehen-sive report produced by Ernst & Young and theNational Retail Federation indicates that elec-tronic commerce does not constitute a signifi-cant percentage of retail activity. Only aboutone-third of consumers with online access haspurchased products or services over theInternet. That means that only 10 percent ofAmerican households have ever made a pur-chase online. And of that group, only 4 percentmake more than 10 purchases a year.63

Sales predictions for electronic commerceroutinely overlook the Internet’s role in drivingconsumer purchases to other channels of distri-bution. Sixty-four percent of those householdswith Internet access research products onlineand later buy them through traditional chan-nels—double the percentage of consumers whoresearch and order the same products online.64

As a Greenfield Online survey notes, “Thehuman factor still drives shopping, and the vis-ceral experience is still the principal shoppingdriver. While stores and malls remain the placefor buying, online has become the ‘window-

Unequal taxation ata lower average rate

may be superior totax neutrality at a

higher rate.

13

shopping’ experience to the world.”65

Moreover, a vast amount of electronic com-merce could not properly be subject to use taxeseven if nexus requirements were completelyeviscerated. Approximately 80 percent ofonline commerce is conducted between busi-nesses.66 Those transactions do not translateinto lost tax revenue because they are taxexempt, or, if not, the funds are voluntarilyremitted by the buyer.

It is inaccurate to say that restricting thetaxation of remote commerce is fundamentallyunfair to traditional retailers, since the “loop-hole” is available to everyone. Indeed, existingbusinesses are often the ones taking advantageof the Internet by setting up Web sites and tak-ing orders. At the national level, many success-ful electronic commerce firms are in fact tradi-tional retailers that have gone online—Barnes& Noble and Macy’s are two prominent exam-ples. The trend is not surprising, since estab-lished businesses have a customer base, a distri-bution network, an inventory system, and soon. Electronic commerce is as much a new wayfor existing firms to market their productsmore widely as it is a source of new competi-tion. To the extent that such efforts are suc-cessful, state and local governments will alsobenefit from greater tax revenues.

Online sales are also within reach of strictlylocal establishments. Grocery stores, restau-rants, and florists are already using the Web totake orders that are delivered the same day.Even independent booksellers—the posterchildren for retailers savaged by Internet com-petitors—are learning to use the Web to theiradvantage. In March, the AmericanBooksellers Association, which is made up ofindependent bookstores from around thecountry, announced the formation of BookSense (www.booksense.com)—an online storethat combines the stocks of independent storesnationwide. The stores will set their own pricesand recommend specialty titles.67 The ability tooffer the convenience of Internet shopping,coupled with rapid delivery at minimal costs,should allow local merchants to compete withremote sellers. Those benefits could, at least inareas with competitive rates, overcome the dis-

advantage of sales tax collection. If states are concerned about equity, they

can address the issue by harmonizing tax ratesdownward for local retailers. Policymakers inboth Minnesota and California have raisedthat possibility, proposing to eliminate the salestax on products that are easily acquired online.Specifically targeted are intangible goods thatcan be downloaded, such as software, music,and books.68 Another positive move would beto push for privatization of the U.S. PostalService, which unfairly benefits mail-ordercompanies through postage rates that do notfully cover costs for catalogs or shipping.69

Out-of-State Companies Should Not CollectTaxes. Out-of-state companies that sell onlinedo not use the same services as local business-es, so those companies should not be taxed topay for such services. When a business paysincome or remits sales taxes to the state inwhich it is located, there is a plausible linkageamong the taxes paid, the services provided,and legislative representation. After all, localfirms benefit from police and fire protection,road construction, waste collection, and otherservices provided by the taxing authority, so itis proper that they help cover the costs.Moreover, local firms can make their voicesheard in government through lobbying, voting,and membership in local interest groups, suchas the Chamber of Commerce.

The circumstances are different, howev-er, for a company that markets goods overthe Internet and delivers them via commoncarrier. In that case, the remote seller doesnot benefit from most of the services thatdistant state or those local governmentsprovide. That does not mean that no one ispaying: telecommunications carriers paytaxes on income earned from building andmaintaining the Internet’s physical infra-structure; common carriers pay for servicesthey use in the form of income taxes, fueltaxes, and similar levies—in short, no oneunfairly benefits from the use of public ser-vices while conducting electronic com-merce. Electronic commerce firms shouldhelp pay for services only in states in whichthey are physically located and actually use

Allowing states toforce use tax collec-tion by out-of-statesellers would notsignificantly furthertax neutrality andwould unfairlyburden manybusinesses.

14

No one unfairlybenefits from the

use of publicservices while con-ducting electronic

commerce.

those services. Use taxes are fine, but theyshould not be collected by businesses thathave no significant contact with the taxingstate.

The case against remote taxation is at leastas strong for sales of intangible products overthe Internet. Clearly, network-delivered prod-ucts do not impose any additional marginalcost on state-provided services. To the extentthat digital products substitute for tangibleproducts, the demand for state-provided ser-vices might even decline. Fewer trips to thevideo store or the newsstand, for example,mean less wear on roads and less need forpolice protection.

Early decisions by the Court concerningdue process established a standard of fairnessfor remote taxation that is still valid today. In a1940 case, Wisconsin v. J.C. Penney Co.,70 thatstandard was described as follows:

[The] test is whether property wastaken without due process of law, or ifparaphrase we must, whether the tax-ing power exerted by the state bearsfiscal relation to protection, opportu-nities and benefits given by the state.The simple but controlling question iswhether the state has given anythingfor which it can ask in return.71

More recently, in a 1996 Internet-relatedcase—Bensusan Restaurant Corp. v. King—afederal district court in New York recognizedlimits on a state’s jurisdiction on due processgrounds. The district court held that the defen-dant, based in Missouri, did not purposefullyavail himself of the benefits of New Yorkthrough the mere creation of a Web site. In thecourt’s opinion, “Creating the site, like placinga product into the stream of commerce, may befelt nationwide—or even worldwide—but,without more, it is not an act purposefullydirected toward the state forum.”72

If that conception of a Web site is upheld,the Due Process Clause is possibly sufficient toprotect many electronic commerce businessesfrom tax collection duties imposed by distantstates. The Court concluded in Quill that due

process concerns were satisfied in part becausethe petitioner had “purposefully directed itsactivities at North Dakota residents.”73

Specifically, the Quill corporation had mailedcatalogs to, and purchased advertising in,North Dakota—activity suggesting that thecompany was actively availing itself of theNorth Dakota marketplace. Many, though notall, Web-based businesses do not target distantmarkets that way. The mere existence of a Website (especially on an out-of-state computerserver) is no more purposeful, regular, or per-sistent solicitation of customers in a foreignstate than is a listing in the local telephonebook, which, like a Web site, is availablenationwide. On the Internet, customers oftenactively seek remote businesses instead of thereverse. If taxpayers can drive across state linesto make purchases from a store that has donenothing to target them, and that business can-not be compelled to collect use taxes for thebuyer’s home state, then there is no reason tohold Web-based firms to a different standard.

The Commerce Clause also prohibits statesfrom imposing taxes on businesses that do notbenefit from state services. The four-prongedtest from Complete Auto, which can help deter-mine when a tax will pass constitutionalmuster, requires that any state tax “be fairlyrelated to the services provided by the state.”74

Although Quill effectively abandoned thephysical-presence requirement for due process,it upheld the Complete Auto test that requires atax to be fairly related to services provided bythe state. As it considers the question ofwhether to protect the Internet from unfairtaxation, Congress should recognize the funda-mental disconnect between remote electroniccommerce and state-provided services.

The aggressive manner in which many statesare attempting to draft out-of-state firms as taxcollectors suggests that new revenue, not equi-tably sharing the cost of services, is their realgoal.75 State officials regularly speak of “lost” taxrevenues to which they are entitled. Their words,however, ring hollow. State and local tax rateswere set in a world where restrictions on cross-border tax collection were the norm. The rev-enue such taxes were expected to raise took that

15

reality into account. It is impossible to lose rev-enue that was never anticipated; however, allow-ing states to tax remote commerce would raisenew revenue—a de facto tax increase thatescapes voter scrutiny. Congress should thus beaware that any federal legislation intended toauthorize remote taxation could have the practi-cal effect of allowing state revenue agencies toexpand taxation by fiat. As the AmericanLegislative Exchange Council recently pointedout: “The authority to levy a tax, expand taxobligation—including tax collection obliga-tion—or broaden the tax base in any way is vest-ed solely in the legislature. A state revenueadministrative entity should have no authorityto levy, increase, or in any way expand a tax, a taxobligation, or a tax collection obligation.”76

If equity were the primary consideration,states should be proposing to lower tax ratesand broaden the tax net simultaneously. Withmost state budgets in surplus, taxpayers shouldreasonably expect any reforms to be, at a mini-mum, revenue neutral. For example, if currentretail sales within a state are $1 billion, and thetax rate is 5 percent, sales tax receipts would be$50 million. If the ability to tax interstate salesincreased the tax base to $1.25 billion, then thetax rate could be lowered to 4 percent to yieldthe same $50 million in revenues..77 Alongthose lines, California’s Electronic CommerceAdvisory Council has recommended that eachstate “review the tax-base-broadening revenueimpact of the new system and consider reduc-ing its sales tax rate,”78 but such advice is rarelyfollowed in state tax circles.

Use Tax Collection by Remote Sellers Would BeBurdensome. If remote sellers were required tocollect use taxes, the result would be aninequitable redistribution of income. State andlocal tax laws are not uniform, which couldmake compliance costly for remote vendors.With a patchwork of more than 6,500 (andpotentially over 30,000) state and local taxingjurisdictions currently levying taxes, sorting outcompeting tax claims would be challenging,particularly for small businesses. Althoughsoftware that can calculate tax liability current-ly exists, it is expensive—often more than$20,000.79 This amount may be trivial for large

nationwide retailers, but for small Internet sell-ers it could be prohibitive. In addition to calcu-lating how much tax is owed to whom, firmswould be required to register with and remittaxes to a bewildering array of local agenciesand to collect and store information about theircustomers.

Complying with a multitude of state andlocal tax laws would disadvantage Internetretailers—whose business is inherently inter-state—relative to their traditional competitors.Brick-and-mortar retailers are tasked only withcollecting sales taxes for the state where theyare located, regardless of where their customersultimately use their purchases. Instead of “lev-eling the playing field,” as its proponents claim,a policy that allows states to enforce out-of-state tax collection would merely shift any defacto tax advantage from remote to local sellers.A recent paper published by Ernst & Youngestimates that small firms selling and collectingtax nationwide would face compliance costs of87 percent of the taxes remitted as opposed tojust 7.2 percent for local businesses.80 Facedwith that disadvantage, many small- and medi-um-sized firms would likely choose not to sellonline, a result that suggests an impermissibleburden on interstate commerce.

If allowed, use tax collection and remissioncould realistically take place only at the statelevel. That would entail either a uniformnational tax rate, such as the 5 percent federalsales tax on all remote sales proposed bySenator Hollings, or at least a single rate foreach state. Both of those options, however,would undermine much of the beneficial taxcompetition that now takes places among juris-dictions. Hollings’s proposal is especially anti-competitive because it removes altogether thepossibility for states to set their own tax rateson cross-border sales. It would also give con-sumers in states with sales tax rates lower thanthe national rate an incentive to avoid shoppingonline, further discriminating against Internetbusinesses.

Although it is true that allowing states toenforce collection requirements on remote sell-ers under a one-rate-per-state system wouldpreserve tax competition among states, that

The aggressivemanner in whichmany states areattempting to draftout-of-state firmsas tax collectorssuggests that newrevenue, not equi-tably sharing thecost of services, istheir real goal.

16

competition would be much less intense thanunder current rules. Prior to the Internet, theonly meaningful behavioral constraints on salestax rates were driving across state lines andordering from catalogs. Few people, however,are fortunate enough to live near a state with alower tax rate, and catalogs are limited in bothcapability and availability. Electronic com-merce gives the option of cross-border shop-ping to people for whom it never before exist-ed and expands the range of products that theycan buy. That is a useful check on the ability ofstate and local governments to raise sales taxesbeyond a reasonable level.

Proposals to require remote sellers to collectuse taxes assume that the location of the cus-tomer will be known. That knowledge cannotbe taken for granted, however, especially forpurchases of digital products and services. Asthe use of anonymous digital cash becomeswidespread, sellers may not even have billingaddresses to use in calculating tax charges. Auniform national tax rate would not solve thatproblem, because tax receipts could not be fair-ly apportioned among the states. The Hollingsbill, for example, does not even attempt toremit funds to states based on the location oftaxpayers; instead, the bill relies on a redistrib-utive formula based on poverty rates andschool-age populations. Even if states managedto allocate the taxes among themselves, itwould be extremely difficult for them to fairlyapportion tax revenues to the localities whereconsumers were located, resulting in an evenmore inequitable redistribution of incomewithin states.

Lack of knowledge of the customer’s loca-tion could also lead to taxation by states thathave no connection to the transaction in ques-tion. Assume, for example, that businesses areinstructed to rely on credit card billing infor-mation for tax collection purposes. Considerthe common example of a traveler who pur-chases a digital product by credit card—say, adownloaded news article—while staying in ahotel room in another state. The seller wouldbe required to collect and remit a use tax to thestate where the buyer’s credit card was regis-tered, but that state would have no connection

to the transaction itself, nor would any use orconsumption take place there. In such cases,the collection requirement of the taxing statewould have a sweeping extraterritorial effectnot permitted under prevailing due processjurisprudence, which precludes the applicationof a state statute to commerce that takes placeswholly outside its borders.

Limiting States’ Taxing Authority Is a CrucialComponent of American Federalism. In 1998 areport published by the National League ofCities asserted, “One of the virtues of federal-ism is that states are able to choose for them-selves how to design their own tax systems,whether to tax information services, andwhether to tax or exempt on-line providersfrom state sales taxes.”82

Although state and local governments arefree to set their own tax policies, their authori-ty does not extend beyond their geographicborders. There is something inherently unset-tling about states’ exercising legal authorityoutside their jurisdictions. Unquestionably,states have the legal right to levy use taxes ontheir own citizens. But imposing a collectionobligation on out-of-state businesses is a fun-damentally unfair government activity. By whatright can New York force a firm in Florida toact as its tax collection agent? Even if it wereconstitutionally permissible, it would set a dan-gerous precedent with enormous potential forconflict.

Because Internet commerce by nature can-not be locally restricted without imposing costson other states, it falls into Congress’s sphere ofauthority. At least some active federal guidancecould be useful, because recent state court deci-sions relating to jurisdiction and the Internetare confusing and often contradictory.Consider Inset Systems Inc. v. Instruction Set Inc.and E-Data Corp. v. Micropatent Corp.83 InInset, the district court held that advertisingthrough use of an Internet site, even though nopurchases or sales could be conducted throughthe site, constituted solicitations of a naturesufficiently repetitive to justify jurisdiction byConnecticut, where consumers were exposed tothe ads. However, in E-Data Corp., the samecourt held that a company engaged in electron-

Electroniccommerce gives the

option of cross-border, tax-free

shopping to peoplefor whom it neverbefore existed andexpands the range

of products thatthey can buy.

17

The Framers ofthe Constitutionwisely erectedstrong protectionsof interstatecommerce andempoweredCongress toenforce thoseprotections.

ic commerce and operating an Internet site wasnot subject to personal jurisdiction byConnecticut solely by virtue of Connecticutresidents’ ability to access the site. Those seem-ingly inconsistent opinions illustrate the uncer-tainty that businesses face when confrontingInternet-related legal issues.84

The overriding priority at the federal levelshould be to ensure that states are not allowedto violate the principle of due process by impos-ing tax collection responsibilities on out-of-state businesses. Quill minimized the legalimportance of due process considerations andapparently gave Congress an opening to autho-rize states to require use tax collection. But thefact that Congress has the authority to resolvethat dispute does not imply that it should rad-ically change the status quo. That action wouldbe neither prudent nor just; the mere potentialfor a revenue crunch is not a compelling reasonto impose burdensome duties on out-of-statefirms.

Other constitutional rationales for main-taining the federal restrictions on state taxationof remote commerce are available.85 The Quillcontention that requiring remote sellers to col-lect taxes places an unconstitutional burden oninterstate commerce, for instance, remainsvalid.

The Framers of the Constitution wiselyerected strong protections of interstate com-merce and empowered Congress to enforcethose protections. If states are allowed to makeout-of-state firms, which have no connectionto or influence over the taxing authority, act asrevenue collectors, those barriers will be signif-icantly weakened. Use taxes may not be uncon-stitutional per se, but states should be requiredto collect such taxes themselves, withoutunjustly extending their authority into otherjurisdictions.

Options for State and Local TaxationDespite claims to the contrary, it is by no

means certain that the growth of electroniccommerce will substantially undermine stateand local tax collections. Online commercemay generate new business and enhance pro-ductivity to such a degree that any revenue

losses will be negligible. But even if there is anegative revenue impact, state and local gov-ernments have several policy alternatives avail-able. At the federal level, the objective shouldbe to maintain a tax system that fosters compe-tition among the states.

The idea that state and local governmentswill be unable to find the money to performlegitimate government functions is laughable.As taxpayers know too well, politicians willalways have such options as income taxes, usetaxes, property taxes, gas taxes, hotel taxes, andthe like. Their insistence on expanding tax col-lection authority without lowering tax ratessuggests that the goal is not equity or revenuesecurity but instead a new source of funds thatwould escape voter scrutiny. If a tax increase isnot the intent, then current policy recommen-dations are misguided. Unfortunately, there islittle reason to expect a change of course. Giventhat several states have enacted voter-approvedtax-limiting initiatives, the taxation of elec-tronic commerce has apparently become anattractive back-door option for lawmakers whochafe at such restrictions.

Justified or not, state and local officials evi-dently believe that erosion of the tax base is onthe horizon. It is thus likely that they willattempt to recover uncollected taxes fromsomewhere. Ideally that would be accom-plished by a combination of budget cutting,waste reduction, and tax reform. In reality,however, the most probable strategies will be toraise existing taxes, redefine taxable transac-tions, impose new taxes, and attempt to expandthe nexus provisions.

Ultimately, states may be forced to lookbeyond such piecemeal reforms. Congress isalready considering the idea of extending theITFA. At least one bill, introduced by Sen.Robert Smith (R-N.H.) in January, wouldimpose a permanent moratorium on taxationof remote electronic commerce. Such a ban islikely to have popular appeal—the leadingRepublican presidential candidates have allendorsed the concept and several bills havebeen introduced in Congress—so states shouldnot ignore the possibility that alternatives totraditional sales taxes might be necessary. A

18

few of the available options are consideredbelow.

Lower Taxes—Cut Spending. If electroniccommerce eventually contributes to a statebudget crunch, it will not be because revenuesare inadequate but because states simply spendtoo much. For most of America’s history, thestates consumed roughly 4 to 5 percent of grossnational product. By 1970 that figure hadgrown to 7 percent; by 1980, to 8 percent; andby 1990, to 8.5 percent.86 At that time, manystates were facing what the New York Timescalled “a fiscal calamity.”87 Then, as now, budgetanalysts and state officials tended to blametheir problems on a multitude of factorsbeyond their control. Especially singled out forblame were the resistance of citizens to newtaxes in the 1980s and a decline in federaltransfer payments.

Although both of those factors likely playedsome role in causing the states’ fiscal predica-ments, the primary culprit was a decade of run-away state government expenditures. With fewexceptions, the states with the most severedeficits early this decade were the ones that sawtheir economies and tax revenues grow rapidlyin the 1980s but allowed spending to groweven faster.88

By 1996, however, the states had moveddramatically in a fiscally conservative direction,with most states cutting taxes and holding gen-eral fund expenditures at or below inflation in1995 and 1996.89 Overall, from 1996 to 1997state budgets expanded just slightly above theinflation rate, as opposed to nearly twice theinflation rate in the early 1990s. The result oftax cuts and fiscal restraint was that states accu-mulated sizable budget surpluses, ending thebudget “crisis” of years past.90

Unfortunately, there has been a clear trendtoward more spending at the state level duringthe past two years. In 1998 many governorssubmitted budget proposals that increasedspending by more than 7 percent, roughly threetimes the rate of inflation.91 On average, statesestimate an increase in general fund spendingof 5.7 percent for FY98 and 6.3 percent forFY99, with only two states reducing theirFY98 enacted budgets.92 Those figures repre-

sent almost twice the rate of inflation plus pop-ulation growth.93 Noting that apparent returnto profligacy, the Wall Street Journal published astory headlined “For Republican Governors,Spending Isn’t a Dirty Word Anymore.”94 Thedesire to spend more is leading state officials toperpetually seek new revenue—and electroniccommerce is now in the cross hairs.

Budget data show that states have no press-ing need to tax remote electronic commerce. Ifevery state had adhered to a population-plus-inflation revenue cap from 1992 to 1998, tax-payers would have saved a total of $75 billion,or $278 per capita, in 1998 alone. Even if stateshad passed $75 billion in tax cuts in 1998, theirrevenues would still have grown by about 22percent, or 3.4 percent per year—the level ofinflation and population growth. Instead, statetax collections climbed by 45 percent, or 6.4percent per year.95

Consider the case of Nevada, where execu-tive director of the Department of TaxationMichael A. Pitlock has called Internet com-merce “a significant concern” for state financesand has proposed “[putting] a requirement onvendors to collect taxes for all products theyship to each state.”96 Again, the real problem isspending, not revenue. As the Las VegasReview-Journal noted while discussing the cur-rent legislative session, “There will be plenty oftalk about ‘pain,’ ‘cuts,’ and a ‘shortfall.’ Don’t befooled: State spending over the next bienniumwill increase by almost 10 percent, to an esti-mated $3.186 billion.”97 Such budget battleshighlight the need to rein in spending, not beefup tax collection.

Local government is not immune to thesiren song of runaway spending. As Newsdayrecently observed of New York’s NassauCounty, “Unbelievably, at a time of unprece-dented prosperity that has created surpluses forgovernments large and small, one of the nation’srichest counties is drowning in red ink.” Theproblem: too much spending. “Nassau has beenliving beyond its means for years, offering toomany, sometimes overlapping, services and pay-ing too many politically connected employeesmore than it could afford.”98

State and local officials are naturally

The idea that stateand local govern-

ments will beunable to find themoney to performlegitimate govern-

ment functions islaughable.

19

inclined to spend an ever-increasing portion ofthe taxpayers’ wealth, but that urge must beresisted. To secure their fiscal futures, statesshould lower tax rates and give taxpayersgreater value for their tax dollars by cuttingback unproductive agencies and privatizingstate services.

States should also emulate the tax- andspending-limit initiatives that have been passedin recent years. Washington’s Initiative 601, forexample, says that state spending can grow by nomore than the rate of inflation plus populationgrowth. That’s running about 3 percent a year,less than half the average annual budget growthfor the past two decades.99 In addition, the samestate’s recently passed Initiative 695 requiresvoter approval of all tax and fee hikes. Alongsimilar lines, some governors—includingChristine Whitman of New Jersey, Tom Ridgeof Pennsylvania, and New York’s GeorgePataki—are pushing bills to require a superma-jority of lawmakers to raise taxes.100

Alternative Tax Structures. The problemsassociated with taxation of electronic com-merce would disappear if states switched to asource-based system of sales taxation. Currentsales taxes are structured on a destination basis,with the intent of imposing the tax at the placeof consumption. Under a source tax, money iscollected where economic production, not con-sumption, takes place. Businesses are assessedtaxes based on total sales volume, regardless ofthe ultimate destination of their output.Reform in that direction need not entail a com-plete overhaul of state tax systems. As KayeCaldwell, public policy director ofCommerceNet, has noted: “All states exemptlocal merchants from collecting sales taxes ongoods that are exported from their states tobuyers in other states. Eliminating that loop-hole and setting the export rate to match thestate rate in the buyer’s state would immediate-ly resolve the [use tax collection] problem.”101

Source taxes have the advantage of lowadministrative costs and high compliancerates; they do not extend a state’s taxingauthority outside its borders, and they main-tain strong incentives for states to engage intax competition. Even critics of a source-based

tax system have conceded some of thoseimportant advantages:

Source-based transaction taxes appliedto electronic commerce have clearcompliance and administrative costadvantages over their destinationbased counterparts through the elimi-nation of the use tax problem. A desti-nation tax requires retailers to accountfor sales made in all market states, dis-tinguish between taxable and exempttransactions, and apply the proper taxrate to the transaction. Under thesource alternative, retailers need onlyknow the transaction tax system with-in their states of location, an especiallyimportant advantage for smaller firmswith relatively high compliancecosts.102

The primary “problem” with source-basedtaxation, according to its detractors, is that taxcompetition may be so intense that businesseswould locate primarily on the basis of tax crite-ria. That argument assumes that tax rate differ-entials will be great enough to offset naturaladvantages such as proximity to suppliers andcustomers, and conversely, that location has asignificant effect on productivity. Both asser-tions cannot be true. If location is a majordeterminant of productivity, firms will beunlikely to move unless the tax savings will bevery high. If, however, modern transportationnetworks make relocation viable for minimaltax savings, there will be little negative effect onthe nation’s overall economic efficiency.

Finally, states could always decide to broad-en the in-state tax base so that services aretaxed more evenly. In addition to achievinggreater neutrality, that approach has the advan-tage of intergenerational equity. In most states,the growing elderly population will spend alarger share of its income on services than willthe working-age population. Taxing all goodsand services at the same rate, the tax burdenwould be spread more evenly among all seg-ments of the local population.

Whether states choose to restrain spending

Under a source tax,money is collectedwhere economicproduction, notconsumption,takes place.

20

or to restructure their tax systems, an importantbenefit of internal reform is that it will forcestate legislators to face public scrutiny. Federalaction, though, would allow local lawmakers topass the buck—to effectively increase taxeswithout having to seek voter approval.

Domestic ConclusionsThe current federal rules do not exempt

online commerce from taxation; they simplyprohibit one means of collection. Thus, elec-tronic commerce does not enjoy any legal taxadvantage. Where current state tax systemseffectively disadvantage local retailers, statesalready have it within their power to addressthe problem.

Although reform may be difficult, states arein no immediate danger of going broke, nor dothey lack alternatives to the current system ofsales and use taxes. Furthermore, the federalgovernment should ensure that states do notunfairly export their tax collection burden,thereby impeding interstate commerce. A fed-eral commitment to that principle will alsohelp guarantee that changes at the state leveldo not undermine tax competition—that indi-viduals and businesses retain the freedom toescape punishing tax rates.

Reform is not urgent, however, so states andlocalities will have time to alter their tax sys-tems as conditions change. Online commerceis not likely to significantly constrain state and

local budgets for the foreseeable future, and inany case, those budgets have been growing toofast. States should concentrate on reducingbloated budgets and returning surpluses to tax-payers, not unfairly expanding their taxingjurisdictions.

Like state budgets, traditional retailers willsurvive the emergence of electronic commerceand may end up being a source of much inno-vation in that field. Except for digital productsdelivered over the Internet, online shopping isnot vastly different from the catalog or televi-sion experience. Those two marketing mediahave more to fear from the Internet than dobrick-and-mortar stores. By lowering ratesand restructuring their tax systems, states canaddress equity concerns without unfairlyburdening out-of-state businesses with taxcollection duties.

Congress should firmly refuse to bow tostate demands for new taxing authority. TheITFA was a good start in ensuring that tradi-tional principles of remote commerce apply tothe online world, but more could be done. IfCongress acts, it should be to unequivocallyblock the extraterritorial taxation of electroniccommerce, in both tangible and intangibleproducts. That would entail a clear definitionof taxable nexus that requires physical presenceby a firm before a state can demand use tax col-lection. Such clarification should include spe-cific language establishing that Internet activi-ty and contracts for services are insufficient toestablish nexus.

By acting firmly, Congress can uphold tra-ditional principles of interstate tax competi-tion, due process, and fairness, while leavingelectronic commerce free to serve as the growthengine for tomorrow’s economy.

Part IIInternational Taxation of

Electronic Commerce

Although it has received relatively littleattention in the United States, a debate overhow international electronic commerce oughtto be taxed has also been raging for several

A positive congressional agenda on electronic com-merce taxation should aim to

• establish a clear nexus standard and definitions—based onphysical presence—to determine when companies can berequired by a state to collect sales or use taxes,

• amend P.L. 86-272 to cover the sale of intangible propertyand services,

• reject all international efforts to draft American business-es as tax collectors for foreign governments, and

• pursue an Internet free-trade agreement in the WorldTrade Organization.

21

The United Statesshould be carefulnot to sign on toany internationalagreements thatwill hamper thegrowth ofelectronic com-merce or undercutbeneficial taxcompetition.

years, and the participants in that dialogue haveoften voiced alarm. Governments fret thatbecause existing international tax rules evolvedin an industrial and agricultural world, theymight be inadequate for the Brave New Worldof electronic trade and tax revenue may be lost.Conversely, businesses worry that conflictingand overly burdensome tax rules could retardthe growth of electronic commerce. Taxpayers,as usual, have few advocates.

Both governments and businesses havebeen prone to exaggerate the threat of inaction.Most of the international tax complicationscreated by electronic commerce have been dealtwith before. Telephone, fax, telex, ElectronicData Interchange, and other new forms ofcommunication between businesses and cus-tomers have challenged international tax rulesduring a good part of this century. So taxauthorities are not in entirely uncharted waters.Predictions of the rapid growth of Internet-based electronic commerce, however, suggestthat it is time to reexamine the principles thatgovern international taxation.

The most important question to ask is,What is the difference between the taxationof an Internet-based international transactionand of a conventional transaction? The answershould provide tax administrators with reasonfor optimism: when a sale results in the phys-ical delivery of goods, there is generally nodifference. Shipments must still go throughcustoms, are subject to import duties, and maybe subject to consumption taxes.103 That factbodes well for both businesses and govern-ments. As an early U.S. Treasury Departmentpaper on electronic commerce notes, “Carefulexamination may very well reveal that few, ifany, of these emerging issues will be sointractable that their resolution will not befound using existing principles, appropriatelyadjusted.”104

It is also encouraging that computer net-works and technologies can increase the effi-ciency of tax collection. Electronic filing, forexample, already promises to radically cut thecosts of administering—and perhaps increasecompliance with—income tax systems in theUnited States and other developed countries.

Electronic payment systems could potentiallybe used to deposit refunds directly in taxpayeraccounts or to accept electronic payments,which would save time, postage, and otheradministrative costs. Streamlined customs pro-cedures using new technology could alsoimprove border-clearing efficiency and thusincrease transaction volumes. As the Internetbecomes more reliable and taxpayers becomeaccustomed to new ways of interacting with taxagencies, the gains from such developmentscan be expected to multiply.

But the growth of international electroniccommerce will undoubtedly pose real—thoughoften exaggerated—difficulties for the admin-istration of national tax systems as they are cur-rently structured. At least four issues have beenthe focus of much recent concern and analysis:

1. Should Internet content be subject tocustoms duties or new taxes?

2. Is the concept of “permanent establish-ment” valid in cyberspace, and, if so, is theexisting definition adequate to ensurethat different jurisdictions do not tax thesame income?

3. Will electronic commerce increase non-compliance with or avoidance of con-sumption taxes? How will the characteri-zation of intangible products and servicesaffect that behavior?

4. Will the ease of conducting business elec-tronically lead to “harmful” tax competi-tion among countries?

To some extent, all those questions arevalid, and governments will be forced to con-front them. The United States in particular,however, will not have to radically redesign itstax system. As the world’s largest exporter ofboth information technology products andservices and intangibles such as movies andmusic, the United States is in an enviableposition.105 The United States should be care-ful not to sign on to any international agree-ments that will hamper the growth of elec-tronic commerce, hinder the development ofnew technologies, burden U.S. businesses, orundercut beneficial tax competition.

22

The question of how international electron-ic commerce should be taxed is a remarkablycomplex one, and the preceding list does notbegin to exhaust the range of possible topics.This paper is not intended to serve as a blue-print for U.S. tax policy; instead, its purpose isto raise some of the more immediate issues fac-ing policymakers and to suggest broadapproaches to dealing with those issues.

Basic Principles of International TaxationThere was an early coalescence around the

Organization for Economic Cooperation andDevelopment as the forum best suited to dealwith the taxation of international electroniccommerce. Work there has already resulted ingeneral agreement on the basic principles thatshould govern its taxation. That consensus isperhaps best reflected in the OECD’s ModelIncome Tax Convention and, more recently, inits set of seven criteria for judging proposals totax the Internet:

1. The system should be equitable: taxpay-ers in similar situations who carry outsimilar transactions should be taxed inthe same way.

2. The system should be simple: adminis-trative costs for the tax authorities andcompliance costs for taxpayers should beminimized as far as possible.

3. The rules should provide certainty for thetaxpayer so that the tax consequences of atransaction are known in advance: tax-payers should know what is to be taxedand when—and where the tax is to beaccounted for.

4. Any system adopted should be effective:it should produce the right amount of taxat the right time and minimize thepotential for tax evasion and avoidance.

5. Economic distortions should be avoided:corporate decisionmakers should bemotivated by commercial rather than taxconsiderations.

6. The system should be sufficiently flexibleand dynamic to ensure that tax rules keeppace with technological and commercialdevelopments.

7. Any tax arrangements adopted domesti-cally and any changes to existing interna-tional taxation principles should be struc-tured to ensure a fair sharing of theInternet tax base among countries, par-ticularly important as regards division ofthe tax base between developed anddeveloping countries.106

Other groups have articulated a similarvision. The Global Information InfrastructureCommission, for example, accepts the “generaltax principles of neutrality, efficiency, certainty,simplicity, effectiveness, fairness and flexibilityas applicable to electronic commerce.”107 TheWorld Trade Organization agrees, noting, “Inprinciple, taxation of electronic or non-elec-tronic commerce should be easy to administerand should not induce unnecessary distortionsand discrimination.”108

It is one thing to agree on vague principles,quite another to translate them into actual poli-cies. Indeed, trade ministers from the top 30industrial nations failed to make much head-way at an OECD meeting in Ottawa at theend of last year because of deep differences,particularly between the United States andEurope. And although generally sensible, theOECD guidelines could easily be stretched tojustify unwise national tax laws. The guidelinesalso do not offer specific suggestions for futurereforms—nothing about how national tax sys-tems might eventually be forced to adapt to thenew reality of international electronic com-merce. In short, the OECD principles providelittle in the way of concrete guidance to U.S.policymakers grappling with the emergingonline economy.

The OECD principles are deficient inother ways. As do the arguments made by stateand local governments in the United States, theOECD international tax principles recognizethe basic common-sense notion that tax sys-tems should be technologically neutral and easyto administer. Also as in the domestic debate,the benefits of tax competition are largelyignored. The OECD is an organization whosemembership consists exclusively of nationalgovernments. Tax competition among those

Just as competitionamong businesses

is a welfare-enhancing process,

so too is taxcompetition among

governments.

23

governments exerts downward pressure on taxrates, so governments tend to favor harmoniza-tion over competition. As a 1998 OECDreport on “harmful tax competition” noted,“Pressures of this sort can result in changes intax structures in which all countries may beforced by spillover effects to modify their taxbases, even though a more desirable resultcould have been achieved through intensifyinginternational co-operation.”109 The question is,More desirable for whom?

Just as competition among businesses is awelfare-enhancing process, so too is tax com-petition among governments. The OECDreport is in part an attempt by countries withhigh levels of taxation to escape the conse-quences of their unwise domestic policies.The United States should reject their argu-ments. Because of some unique tax systemadvantages and a generally hospitable com-mercial climate, the United States is wellpositioned to benefit from international taxcompetition. There is nothing harmful orunfair about the United States’ taking a light-handed approach to taxation and regulation ofelectronic commerce; in fact, it is essentialthat we do so to ensure that we remain themost attractive market for businesses engagedin electronic commerce.

Policymakers in both Congress and theadministration must retain a healthy skepti-cism about all schemes that undercut taxcompetition and recognize that internationalcooperation among governments to achieve“revenue stability” could undermine the poten-tial of electronic commerce. But if allowed toflourish, electronic commerce will significant-ly improve the efficiency of economies,enhance their productivity, improve resourceallocation, empower consumers, and increaseoverall long-term growth.

In charting our course in this area, policy-makers should be guided by three key con-cerns:

1. The United States should refuse to act asa tax collector for other nations—an ideacurrently under consideration by theOECD.110 National autonomy has gener-

ally been the rule in international taxagreements, but the borderless nature ofelectronic commerce will make it increas-ingly attractive for some national govern-ments—especially those with onerous taxand regulatory structures—to rely on rec-iprocal enforcement arrangements. TheUnited States has little to gain but muchto lose by following that path.

2. The United States should welcome themore intense tax competition that mayresult from the growth of internationalelectronic commerce. Europe, by con-trast, troubled by this phenomenon, hasbeen studying ways to kill it since atleast 1996, and the OECD has shownconcern. Its paper on the “harmful”effects of tax competition calls for “co-ordinated action at the internationallevel.”111 The United States, by demon-strating the benefits of open marketsunburdened by excessive taxation, canencourage other nations to adopt similarpolicies.

3. The United States must be wary ofinternational agreements that wouldcompromise the privacy of Internet con-sumers, especially ones that would banthe use of emerging privacy-enhancingtechnologies. Some nations have sug-gested, for example, that the use of unac-counted digital cash should be restrictedbecause of its potentially negative impacton their tax systems. That is a wrong-headed approach. In addition to losingprivacy, the suppression of new tech-nologies will slow the advancement ofelectronic commerce and leave govern-ments with less revenue to tax. The tech-nological shape of the marketplaceshould drive the design of tax systems,not the reverse.

All proposals relating to the taxation ofinternational electronic commerce should takeinto consideration the preceding criteria. Theremainder of this paper discusses a few of themost immediate issues that are likely to faceU.S. policymakers. Those issues are grouped

The United Statesmust be wary ofinternational agree-ments that wouldcompromise theprivacy of Internetconsumers.

24

The real goal ofsupporters of the bit

tax is apparently toexpand government

rather than createan efficient tax

system.

into three categories: new and Internet-specif-ic taxation, direct taxation of income, and con-sumption taxation.

New and Internet-Specific TaxationThe first operating rule for policymakers

should always be to do no harm. With regardto the taxation of international electronic com-merce, that means that no new or discrimina-tory taxes should be enacted.

The Bit Tax. One proposal is the “bit tax”—essentially a minuscule tax on each “bit” of dig-ital information that flows across global net-works. Proposals for the bit tax date back atleast to a 1994 paper by Arthur Cordell andThomas Ran Ide.112 Cordell and Ide argue thatexisting tax bases are no longer appropriate inan environment where the major economicactivity is the transmission of data. It is time,they write, to move to a more appropriate taxbase. Luc Soete, chairman of the EuropeanUnion’s so-called High Level Expert Group,and Karin Kamp went further, arguing in a1996 paper that additional research on the bittax was needed because the “taxing of the dis-tribution of [physical] goods, which has tradi-tionally formed one of the essential bases fornational, state or even local government’s taxrevenues is . . . eroding rapidly.”113

No detailed plan for implementing a bit taxhas been drawn up; however, the typical con-cept is that revenues collected under a bit taxwould be allocated among various jurisdictionson the basis of some agreed-on formula.Cordell and Ide envision the followingarrangement:

For public long distance lines, the taxwould apply to the actual informationor flow of digital traffic. For leasedlines, a fixed amount would becharged, based on the carrying capaci-ty of the line measured in bits per sec-ond. Carriers would measure the localflow within a specified area. . . . Thismeasurement would produce a statisti-cal average for the designatedregion—an amount that would repre-sent the number of bits flowing in the

area. This would provide the base rateof tax for that local area.114

Apart from its substantial technical hur-dles,115 the bit tax is a fundamentally flawedconcept that is ill suited to the reality of elec-tronic commerce. The chief failing of the bit taxis that it takes no account of the true value ofwhat is being taxed. Thus, the transmission of anewly released novel would be taxed at a farlower rate—possibly thousands of timeslower—than the transmission of an amateurvideo or even a personal photograph. Theincentive would be to avoid any high-band-width use of the Internet, regardless of its avail-ability and price. Some proponents of the bit taxrecognize and applaud that result, noting thatthe tax would end the “rapidly growing conges-tion and increasing amount of ‘junk’ and irrele-vant information being transmitted.”116 Ofcourse, one man’s junk is another man’s treasure.

As with state and local officials in theUnited States, the real goal of supporters of thebit tax is apparently to expand governmentrather than create an efficient tax system. Soeteand Kamp speak of the “additional bit tax rev-enues” that will be collected and how suchfunds could be used to finance the deteriorat-ing social security system in Europe,117 whileCordell has lamented the fact that “govern-ment has not yet figured out a way to tax andredistribute some of the new wealth created byglobal digital networks.”118 Along those lines,the EU’s High Level Expert Group’s report“Building the European Information Societyfor Us All” advocates exploring the “appropri-ate ways in which the benefits of theInformation Society can be more equally dis-tributed between those who benefit and thosewho lose.”119 However, commanding newsources of private wealth should be the lastthing U.S. policymakers seek. Instead, theyshould concentrate on redesigning antiquatedpublic-sector programs—such as our own fail-ing Social Security system—so that individualscan more easily take advantage of the wealth-creating dynamism that characterizes the mod-ern high-tech economy.

Fortunately, the bit tax has few supporters

25

these days. It was roundly criticized at theOECD’s 1998 Ottawa ministerial meeting,and both the Clinton administration and theEU Commission have essentially dismissed itas unworkable. Also recognizing the inherentshortcomings of the bit tax, the WTO has con-cluded that the bit tax would be “a blunt instru-ment, blind to any subtlety in public policyconsiderations.”120 Despite those encouragingsigns, policymakers should remain vigilant sothat the bit tax—or other Internet-specifictax—does not resurface as a serious option infuture deliberations. The latest human devel-opment report published by the UnitedNations Development Program, for instance,calls for a one-cent tax on the transmission ofevery 100 e-mails.121 Similar Internet taxschemes are certain to be hatched in the future.

Free Trade in Cyberspace. True electroniccommerce—the purchase and delivery of prod-ucts and services online—already takes place ina largely free-trade environment. Whetherbecause of prudent restraint or lack of techno-logical capability, no nation currently leviescustoms duties on wholly electronic transac-tions. Given that nations have devoted consid-erable time and energy to lowering barriers tointernational trade, it makes sense that thosecountries work to maintain the beneficial statusquo for trade in electronic goods and services.

Free trade in electronic goods and services isa unique situation. Never before have allnations started from a free-trade position beforeany negotiations began. Thus, for network-delivered digital content, countries should beable to easily agree to a zero-tariff rating. TheClinton administration’s “Duty-Free Zone”proposal in “Framework for Global ElectronicCommerce”122 was a commendable startingpoint that has helped build international sup-port for zero-tariff rating, and this past May,132 members of the WTO reached a tempo-rary agreement on the exemption of electronictransactions from customs duties.123 TheOECD has also endorsed the idea, noting thatit is not intended to “limit the application ofVAT/GST as appropriate by any national taxadministration in respect of importations of allrelevant goods and services.”124 In other words,

establishing the Internet as a duty-free zonewill not result in revenue losses for govern-ments (since tariffs are currently nonexistent)and will not interfere with national income orconsumption tax systems. To guarantee thatfree trade in electronic commerce continues, anagreement on the tariff treatment of digitaltransactions should be pursued in future WTOnegotiations.

Establishing the Internet as a digital free-trade zone would also dispense with the needto characterize electronic products as eithergoods or services under the WTO. However, ifcountries decide to apply tariffs to trade in dig-ital goods, it will be necessary to classify thecontent of data flows to determine whetherthey are to be governed by the GeneralAgreement on Tariffs and Trade or the GeneralAgreement on Trade in Services. That wouldbe a difficult task because many online transac-tions are clearly services, yet no universallyagreed-on system for classifying those servicesexists. Furthermore, developing such a systemwould needlessly squander scarce WTOresources.125

As the world’s leading producer of electron-ic goods and services, the United States has anespecially strong interest in setting a goodexample by resisting domestic pressures tocharge customs duties on electronic transac-tions. As a 1998 paper published by the WTOpointed out: “85 per cent of Internet revenue isgenerated in the United States while only 62per cent of the users are located there. Thissuggests that the United States is probably anet exporter of products through theInternet.”126 Moreover, because the U.S.Treasury derives most of its revenues from per-sonal and corporate income taxes, Washingtonmust be careful not to raise barriers to trade indigital content that will encourage businessesto locate elsewhere. Federal income tax receiptswill rise to the extent economic activity isencouraged through a commitment to freetrade online.

Apart from the sale and electronic deliveryof digital content, the Internet will also pro-mote the flow of low-value shipments of phys-ical goods directly to consumers. The growth of

To guarantee thatfree trade in elec-tronic commercecontinues, anagreement on thetariff treatment ofdigital transactionsshould be pursuedin future WTOnegotiations.

26

electronic storefronts on the Web, for example,makes it relatively simple for a customer in onecountry to order a product directly from a for-eign seller. Because the costs of insurance andcustoms administration can equal or evenexceed the value of a low-dollar shipment, thistype of commerce may not reach its full poten-tial unless reforms are instituted.

To facilitate the growth of those transac-tions, governments should consider expandingtax- and duty-free thresholds, especially whenthe costs of inspection and collection wouldlikely exceed revenues raised. As the countrywith the most commercial Web sites, theUnited States will benefit greatly if such salesare allowed to flourish. And as with any reduc-tion in trade barriers, the U.S. economy willbenefit even from unilateral action.Consequently, the United States should raisethe threshold for customs treatment on smallcross-border purchases—at least doubling thecurrent $50 limit—regardless of whether othernations initially follow suit.

Direct Taxation of IncomeThe expected growth of electronic com-

merce raises some important issues relating tonational systems of direct taxation but doesnot fundamentally challenge existing con-cepts. The most immediate problem facingtax authorities will be attributing to a particu-lar country the income generated by electron-ic commerce. Although the “permanent estab-lishment” standard has been serving that pur-pose for a long time and will continue for theforeseeable future to assign tax liability inelectronic commerce, eventually, national gov-ernments could be compelled to think aboutmoving toward a residence-based system ofdirect taxation.

Current Principles of Direct Taxation.Direct—or income—taxes in the internationalcontext currently rely on the twin concepts ofsource and residence to specify who is liable fortaxes and, for those who are, what income issubject to tax. Source-based taxation is intend-ed to limit income tax collection to the juris-diction where economic activity takes place.Thus, when activity in the United States is the

source of income earned by a foreign citizen orentity, that person or entity is subject to U.S.income taxes. Conversely, residence-based tax-ation is predicated on the nationality of theperson or entity earning the income. Theworldwide earnings of U.S. resident citizensand corporations, for example, are generallysubject to taxation at home.

To avoid paying taxes on the same incomein both the United States and abroad, U.S. res-idents are eligible for domestic credits on taxespaid to foreign governments.127 Double taxa-tion is also guarded against through an exten-sive network of bilateral income tax treatiesthat the United States has with at least 48countries.128 Under those agreements, residentsof foreign countries are taxed at a lower rate orare exempt from U.S. income taxes on certainitems of income they receive from sourceswithin the United States. The application ofthose lower rates and exemptions vary amongcountries and specific types of income. Inexchange, the U.S. government is granted theright to tax income earned by American com-panies in the treaty partner’s country. Theintent is to fairly allocate taxing rights betweennations, as well as to assist in the exchange ofinformation between tax authorities to mini-mize the misreporting of income from foreignsources.

Such treaty and tax credit safeguards arenecessary because source- and residence-basedtaxation are inherently conflicting. Generally,the country where economic activity takesplace (the “source” country) has a right to taxincome that is generated within its borders.However, governments also claim the right totax income earned by their citizens and residentcorporations abroad. Clearly, one of those twoprinciples must yield, or the same incomewould be taxed simultaneously by two govern-ments. Tax treaties thus establish rules for “per-manent establishment” to determine whichprinciple will govern in a particular case. Thatapproach is laid out in Article 7 of the OECDModel Treaty, which states that a country maytax an enterprise’s business profits attributableto a permanent establishment located in thatcountry, regardless of the enterprise’s country

The expectedgrowth of electronic

commerce raisessome important

issues relating tonational systems ofdirect taxation but

does not funda-mentally challenge

existing concepts.

27

The ability to accessa foreign Web siteis actually a lesserdegree of contactthan the solicitationof orders via catalogor telephone.

of residence for tax purposes.129 In cases whereno permanent establishment is deemed toexist, the general consensus among OECDmember countries is that residence-based taxprinciples should govern.

In the absence of a treaty, source principlesgenerally govern taxation. Foreign personsfrom nontreaty countries are thus subject toU.S. tax on all income connected with the con-duct of a U.S. trade or business. For treatycountries, however, Washington usually cedesits right to tax income earned by a foreign enti-ty unless that income can be attributed to apermanent establishment—a higher standardthan the mere “conduct of a trade or business.”Permanent establishment is defined by theOECD as “a fixed place of business throughwhich the business of an enterprise is wholly orpartially carried on.” Facilities used solely forthe purpose of storage, display, or delivery ofgoods do not meet the permanent establish-ment threshold.130

What Constitutes Permanent Establishment?What constitutes permanent establishmentwith regard to electronic commerce may poseproblems that existing tax treaties do notaddress. The most obvious concern is the abili-ty to access a Web site from within a particulartaxing jurisdiction. Does the fact that con-sumers can place orders through a foreign firm’sWeb site subject that firm to income taxes inthe country where the customer lives? Theproper answer is almost certainly no. A Web sitehas no physical presence and thus cannot beconsidered as a permanent establishment in anymeaningful sense. To say that the ability toaccess a Web site, without more substantialcontact, is sufficient to create permanent estab-lishment is to say that online businesses areliable for income taxes in every country inwhich their customers reside. Such a broad def-inition would be virtually useless. The ability toaccess a foreign Web site is actually a lesserdegree of contact than the solicitation of ordersvia catalog or telephone. Under existing taxprinciples, which should not be abandoned,mere solicitation does not create a permanentestablishment.

Another, more complex, question concerns

the location of computer file servers: Shouldthe mere presence of a server in a particulartaxing jurisdiction be considered sufficient tocreate permanent establishment? Again, thebest answer is no. In most cases, the existenceof a foreign-owned server does not requireemployees to be present in the host country—traditionally a prerequisite for permanentestablishment. But even when a business main-tains its own server through its own employees,the level of contact with the host country rarelyrises above the “storage, display, or delivery ofgoods” standard that exists in the OECDModel Treaty. Following the OECD’s guide-lines, most tax treaties do not consider facilitiesthat are used in that manner as a permanentestablishment.

There are additional reasons why an in-country file server should not be defined as apermanent establishment, not the least ofwhich is Article 5 of the Model Treaty. Article5 has generally been interpreted to excludemail-order activities as insufficient to createpermanent establishment. A Web site that dis-plays product information and takes ordersfrom customers is equivalent to an electroniccatalog and should thus receive the same taxtreatment as postal solicitations.

A more practical problem is that definingservers as permanent establishments wouldrender the allocation of income among com-peting jurisdictions very complex. It is all butimpossible to determine the income attribut-able to any one server, and many Web sites arehoused on multiple servers located throughoutthe world. Apart from the jurisdictionalheadaches, using the location of a server as thecriterion for determining the place of econom-ic activity would result in a largely arbitrary taxstandard that bears no relation to where eco-nomic activity occurs.

Finally, as companies will seek the besttreatment available, countries that do not tietax strings to the placement of servers withintheir borders will clearly benefit. Because thelocation of a server is irrelevant from a techni-cal standpoint, shifting the location of serverswould be an irresistible way to minimize liabil-ities. Tax advisers are already telling their for-

28

eign clients that to “avoid the possibility of aninadvertent permanent establishment in theUnited States, [they should] use a Web serverlocated outside of the United States,” whichsuggests the United States should clarify itsposition on the issue.131 Despite that reality, taxauthorities in several countries and at least oneOECD Discussion Paper have indicated thatthe presence of a server might be sufficient tocreate permanent establishment.132

Regardless of what individual governmentsdecide to do, the classification of computerservers as permanent establishments is notlikely to survive without an international agree-ment.133 The borderless nature of electroniccommerce means that countries that make tax-ation contingent on Web server location willencourage the migration of servers beyondtheir borders. Few governments would be will-ing to adopt such a policy unilaterally. Anexample of such policy competition can be seenin the United States, where some states havebeen thwarted from taxing on the basis of serv-er presence by other states that have disavowedthat tactic.

The Adaptability of Current Standards.Nothing in the preceding discussion of perma-nent establishment is meant to imply thatonline businesses will escape taxation. Thepoint is that existing concepts are sufficientlyrobust to fairly allocate tax revenues withoutresorting to strained definitions of what consti-tutes “presence” in a remote jurisdiction. As arecent article in Tax Management InternationalJournal explains:

The fact that no tax liability is cre-ated in the customer state does notmean that the e-commerce enterpriseavoids full tax in those places where itsphysical inputs are deployed. Transferpricing rules will remain available toallocate income among those jurisdic-tions where capital and labor in factare employed to create wealth. Adirect tax obligation arising in thecountry of source when the enterprisehas no physical presence there wouldcreate a disproportionate tax burden

in terms of both compliance costs andamount of tax paid compared to theenterprise’s connection to the localeconomy.134

Fortunately, Washington appears to havegrasped the truth of that situation. TheTreasury Department’s paper on the tax impli-cations of electronic commerce indicates thatthe Treasury will regard both the presence of aserver in the United States and the fact that aforeign person’s Web site may be accessible bycomputers in the United States as insufficientto be considered either permanent establish-ment or a U.S. trade or business.135 Certaincourt cases also provide hopeful guidance. InPiedras Negras v. Commissioner—a case involv-ing cross-border radio transmissions (a reason-able analogy for Internet communications)—the United States unsuccessfully tried to tax aMexican broadcaster that retained 90 percentof its listeners and advertisers north of the bor-der. A federal circuit court held that the UnitedStates did not have jurisdiction to tax the sta-tion, since there was no capital, labor, or estab-lishment in the United States. The electroniclinks between the station and its listeners weredeemed insufficient to give the U.S. govern-ment taxing authority.136

That is also the best policy for electroniccommerce, and it should be formally adoptedas soon as possible. The United States enjoysthe highest concentration of Internet servers inthe world and should therefore stake out aminimalist position on server tax treatmentregardless of what other countries do. In fact,the United States will prosper to the extentthat other countries insist on adopting a moreaggressive server policy, with more U.S.-basedelectronic commerce resulting in an expandedtax base. Ultimately, however, internationalefforts to tax on the basis of server presence willalmost certainly be abandoned if Washingtonrefuses to go along.

In addition to a commitment by the UnitedStates not to treat computer servers as perma-nent establishments, the Treasury Departmentshould consider other measures to simplify taxliability for multinational enterprises. One such

The borderlessnature of electronic

commerce meansthat countries that

make taxationcontingent on Webserver location will

encourage themigration of servers

beyond theirborders.

29

positive change would be for the United Statesto replace the “conduct of a trade or business”standard that currently applies to businessesbased in nontreaty countries with a uniformpermanent establishment standard. That sim-plification would encourage electronic com-merce with nontreaty countries by giving thema clearer picture of when they would be liablefor U.S. income taxes.

Taxation and ISP Obligations. Agency issuesmay also need to be clarified as they relate tothe conduct of electronic commerce. For exam-ple, some national governments will likelyargue that a domestic ISP—by connectingconsumers to a foreign business’s Web site—acts as an agent for determining the existenceof permanent establishment. That positionwould be very difficult to defend. Article 5 ofthe Model Treaty defines agency sufficient tocreate permanent establishment as a relation-ship in which the foreign corporation relies onthe domestic agent to conclude binding con-tracts in its name. An independent agent thatlacked such authority would not be sufficient tocreate permanent establishment.

As business groups have pointed out, in thecourse of normal commercial activity, “the rela-tionship of an enterprise with its Internet ser-vice provider is simply a business contract forservices to be provided to the enterprise ratherthan to act on behalf of the enterprise as a legalagent.”137 Thus, the fact that an ISP may facili-tate the conduct of business in the source coun-try—like a local telephone exchange or postalservice—does not mean that the ISP has anagency relationship with the foreign enterprise.Tax authorities should clarify that the existingdefinition of what constitutes agency for pur-poses of permanent establishment does notinclude the ordinary activity of domestic ISPs.By contrast, when a U.S. business provides ser-vices that are clearly integral to the primarybusiness activity of the foreign enterprise—such as selling Internet access services onbehalf of a foreign ISP—a taxable agency rela-tionship might be appropriate.

Transfer Pricing. A transfer price is chargedbetween related parties in international trans-actions—for example, when a U.S. firm buys

goods or services from a related or subsidiarynonresident corporation. Governments areconcerned that the prices used in such transac-tions be equal to those that would be chargedto an unaffiliated corporation in the open mar-ket (known as the “arm’s length” principle).When that is not the case, price manipulationmay allow firms to shift profits from high- tolow-tax jurisdictions. Transfer-pricing rules areintended to ensure that the prices charged byrelated businesses to each other are accurate.

The increasingly dense electronic networksof multinational enterprises present, in theory,no new problems for existing transfer-pricingrules. However, the practical effect of the newcommunications technologies is a degree ofintegration that has not been seen before.Inexpensive computer network communica-tions have made it possible for companies tocoordinate previously impossibly fragmentedproduction processes, particularly for intangi-ble products and services. Thus, current report-ing rules for transactions involving affiliatedcompanies or divisions may not be sufficient totrack electronic transactions and allocateincome and expenses among competing taxjurisdictions. At the very least, electronic com-merce has the potential to make the currentproblems with transfer pricing more common.

Preliminary analysis by the OECD suggeststhat the existing Transfer Pricing Guidelinesfor Multinational Enterprises and TaxAdministrations are applicable to the specialcircumstances of conducting business throughelectronic commerce.138 At the least, it is toosoon to tell if significant problems will arise.U.S. policymakers should follow the OECD’songoing work in this area and insist that thebusiness community be included in the processof crafting any new rules.

A Residence Alternative? The difficulties indetermining when and where a permanentestablishment exists may necessitate a greaterreliance on residence-based taxation. Underthat system, individuals and corporationswould be subject to income tax in the countrywhere they reside or maintain the strongestties. That approach would greatly simplify theallocation of taxing rights and increase the

Tax authoritiesshould clarifythat the existingdefinition of whatconstitutes agencyfor purposes ofpermanent estab-lishment doesnot include theordinary activity ofdomestic ISPs.

30

A residence-basedtax system would

foster competitionand could thus lead

to lower and moresimplified taxes,

with a consequentincrease in world

economic growth.

efficiency of administration. In addition, aresidence-based system would ensure thatnations will be forced to compete for increas-ingly mobile businesses by maintaining soundtax policies and low rates. The TreasuryDepartment, speculating that “source basedcommerce could lose its rationale and berendered obsolete by electronic commerce,”suggests that the idea is worthy of furtherconsideration.139

An international tax system based on resi-dency is both feasible and potentially desirable,as evidenced by the permanent establishmentstandard present in most tax treaties.Permanent establishment describes a thresholdbelow which source-based taxes will not be col-lected. As cross-border electronic commerceexpands, it may turn out that the source ofincome becomes more difficult to reasonablydetermine. Residence-based taxation, alreadyin common usage, is the logical alternative.

The most obvious benefit of residence taxa-tion is ease of administration—it is not neces-sary to identify the source of economic activitywhen income is subject to taxation only in thecountry of residence. That tremendously sim-plifies the calculation of tax liabilities for firmsengaged in electronic commerce whose incomemay not be attributable to any specific geo-graphical location. Since nearly all individualsand businesses claim residency somewhere(under U.S. law, all corporations must be estab-lished under the laws of a given jurisdiction),electronic commerce would not escape taxa-tion. The danger of double or overlapping tax-ation would also be minimized, since countrieswould not need to squabble over the location ofthe source of income generated in cyberspace.Moreover, tax authorities are best able to collecttaxes from those firms that are unquestionablytied to their national jurisdiction.

The residence of the seller is as good anapproximation of where economic activitytakes place as is the location of the buyer—especially with regard to intangible goods orservices. The production of intangible propertyis becoming increasingly difficult to attribute toany specific geographic location, so if suchactivity is to be taxed at all, it will need to be

under a system that does not rely on knowingwhere income was created. Residence-basedtaxation is well suited to the taxation of elec-tronic commerce precisely because it requiresrelatively few pieces of information to functioneffectively. As the Treasury Department paperpoints out, residence principles have alreadybeen adopted for certain space- and ocean-based activities—a borderless situation notunlike the world of cyberspace.140

Most important, a residence-based tax sys-tem would foster competition and could thuslead to lower and more simplified taxes, with aconsequent increase in world economic growth.Under a system of residence taxation, the loca-tion of a corporation becomes more important,especially for online companies whose physicaldistance from their customers is irrelevant.Some companies might set up shop in countriesthat offer low taxes, or alternatively where gov-ernments would compete more intensely thanthey do now to provide an environment that isconducive to economic activity.

U.S. policymakers should realize, of course,that the benefits of low tax rates and unobtru-sive compliance procedures are their ownreward; they are not contingent on other coun-tries’ adopting similar policies. Countries thatmaintain a business-friendly environment rela-tive to their trading partners are likely to bene-fit at their expense. As former Citicorp chair-man Walter Wriston observed: “Capital goeswhere it is wanted, and stays where it is welltreated. It will flee onerous regulation andunstable politics, and in today’s world technol-ogy assures that that movement will be at nearthe speed of light.”141 Wriston’s observationundoubtedly applies equally to sound tax poli-cy. Although tax competition is to some extentinevitable, the efficiency of capital allocationcan be enhanced when nations agree to princi-ples of taxation that will avoid double taxationand refrain from using national tax codes toexclude foreign producers.

Problems with Residence Taxation. Onepotential unintended beneficiary of residence-based taxation would be tax havens—small off-shore financial centers with low or no corporatetaxation, lax regulation, and strong secrecy pro-

31

tections. Tax havens are already home to someInternet-related businesses, most notably,online casinos.142 Nevertheless, it is far from cer-tain that such tax havens would succeed inattracting a significant number of mainstreamcompanies involved in electronic commerce ifresidence taxation becomes widespread. Taxhavens lack the facilities and critical mass ofhigh-technology companies that exist in devel-oped countries. Although it is technically possi-ble for firms to shift some amount of the pro-duction of digital content to such places, it isunlikely that many of the highly skilled employ-ees involved in that process would be keen onliving permanently abroad. Even if havens dobegin to undermine tax revenues, governmentsof developed countries could respond by mak-ing their own tax systems more attractive,through direct negotiation with havens or byother means of political persuasion.

Critics have also charged that residence-based taxation would entail shifts in the inter-national distribution of tax revenues, especiallyfrom developing to developed countries.143

That concern is overstated for two reasons.First, for revenue losses to occur, there wouldhave to be significant source income currentlybeing taxed, which is generally not the case inthe sale of digital goods and services. Mostdeveloping countries have very low levels ofInternet connectivity and thus would not seemuch change in their taxable base.144 Second, asdeveloping countries become a part of theinformation economy, their collections of for-eign-source income tax will increase. If oneassumes that consumer demand for importeddigital content develops at roughly the samepace as the domestic information economy,then tax flows would tend to balance eachother to some extent. In any case, OECDcountries should not base their own intramem-ber tax system on the revenue fears of countriesthat account for a relatively small portion ofworld trade.

Consumption Taxation: VATs and GSTsTaxes on consumption account for an aver-

age 30 percent of the revenues collected byOECD member countries, and all of them

impose a Value Added Tax (or equivalentGoods and Services Tax) except for the UnitedStates and Australia.145 In theory, governmentscollect a VAT from taxpayers in the jurisdictionwhere consumption takes place. In practice,however, consumption taxes are usually collect-ed indirectly, from the final seller of a productinstead of from the consumer. That approachhas allowed governments to shift the burden ofcollection to private businesses, making taxavoidance relatively difficult. The problem fac-ing governments is that as consumers increas-ingly buy from foreign online businesses, taxcollection may suffer.

Should U.S. Businesses Collect Europe’s VATs?Unlike the income tax treaties that specify whois eligible to tax international economic activity,there are no agreements or treaties that coordi-nate the collection of indirect taxes. That shouldnot overly concern U.S. policymakers, sinceWashington relies on income rather than con-sumption taxes. For that reason, the growth ofinternational electronic commerce poses muchmore of a threat to VAT-reliant countries than tothe United States. Federal officials must there-fore be wary of agreeing to a system that wouldburden U.S. businesses with tax collectionresponsibilities for other governments. After all,the American Revolution was fought overEngland’s jurisdiction to tax remote sales in thecolonies. The rallying cry of America’s Founderswas not “No taxation without representation . . .or a mutual cooperation agreement.”

Unfortunately, that possibility is all too real:work is already under way at the OECD tointroduce a system of international cooperationamong member countries for indirect taxation.“In an era of globalisation and increased mobil-ity for taxpayers,” the OECD warns, “tradi-tional attitudes towards assistance in the collec-tion of taxes may need to change.”146

Specifically, the Committee on Fiscal Affairs ofthe OECD has been considering including inthe Model Tax Treaty an article to allow forassistance by one state in the collection of taxesfor another.147 According to Joseph Guttentag,deputy assistant secretary of the Treasury, suchassistance would mean that “Norway wouldcollect tax on sales out of California and

The growth ofinternational elec-tronic commerceposes much moreof a threat toVAT-reliantcountries than tothe United States.

32

California would collect on sales out ofNorway.”148

That scenario is neither inevitable nordesirable. First, it is important to note that notall electronic commerce seriously threatensVAT revenues. A large amount of internation-al electronic commerce is business-to-businesstransactions, which if not tax exempt, enjoy ahigh rate of voluntary compliance. A 1999Forrester Research study estimates that in 2001taxable business-to-consumer electronic com-merce will represent only 7 percent of totalEuropean Internet electronic commerce, orroughly 0.25 percent of European GDP. In theUnited States that figure is expected to be 8percent, or 0.58 percent of GDP.149 Most ofthat commerce is not expected to cross interna-tional borders: the WTO predicts that by 2001only $60 billion of international trade will beconducted over the Internet, or 2 percent oftotal estimated global commerce.150

Second, consumption taxes will be collectedon many international sales. When theInternet is used for taking orders directly fromconsumers, with a physical product’s beingshipped to a foreign tax jurisdiction, there isgenerally no difference between electroniccommerce and traditional mail-order business.Mechanisms are already in place for such com-merce, and goods imported from outside acountry are subject to VAT at importation. Theonline delivery of digital content to consumers,which is the type of transaction most difficultto tax, presents a different set of issues that arediscussed below. If an increasing volume oflow-value transactions makes VAT collectionburdensome, it may be necessary to expand deminimis thresholds so that the flow of low-value packages is not impeded.

Finally, no agreement on international taxcollection assistance is likely to be reachedunless the United States participates, so thereis little danger of Washington’s missing theinternational boat. As the Australian TaxationOffice has observed, “Given the dominantplace that United States entities play inelectronic commerce, from Internet softwareproviders, to content providers, to electronicpayment system providers and as the home

of many of the major international credit cardcompanies, the support of the United Statesin any co-operative arrangement will besignificant.”151

The VAT and Digital Content. The mainconcern of VAT-reliant countries is not the saleover the Internet of tangible goods but ofintangible ones. Such products as books, music,and software have been easy to tax, becausethey have traditionally been sold on physicalmedia and distributed by local retailers. On theother hand, foreign businesses that sell directlyonline do not collect the VAT. Under currentrules in Europe, U.S. companies without a fixedestablishment can invoice EU customers VATfree, whereas domestic businesses must chargethe tax. From the U.S. perspective, any equi-table system must retain that practice, since asnoted earlier, it would be grossly unfair forAmerican businesses to act as tax collectors forEuropean governments in cases where no sub-stantial connection exists between the sellerand the consumer’s country. That prospect hasmany European businesses worried that theywill be unable to compete with VAT-free salesof digital content. As the Times of London hasnoted, “With VAT rates averaging nearly 20per cent in the EU, domestic businesses risklosing out to overseas rivals.”152

Fears of rampant tax evasion are probablyunfounded. The Forrester and WTO data sug-gest that international sales of digital content,although growing rapidly, will remain a rela-tively insignificant percentage of economicactivity. In fact, digital content sales by 2001 areexpected to equal only 5 percent of overall elec-tronic commerce revenues in Europe and only3 percent in the United States—less than 0.18and 0.22 percent of GDP, respectively.153

When an international transaction takesplace and no VAT is charged, the customersthemselves are generally required to assess theappropriate tax. Businesses frequently comply,although most individual taxpayers areunaware of their obligations in internationaltransactions and are thus unlikely to remit theappropriate funds. Some governments arealready taking steps to address that problem.Canada, for example, has proposed a program

The rallying cry ofAmerica’s Founders

was not “Notaxation without

representation or amutual cooperation

agreement.”

33

The imposition ofconsumption taxesis inherentlydifficult when bothpurchase anddelivery of aproduct takeplace online.

designed to educate taxpayers on the tax oblig-ations associated with doing business over theInternet.154 To the extent that tax rates are per-ceived as reasonable, governments may findthat voluntary compliance by both businessand consumers will render groundless many ofthe fears of rampant tax evasion.

Nevertheless, some observers in both gov-ernment and business think that the adminis-tration of consumption taxes—particularly aEuropean-style VAT system—will becomeincreasingly unworkable as electronic sales ofdigital content expand. If consumers regularlyturn to nonresident suppliers in order to avoidthe VAT, local businesses fear, probably rightly,that they will lose customers. The Europeane-business tax group, for example, has called onthe European Commission to update its VATrules to keep up with the booming electroniccommerce market.155 Governments, as always,want to ensure that electronic commerce doesnot undermine tax receipts.

The imposition of consumption taxes isinherently difficult when both purchase anddelivery of a product take place online. Toeffectively impose a VAT, tax authorities needat least three pieces of information. First, itmust be known where a transaction takes placeto assign tax revenues to the appropriate juris-diction; second, a transaction must be classifiedas the sale of either a good or a service to knowwhat tax to apply; and third, a business sellinga product or a service must be able to deter-mine when it is liable to collect and remit taxes.

Jurisdiction: Where to Tax?On the issue of jurisdiction, tax authorities

have concluded cross-border electronic tradeshould be taxed in the jurisdiction where con-sumption takes place.156 Unfortunately, that isnot always a straightforward proposition.Companies generally have no need to know thephysical location of their customers to sell elec-tronic products and services to them. ManyInternet shoppers place a high value on privacyand may avoid doing business with firms thatinsist on collecting such information.Alternatively, to avoid taxes, online buyerscould easily submit false information when

making a purchase.The Credit Card Solution? Some tax authori-

ties have suggested relying on credit card billinginformation to locate sales.157 “Along withadvances in Internet technology,” says an articlein Accountancy Age, “we may expect advances inthe monitoring of transactions. Customs &Excise should be able to track down what youhave spent and collect the [tax] straight off yourcredit card.”158 However, relying on credit cardinformation is extremely problematic. Servicespurchased with a credit card are typically billeddirectly to the credit card company addressrather than to the location where the buyer con-sumes the service. The only information avail-able to tax authorities would be the billingaddress on file with the credit card company.But that address need not have any connectionto where a digital product or service was actual-ly downloaded and consumed. Moreover, anysuch approach could be easily abused. Forexample, by using a post office box, the addressof friends or relatives, or a second home or busi-ness, individuals could establish a billing addressin a low-tax jurisdiction. That would allowthem to access and consume digital goods frominside a high-tax jurisdiction. In addition, ser-vices are available that allow mail to be sent to aprivate center that forwards the mail to a secondaddress. Tax administrators could seek to verifyeach consumer’s address, but enforce-ment would be expensive and produce littleadditional revenue.159

Assuming a credit card–based identificationsystem could be made to work, it would raisesome troubling privacy issues. Currently, gov-ernments generally do not have access to cred-it card company data unless a particular card-holder is suspected of criminal activity. The useof such data for tax collection purposes wouldpotentially put a detailed record of a person’sbuying habits in the hands of governmentauthorities—without the normal judicial pro-tections. The possible abuses of that informa-tion are enormous, and it is doubtful whethermany individuals would easily accept theunprecedented invasion of their privacy. Thus,consumers would have an incentive to usecredit cards issued by foreign companies that

34

would not surrender personal data.Even if all issuers could be drafted as tax

collectors, credit cards are not likely to work forlong as a means for locating sales, becauseunaccounted digital cash will take the place ofthe cards. Digital cash systems are more than atheoretical possibility. MasterCard andMondex, for example, have been testing “smartcards” for several years; and in Denmark, a con-sortium of banking, utility, and transport com-panies has announced a card that may replacecoins and small bills.160 A tax system based oncredit cards would only exacerbate the trendtoward digital cash: the anonymity it offerswould become immediately more attractive ifgovernments seek to monitor consumersthrough their credit transactions. Governmentsmay simply be forced to accept that the loca-tion of many consumers may not be availableon purchases of digital content.

Permanent Establishment and the VAT.Another option that has been discussed is anexpansion of permanent establishment forVAT purposes.161 That concept is identical topermanent establishment and direct taxation.Essentially, the idea is to lower the standard forwhat constitutes a fixed (and thus taxable)establishment to include electronic connec-tions—computer servers, telecommunicationslinks, and so on. The purpose of broadeningthe definition is, of course, to extend tax collec-tion liability to nearly every firm that doesbusiness with a person living inside a particulartax jurisdiction. When a consumer in Milan,for example, orders a book from Amazon.com,the VAT tax would be collected by Amazonand remitted to a collection point in Europe.

As with direct taxation, stretching perma-nent establishment to include such a limited“virtual presence” would essentially make it ahollow concept. The purpose of limiting taxa-tion to businesses that maintain an actual phys-ical connection with a taxing jurisdiction is notonly to allocate taxing rights among govern-ments but also to recognize that businesses andindividuals ought not be subject to the author-ity of governments from which they derive nosubstantial benefits. Foreign governments haveno right to expect U.S. firms to be their VAT

collectors, especially since Washington doesnot impose such obligations on foreign busi-nesses that sell their products here.

Countries with national consumption taxeswill not be able to enforce collection even withthe help of the United States. It is not possibleto track the transmission of digital contentacross borders, especially since such transac-tions can be easily encrypted. Some analystshave suggested that foreign firms could becompelled to collect taxes by technologicalmeans.162 A country might decide to “blackout” the Web site of a company that refuses toregister for VAT collection, for example.Customers in a country in which a Web site isblacked out would be unable to access that sitefrom their Web browsers and thus unable tocomplete purchases.

It is questionable how effective such solu-tions would be. Consider that, despite a highlycentralized system of Internet service provi-sion, authoritarian governments (such asChina) have been unable to effectively controlaccess to dissident Web sites. Moreover, thecensorship of foreign Web sites would likelyface legal challenges; the fact that someonemight avoid taxes is a shallow pretext for anoutright ban on the flow of information.Finally, a proliferation of alternative means ofInternet access—via satellite or cross-borderdial up—will make it progressively more diffi-cult for governments to maintain centralizedaccess controls. Even when customers in VAT-imposing countries log on through a govern-ment-monitored channel, they will probably beable to ship their digital purchases throughthird parties in non-VAT countries or orderfrom an ever-changing array of mirror sites.The inability of governments to enforce intel-lectual property rights on recorded music(online pirate sites are ubiquitous) suggests thatattempting to collect consumption taxes on theinternational sale of digital content will be asimilarly fruitless endeavor. Reducing expendi-tures or looking elsewhere for tax revenuewould be more effective than attempting dra-conian enforcement of consumption taxesonline. The Internet is simply too massive anddecentralized to police effectively.

A tax system basedon credit cards

would onlyexacerbate the

trend towarddigital cash.

35

From the U.S. perspective, the debate overcollection of online consumption taxes interna-tionally is largely academic. In the absence ofan international agreement, the onus will be onthe countries that impose a VAT to either dis-cover effective ways of levying taxes on importsof seemingly untraceable intangible goods orabandon the attempt altogether. Whetherthrough reliance on voluntary self-assessment,incentives for foreign sellers to collect,increased use of direct taxes, or exemption ofintangibles from taxation, the problem of levy-ing taxes should be tackled by the affected gov-ernments.

Classification: What Tax Applies?Another issue—how to classify digital

transactions as either the sale of goods or ser-vices—also poses problems for consumptiontaxes. Since differing VAT rates generally applyto goods and services, it is necessary to classifyonline transactions as one or the other. Therehas already been some controversy over thatissue. The position taken by the EuropeanCommission has been that digital productsshould be considered as services.163 The UnitedStates, however, suggested that digital productsshould be characterized on the basis of therights transferred in each particular case.Speaking at the OECD’s Ottawa meeting,Guttentag criticized the European approach,saying that “we should resist the temptation tosettle on answers that represent oversimplifica-tions and over-generalizations, such as, forexample, the conclusion that the provision ofdigitized information is in all cases the provi-sion of services and not the provision of goodsor the right to use an intangible.”164

Although the EU’s approach provides cer-tainty, it has the significant drawback of dis-criminating against products delivered online.Books and newspapers, for example, face a zeroVAT rate in some European countries. If view-ing the identical newspaper online were classi-fied as the sale of a service, it would be taxeddifferently from its physical counterpart—aresult contrary to the principle that like prod-ucts should be taxed the same regardless of themeans of delivery. Harmonizing VAT rates for

goods and services would result in equal treat-ment, of course, but policymakers in Europeand elsewhere would likely attempt to parlaythat into a tax increase by “harmonizingupward.”

U.S. policymakers have little if any influenceover such domestic reforms, so the onlyremaining option is to seek common interna-tional standards for the classification of digitalcontent. Besides violating the principle of neu-trality, the EU’s move to classify all onlinetransactions as the sale of services will poten-tially serve as a trade barrier to U.S. exports.Specifically, uneven tax treatment will meanthat European consumers have an incentive topurchase zero-rated domestic products insteadof digital imports.

The U.S. approach, leading presumably tomore neutral tax treatment, is to characterizedigital transactions by the rights transferred tothe consumer. (The OECD has also endorsedthat general methodology).165 The goal is to taxfunctionally equivalent transactions in the sameway. For example, for tax purposes, the pur-chase of an off-the-shelf software packagefrom a traditional brick-and-mortar retailer isusually classified as the sale of a good. Insteadof treating the sale of that software as a servicewhen it is downloaded off the Internet, theU.S. approach would classify that transaction asthe sale of a copyrighted article because theconsumer has purchased only the right to useor copy the software. Customized software orthe transfer of copyright rights, however, wouldface different tax treatments. That nuancedapproach would more accurately capture theessential quality of each transaction than wouldthe one-size-fits-all characterization proposedby the EU.

Although no detailed guidelines for thecharacterization of digital commerce have beenpresented by the United States, the InternalRevenue Service has issued regulations relatingto the U.S. internal income taxation of softwaretransactions.166 Those regulations make it clearthat the IRS will consider the sale of standard-ized software over the Internet as the sale of adigital product, which means the company sell-ing it would be liable for income taxes only if it

Although the EU’sapproach providescertainty, it has thesignificantdrawback ofdiscriminatingagainst productsdelivered online.

36

Governments mustcome to grips with

the fact that evasionof VAT taxes will

likely always bepossible on sales of

digital products andservices.

had a permanent establishment in the UnitedStates. In the case of customized software—which would be classified as the sale of ser-vices—the income would normally be taxedwhere the service is performed, likely the for-eign company’s home country. Where softwareis sold with a license that allows multiple copiesto be made and then resold, income would betaxed as royalty income and a permanent estab-lishment would not be required. In principle,there is no reason why the software regulationscannot serve as the basis for regulations thatwould cover the sale of a broader range of dig-ital products as well.

Collection: Who Must Collect and How?As more companies began to sell online, it

will become increasingly difficult for them toknow when and where they are liable for taxcollection and remission. Even for firms thatwish to comply, the costs of registering and col-lecting for hundreds of VAT systems world-wide could be enormous unless the process isgreatly simplified. Fortunately, the concept offixed place used for VAT is sufficiently com-prehensive to deal with electronic commerce.As with direct taxes, companies that do nothave a physical connection to the taxing coun-try should not be expected to collect the VAT.The United States should work in the OECDto reach an agreement to reaffirm and clarifythat basic principle as it relates to electroniccommerce.

Governments must come to grips with thefact that evasion of VAT taxes will likely alwaysbe possible on sales of digital products and ser-vices. The ability to route electronic purchasesthrough low-tax jurisdictions, as well as widelyavailable encryption technology, makes it rela-tively easy to hide transactions from tax admin-istrators. Because the Internet is so large andfragmented, effective monitoring by anynational authority is difficult. Unless funda-mental reforms are made, VAT authorities maybe forced to rely on voluntary compliance.

One possible alternative would be to simplydeclare that digital transactions will be free ofVAT taxes. As noted earlier, books, newspa-pers, and other similar products are charged a

zero VAT rate in some European countries.Given the technical and privacy barriers totracking online transactions, as well as the cur-rent incentive for residents in countries thatcharge VAT taxes to buy from foreign suppli-ers, the best way to level the playing field mightbe to forgo taxation. The result would be non-neutral tax treatment of tangible alternatives todigital goods (unless such items were also zerorated), but that result might be preferable togiving remote Internet sellers a de facto taxadvantage. In any case, the relatively smallshare of international commerce conductedonline is an indication that the tax losses fromexempting digital content will be minimal forthe foreseeable future.

If exemption is politically unacceptable, amore palatable option might be to levy con-sumption taxes on digital transactions at theplace of origin—where a good or a service isproduced—instead of where it is consumed.The arguments for such a system are similar tothose for residence-based direct taxation, andreform in that direction could potentiallyimprove the prospects for national tax systems,businesses, and taxpayers as the global infor-mation economy develops.

VAT and Place of Supply RulesAnother aspect of consumption taxes that

might create uncertainty for businesses is “placeof supply” rules. VAT systems generally seek tocharge taxes at the place where goods or ser-vices are supplied.167 Unfortunately, that is notalways a simple task. The basic rule for goods isthat the place of supply is the location fromwhich they are shipped. The situation is morecomplex for services: place of supply can beeither where the supplier or the customer islocated—depending on the specific type of ser-vice being delivered.

In the EU, most services are taxed accord-ing to where the supplier has a fixed establish-ment. There are several exceptions to that rule.Most relevant to the conduct of electroniccommerce is that “cultural, entertainment, orartistic” services are taxed where they are per-formed, and intangible or intellectual ser-vices—such as copyrights, licenses, financial

37

transactions, and professional consultations—are taxed where the customer who receives theservice is established.

However, the Internet makes it possible formore intangible goods and services to bedelivered to customers by suppliers who haveno physical presence in the country whereconsumption takes place. As a result, bothbusinesses and consumers may be able tostructure their buying patterns to avoid payingthe VAT. That has prompted governments tolook at how place of supply rules might bereformed to handle online transactions moreeffectively.

One option would be to change the stan-dards for what constitutes a fixed establish-ment. The drawbacks to that approach are dis-cussed above, under “Direct Taxation ofIncome.” Similar objections obtain to loosen-ing the standard for VAT tax collection respon-sibilities. Furthermore, VAT countries wouldbe asking the U.S. government to forceAmerican firms to perform a service thatwould not be reciprocated. Washington thushas little incentive to agree to that arrange-ment; however, unless there is internationalcooperation, enforcing VAT collection require-ments on firms without permanent establish-ment would be virtually impossible.

A better alternative would be to rethink therules that govern place of supply. Instead ofattempting to fit Internet transactions into acomplex classification system, governmentscould simplify consumption taxes on servicesby levying those taxes uniformly at the placewhere the customer is established. Such a sys-tem would require customers purchasing ser-vices over the Internet to assess the VAT if theseller is established abroad and has no presenceof company personnel or agents in the VATcountry. The fear, of course, is that when for-eign firms sell directly to consumers (asopposed to VAT-registered entities), taxes willnot be voluntarily remitted.

To solve that problem, governments thatimpose a VAT would need to make consumersaware of their tax obligations with respect todownloaded digital content. Those govern-ments might also decide to offer incentives for

voluntary collection by foreign firms, such as aflat fee or percentage of the tax that could bekept by the firm doing the collecting. Thosemeasures might be sufficient to entice at leastthe online sellers who do the most business toparticipate in the VAT system.

Once again, the best alternative might besimply to exempt digital products and servicesfrom the VAT when such purchases are madeby individuals. For the most part, when thecustomer is an individual, no VAT is currentlybeing collected by either the buyer or the U.S.seller. Instead of dealing with the costs (bothfinancial and in lost privacy) that effective col-lection would entail, governments could rea-sonably decide to deal in other ways with theresultant economic distortions and cede theloss of VAT revenue in this area.

Origin-Based TaxationLike the case for residence-based taxation

for direct taxes, the growth of electronic com-merce will necessitate a change in how con-sumption taxes are collected. Although there isnothing inherently wrong with charging indi-rect taxes at the place of consumption, it is inpractice far more complex than levying taxes atthe place of origin. As the Global InformationInfrastructure Commission has noted, “An ori-gin-based system, universally applied, wouldsimplify indirect taxation, would result in moreeffective enforcement, would reduce opportu-nities for avoidance, and would eliminate dou-ble taxation.”168

Under a destination-based VAT, tax isapplied to goods imported into the taxing juris-diction, and exports from the jurisdiction aretax free. Under an origin-based VAT, exportsare subject to tax, and tax is applied only to thevalue that is added after importation.

One advantage of an origin-based system isthat since the location of the consumer is irrel-evant, that information need not be collected.Instead, taxes would be levied on business sales,regardless of where the product or service isultimately enjoyed. For example, if an onlinesoftware company in the United Kingdomuploaded a game to a customer in Oregon, thesoftware company would be liable for the VAT.

The bestalternative mightbe simply toexempt digitalproducts andservices from theVAT when suchpurchases are madeby individuals.

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The same would be true if the software wereuploaded to a customer in London, Moscow, oran airplane crossing the Atlantic. Under an ori-gin-based system, taxes would be collected onall sales out of the relevant tax jurisdiction, andno businesses would be expected to collecttaxes for a government from which they deriveno benefits.

Since businesses are subject to audit, theexpected compliance rate with origin-based taxrules is very high. Mechanisms to enforcecompliance with tax collection responsibilitiesfor domestic consumption are already in place,so a move to origin-based taxation would placeno additional burdens on businesses andlittle (if any) new burdens on national taxadministrations.

A final benefit of origin-based taxation—although most governments do not see it thatway—is that an orgin-based system fostersrobust tax competition among governments.Critics of origin-based taxation often warn thatsuch tax competition will not be healthy butinstead will be a “race to the bottom” for nations,undermining their ability to raise revenue.169

This is identical, of course, to the claims madeconcerning residence-based taxation.

The revenue impact of origin-based taxa-tion could be limited by applying it only toelectronic commerce in digital content.Physical commerce—which will certainly con-tinue to be a major component of internation-al trade flows—could continue to be taxedunder the existing destination-based standard.Origin-based taxation for digital contentwould be preferable to destination-based taxa-tion, which is difficult to monitor and collectbecause of the nature of the Internet and therise of unaccounted digital cash.

Critics of origin-based taxation have alsoargued that it would disadvantage domesticproducers on their export sales. Although thedesign of a nation’s tax system can affect exportcompetitiveness, the true burden facingdomestic producers is the overall level of taxa-tion. High income tax rates, for instance, woulddamage the international competitiveness ofU.S. firms just as surely as would an origin-based consumption system that raised the same

level of revenue. In both cases, it does not mat-ter so much how taxes are levied but rather howhigh the overall tax burden is. Thus, businessessubject to VAT collection responsibilities maynot suffer any competitive disadvantages underan origin-based system if tax rates are kept atreasonable levels. A Deloitte & Touche paperput it this way:

A consumption tax without border taxadjustments (an origin-principle con-sumption tax) . . . at first appears tocreate a disadvantage for domesticproducers relative to foreign producersin overseas markets. Border tax adjust-ments, though, may not be the onlymechanism operating to maintainneutrality. Other self-executing adjust-ments by the markets, such as reduc-tions in wage rates or in the value ofthe domestic currency, could offsetwholly any potentially detrimentaltrade effects of origin-based taxationon exported goods.170

Even the European Commission has recog-nized the inherent benefits of origin-basedconsumption taxes, albeit only on an internalbasis. In its work program for the gradualintroduction of a new common VAT system,the commission announced its intention toadvocate a switch from taxation at destinationto taxation at origin for sales within Europe.The changes being contemplated are anythingbut minor. “All transactions giving rise to con-sumption in the EU,” a commission paperstates, “would be taxed from their point of ori-gin so that the existing remission/taxationmechanism for trade between Member Stateswould be abolished.”171 Origin-based taxationon an international basis would offer the sameadvantages that it would within Europe. U.S.policymakers should thus actively encourageshifting to such a system as a viable option fordealing with the growth of electronic com-merce.

Other Issues to WatchTax Rules as Trade Barriers. Uncertainty

One advantage ofan origin-based

system is that sincethe location of the

consumer isirrelevant, that

information neednot be collected.

39

Tax authorities mayattempt to blockthe implementationof new technologiesinstead of dealingwith their taxconsequences.

over how to apply the rules of international tax-ation to electronic commerce provides anopening for nations wishing to use their taxcodes as a barrier to trade. Because the UnitedStates is the leading exporter of electronicgoods and services, other countries may some-times be tempted to use their tax codes as bar-riers to digital imports. On a country-by-coun-try basis, the WTO is the proper forum tochallenge such nontariff barriers to cross-bor-der electronic commerce, and U.S. trade offi-cials should not hesitate to challenge illegalimpediments to our exports.

At the same time, proposed changes tointernational rules should be scrutinized andchallenged whenever they pose a threat to theglobal free flow of information. Seeminglyarcane domestic tax regulations, such as theEU’s decision to classify all network-deliveredcontent as services, can often have the practicaleffect of discriminating against imports andshould therefore be opposed. Trade officialsshould also keep an eye on domestic regula-tions governing electronic commerce. Therecent proposal by the National GamblingImpact Study Commission to ban online gam-bling, for instance, may effectively bar foreignproviders of gambling services from competingin the U.S. marketplace.172 Such proposed rulesshould be challenged at home, where they vio-late U.S. trade commitments.

Privacy Implications. U.S. policymakersshould also remain alert to the privacy implica-tions of any proposed changes to the interna-tional tax regime. Unfortunately, the EU—although highly skeptical of private data collec-tion and use—has not shown a great degree ofconcern over potential governmental privacyinvasions that could occur in the name of taxcollection. If international trade in intangibledigital content grows as rapidly as expected,European governments will undoubtedly seeknew ways to track and tax that commerce.Consumer privacy could easily be viewed asexpendable in the quest for revenue.

Officials in the United States have also beenguilty of taking a cavalier attitude toward pri-vacy issues. The Federal Deposit InsuranceCorporation recently proposed a controversial

“know your customer” rule that would haverequired banks to collect information from cus-tomers, monitor their accounts, and report“suspicious” activities.173 The FDIC backeddown after receiving thousands of complaintsfrom outraged customers, but the fiasco illus-trates that administration officials cannot berelied on to safeguard consumer privacy.

Suppression of New Technologies. Tax con-cerns are also used to justify unwise regulationin other areas. For example, some authoritiesin the EU will not allow business-to-businesselectronic invoicing, one of the most wide-spread forms of electronic commerce in usetoday.174 More worrisome, however, is the sug-gestion that tax authorities may attempt toblock the implementation of new technolo-gies instead of dealing with their tax conse-quences. Currently, the technology that rev-enue authorities dread most is anonymouselectronic cash.

The revolution in electronic payment sys-tems means that banks and other organizationsare now able to create their own digital moneythat consumers can use to make purchases bothover the Internet and in retail stores.175 This “e-cash” has no physical manifestation; it existsonly as a set of encrypted data that the issuerpromises to ultimately redeem for legal curren-cy or other store of value. Like paper money,e-cash can be passed from buyer to seller withno automatic record of the transaction. Placedon an electronic wallet or smart card, e-cashcan be used to complete a transaction withoutthe need for a telecommunications link to thebanking network. Thus, e-cash has the poten-tial to become a secure, private, and widely usedmedium of exchange.

Many governments are instinctively hostileto the idea of e-cash, and their response hasbeen to quash it. They fear that it will enablepeople to avoid paying taxes, especially con-sumption taxes on digital content from abroadsold over the Internet. The OECD, for exam-ple, has suggested that revenue authorities“press the appropriate bodies to ensure thatelectronic payment system providers operatetheir systems in a way that enables the flow offunds to be properly accounted according to

40

prevailing legislation. Revenue authorities mayseek limits on the values attached to unac-counted electronic payment systems.”176

Undoubtedly, e-cash will not escape scruti-ny and regulation, but as law professor DavidPost has observed, “It is going to take someserious thinking to design a regulatory schemethat does not fulfill our worst fears about thepersonal privacy implications of the new digitalworld.”177 Government officials have threechoices: they can monitor the development ofnew technologies and adjust their tax systemsto deal with new realities, they can outlawemerging technologies and financial innova-tions, or they can try to establish a system inwhich every expenditure by individuals is mon-itored and scrutinized. In a free society, the lat-ter two options are simply unacceptable.Novecon president Richard Rahn put it thisway: “In the new world of monetary freedomthere is no halfway ground. Either the govern-ment will know everything, or the governmentwill only know what is voluntarily revealed.”178

International ConclusionsElectronic commerce has the potential to

radically alter the way the world does business,serve as an engine of growth and development,and bring people together across borders. Tofulfill that promise, however, electronic com-merce must not be strangled by burdensometaxation. As the birthplace and the heart of theInternet, the United States has a special role toplay in ensuring that revenue-hungry govern-ments do not kill the goose that may lay thegolden egg. As U.S. Supreme Court ChiefJustice John Marshall observed, the power totax is indeed the power to destroy.

So far, the U.S. government has been aresponsible leader in this area. It has led thefight against customs duties on digital contentand opposed new Internet-specific taxes suchas the bit tax. Both of those were relatively easybattles, however, and the real test is yet tocome. The future direction of Internet taxationdepends largely on how the U.S. governmentchooses to approach problems as they arise.

If the United States maintains a commit-ment to tax sovereignty—to the principle that

American businesses should not be forced tocollect taxes for foreign governments—then taxcompetition will flourish, as will electroniccommerce. The Internet allows the productionof goods and services to be increasingly disin-tegrated and freed from geographic constraints.That new reality will undoubtedly place down-ward pressure on government revenues over theshort run but will ultimately lead to productiv-ity gains and wealth creation worldwide. It is afuture that should be welcomed by U.S. policy-makers.

The rise of the Internet economy may her-ald changes for national tax systems. As factorsof production become more mobile, the tradi-tional methods and levels of taxation may notstand the test of time. The best course is forgovernments to embrace lower spending—ifnot in absolute terms, then as a decreasingshare of the overall economic pie. The worststrategy would be to succumb to the fears ofshort-sighted governments that seek to piecetogether an international tax cartel designed toconscript low-tax countries into roles as taxcollectors. That approach seeks to achieve theideal of tax neutrality at the expense of theprocess of tax competition but is likely to leaveus with neither.

Governments may even find that theInternet, as the ultimate global marketplace,empowers individuals in ways that will makethem less dependent on state services. An evo-lution in online financial services, for example,has made it possible for tens of millions of indi-viduals to inexpensively manage their retire-ment investments, obtain price and safetyinformation, and communicate with fellow cit-izens. The Internet also benefits individuals byforcing producers to compete for increasinglyinformed and mobile dollars, an act that lowersprices and shifts bargaining power firmly infavor of consumers. The goal of governmentofficials should be to provide the few publicgoods that the market fails to produce. Whenmarkets advance to fill new roles, governmentshould happily recede. Governments shouldseek to tax as broadly and as lightly as possible.The new online economy offers the perfectopportunity to move in that direction.

As factors ofproduction become

more mobile, thetraditional methods

and levels oftaxation may not

stand the testof time.

41

Is a new international agreement onInternet taxation necessary? Certainly, cooper-ation among governments with the purpose ofavoiding double taxation is useful and in somecases necessary. However, there are also dangersin international negotiations, and cautionshould be the watchword. The United Statesshould strive to create an environment in whichelectronic commerce can reach its full poten-tial—regardless of the path taken by other gov-ernments. Virtue is its own reward, and taxa-tion is no virtue.

Notes1. Nathan Newman, “Prop 13 Meets the Internet:How State and Local Government FinancesAre Becoming Road Kill on the InformationSuperhighway,” Center for Community Eco-nomic Research, University of California atBerkeley, August 1995.

2. Michael Mazerov and Iris J. Lav, “A Federal‘Moratorium’ on Internet Commerce TaxesWould Erode State and Local Revenues and ShiftBurdens to Lower-Income Households,” Centeron Budget and Policy Priorities, May 11, 1998,http://www.cbpp.org/512webtax.htm.

3. William F. Fox and Matthew N. Murray, “TheSales Tax and Electronic Commerce: So What’sNew?” National Tax Journal 50, no. 3 (September1997): 573.

4. Eileen Shanahan, “WWW.TAXFREE.COM,”Governing Magazine, December 1998, p. 34.

5. “Taxing Times on the Internet,” WashingtonTimes, April 10, 1998. The 19-member commis-sion comprises the heads of the Treasury andCommerce Departments, as well as the U.S. traderepresentative. The other 16 members were cho-sen by Senate Majority Leader Lott, SenateMinority Leader Thomas Daschle (D-S.D.), for-mer speaker of the House Newt Gingrich (R-Ga.),and House Minority Leader Richard Gephardt(D-Mo.).

6. Multistate Tax Commission, Draft Resolution onInterstate Sales Tax Collections, August 7, 1998,http://www.mtc.gov/POLICY/98-1.pdf. MTC isan umbrella organization of 21 member statesand 16 associate member states that formulatesuniform state tax policy.

7. Robert MacMillan, “Daschle Alters Tax FreedomAct Selections,” Newsbytes, December 11, 1998.

8. Shannon P. Duffy, “Suit Challenging InternetTax Group Voluntarily Dropped,” LegalIntelligence, April 29, 1999.

9. National Governors’ Association, “50-StateReport on Fiscal 1999 Budgets Released,” NGAPress release, December 30, 1998, http://www.nga.org/Releases/PR-30December1998Fiscal. htm.

10. Steven Levy, “Xmas.com,” Newsweek, Decem-ber 7, 1998, p. 50.

11. William J. Holstein, Susan Gregory Thomas,and Fred Vogelstein, “Click ’Til You Drop,” U.S.News & World Report, December 7, 1998, p. 42.

12. James Ledbetter, “The Web’s Free Ride,” NewYork Times, November 30, 1998.

13. Charles Selle, “Santa.com Is Not a TaxingVenture,” Copley News Service, December 7,1998.

14. Norm Alster, “Are We Stealing from OurSchools?” Upside, May 1999, p. 74.

15. Bob Metcalfe, “The Internet in 1999: This WillProve to Be the Year of the Bills, Bills, and Bills,”Infoworld, January 18, 1999, p. 90.

16. “Online Merchants Enjoyed Strong Sales ThisHoliday,” Wall Street Journal, December 28, 1998.

17. Low figure taken from Boston ConsultingGroup, “The State of Online Retailing,” Researchreport, November 18, 1998, http://www.shop.org/research/highlights.htm; high figure taken fromRobert J. Cline and Thomas S. Neubig, “The Sky IsNot Falling: Why State and Local Revenues WereNot Significantly Impacted by the Internet in1998,” in “Ernst & Young Economics Consultingand Quantitative Analysis,” June 18, 1998, p. i,electronic version.

18. Figure cited in Newman.

19. Laura Loro, “Marketers Look to Stave Off NetTaxes,” Business Marketing, April 1, 1999, p. 1.

20. Cline and Neubig, p. i.

21. Austan Goolsbee and Jonathan Zittrain,“Evaluating the Costs and Benefits of TaxingInternet Commerce,” Draft article for the NationalTax Journal, May 20, 1999, http://gsbwww. uchicago.edu/fac/austan.goolsbee/research/jzntj.pdf.

22. Figure taken from U.S. Department ofCommerce, “Falling through the Net: Definingthe Digital Divide,” July 1999, p. 34, http://www.ntia.doc.gov/ntiahome/fttn99/fttn.pdf.

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23. States that are eligible for the grandfatherclause on Internet access charges are Connecticut,Iowa, New Mexico, North Dakota, Ohio, SouthCarolina, South Dakota, Tennessee, Texas, andWisconsin. Not all of those states have chosen tolevy the tax.

24. For a more detailed analysis, see DavidHardesty, “Internet Tax Freedom Act,” Tax Adviser30, no. 1 (January 1999): 53.

25. See an analysis by Fred O. Marcus, “Nexus onthe Information Superhighway,” Paper presentedat the National Association of State BudgetOfficers, Spring meeting, April 1997, http://www.nasbo.org/resource/taxfee/marcus01.htm.

26. National Bellas Hess v. Illinois, 386 U.S. 753 (1967).

27. The MTC defines “nexus” as sufficient con-tacts with a taxing state under the Due ProcessClause and the Commerce Clause of the U.S.Constitution in order to support application of ataxing state’s sales or use tax, including a duty tocollect a sales tax or a use tax from the out-of-statebusiness’s customer. Multistate Tax Commission,“Nexus Guideline,” Draft, January 25, 1995.

28. In defining “substantial nexus,” the Courtadhered to the physical presence bright-line testcontemplated in its 1967 decision in NationalBellas Hess. It found such a test in the area of statesales and use taxation to be useful to encouragesettled expectations and to protect interstatecommerce against undue burdens.

29. See Scripto, Inc. v. Carson, 362 U.S. 207 (1960);and Tyler Pipe Industries, Inc. v. WashingtonDepartment of Revenue, 483 U.S. 232 (1987).

30. Complete Auto Transit, Inc. v. Brady, 430 U.S. 274(1977).

31. Quill Corp. v. North Dakota, 504 U.S. 298 (1992).Quill upheld state tax collection restrictions fromearlier decisions such as Bellas Hess and CompleteAuto Transit, although it suggested that Congresscould authorize cross-border sales taxes throughlegislation instead of constitutional amendment.

32. Quill at 298.

33. “Survey Results: State Use Tax Collection,”Software Industry Issues, 1996, http://www.SoftwareIndustry.org/docs-htm/usetaxcl.html.

34. Neal Osten, Speech to the Syracuse UniversityAlumni Association, Washington, D.C., May 19,1999.

35. Multistate Tax Commission Bulletin 95, no. 1(December 1995).

36. Karl A. Frieden and Michael E. Porter, “TheTaxation of Cyberspace: State Tax Issues Relatedto the Internet and Electronic Commerce,”Arthur Andersen, 1996, http://www.caltax.org/andersen/contents.htm.

37. Section 1104(2)(B)(i) defines “discriminatorytax” as “any tax imposed by a state or politicalsubdivision thereof, if (i) except with respect to atax (on Internet access) that was generallyimposed and actually enforced prior to October 1,1998, the sole ability to access a site on a remoteseller’s out-of-state computer server is considereda factor in determining a remote seller’s tax col-lection obligation.” See “Section-by-SectionAnalysis of the Internet Tax Freedom Act,” http://www.house.gov/cox/nettax/lawsuml. html.

38. The ITFA is unclear on this point. See WalterHellerstein, “Internet Tax Freedom Act LimitsStates’ Power to Tax Internet Access andElectronic Commerce,” Journal of Taxation 90, no.1 (January 1999).

39. Lunney v. Prodigy Services Company, 1998 WL909836 (N.Y. 2d Dept., Dec. 8, 1998), cited inDickerson M. Downing, “Year Ends with Flurry ofNet News; Bugs, Hacks, Laws and the Starr Report,”New York Law Journal, January 25, 1999, p. 34.

40. Ideally, of course, states should subject allgoods and services to taxation at a uniform lowrate. Until such reforms are instituted, however, itseems reasonable to expect that electronic com-merce not be singled out for special taxation.

41. For a detailed analysis, see Interactive ServicesAssociation, “Logging on to Cyberspace TaxPolicy,” ISA White Paper, 1998, http://www.isa.net/policy/whitepapers.html.

42. “If I’m So Empowered, Why Do I Need You?”California Electronic Commerce Advisory Coun-cil report, http://www.e-commerce.ca.gov/1d_tax.html.

43. Harley T. Duncan, executive director of theFederation of Tax Administrators, made thispoint in a presentation at the George MasonUniversity School of Law on April 28, 1999.Outline of remarks available on request.

44. Taxation of Cyberspace, 2d ed. (San Jose, Calif.:Deloitte & Touche LLP, 1989), pp. 32, 43.

45. Public Law 86-272 8505, 101(a), codified asamended at 15 U.S.C. 381–84.

46. William Wrigley, Jr. Co. v. Wisconsin, 505 U.S. 214(1992) at 225.

47. “Recent P.L. 86-272 Decisions Reveal States’

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Attempts to Wriggle around Wrigley,” KPMGPerspectives in State and Local Taxation, June 1998,http://www.us.kpmg.com/salt/perspectives/pers698/index.html.

48. Hardesty, “Internet Tax Freedom Act,” p. 53.

49. Austan Goolsbee, “In a World withoutBorders: The Impact of Taxes on InternetCommerce,” National Bureau of EconomicResearch Working Paper no. 6863, November1998, http://gsbwww.uchicago.edu/fac/austan.goolsbee/research/intertax.pdf.

50. Stephen Moore and Dean Stansel, “Tax Cutsand Balanced Budgets: Lessons from the States,”Cato Institute Fact Sheet, September 17, 1996,http://www.cato.org/pubs/wtpapers/taxcuts.html.

51. National Association of Counties, “New Pushfor Taxing E-Commerce,” Wired News Report, July19, 1999, http://www.wired.com/news/news/politics/story/20819.html.

52. See “Internet Tax Horror Stories,” http://www.house.gov/cox/nettax/Web-horror.html.

53. Senator Hollings’s bill is S. 1433, the “SalesTax Safety Net and Teacher Funding Act.”

54. Duncan.

55. “Do State Tax Cuts Work?” Investor’s BusinessDaily, “Perspective,” November 5, 1996.

56. Ken Magill, “CA Governor Passes 3-Year Banon E-Taxes,” DM News, September 7, 1998,http://www.dmnews.com.

57. Taxation of Cyberspace, p. 50.

58. Charles E. McLure Jr., “Taxation of ElectronicCommerce: Economic Objectives, TechnologicalConstraints, and Tax Law,” Draft paper, May 15,1998, sec. VII (b).

59. Lorrie Grant, “Stores with Doors Not Passé,”USA Today, August 4, 1999.

60. Dean Andal, Letter to the Sacramento Bee, April1999. Available on request.

61. National Association of State Budget Officers,“The Fiscal Survey of States: May 1998,”http://www.nasbo.org.

62. “Glorious Dilemmas,” The Economist, January23, 1999, p. 25.

63. Ernst & Young/National Retail Federation,“Internet Shopping Study: The Digital ChannelContinues to Gather Steam,” January 1999, pp. 8–9.

64. Ibid.

65. Internet Shopping: A Digital Consumer Study, aGreenfield Online presentation at the BearStearns E-Tailing Conference, April 1999,http://www. greenfieldcentral.com.

66. Peter Coy, “You Ain’t Seen Nothin’ Yet: TheBenefits to the Economy of E-Commerce AreBoundless,” Business Week, June 22, 1998, p. 130.

67. Bryant Urstadt, “Is the Internet the End of theStory for the Little Bookshop on the Corner? OrJust the Next Chapter?” Yahoo! Internet Life, June1999, p. 123.

68. Henry Breimhurst, “Growing Internet SalesSpark Study of Tax Issue,” City Business Journal—Minneapolis 16, no. 30 (December 25, 1998): 3. Seealso “If I’m So Empowered, Why Do I Need You?”

69. See Edward Hudgins, ed., The Last Monopoly:Privatizing the Postal Service for the Information Age(Washington: Cato Institute, 1996).

70. Wisconsin v. J.C. Penney Co., 211 U.S. 435 (1940),rehearing denied, 312 U.S. 712 (1941).

71. J.C. Penney Co. at 444.

72. Bensusan Restaurant Corp. v. King, 96 Civ. 3392(SHS), http://www.loundy.com/CASES/Bensusan_v_King.html, September 9, 1996. For a detailedanalysis, see also Taxation of Cyberspace, p. 35.

73. Quill at 298.

74. Complete Auto Transit at 274.

75. For a detailed discussion of questionable statetax collection efforts, see Kaye Caldwell, “StatesBehaving Badly,” CommerceNet Public Policy Report1, no. 6 (June 1999), http://www.commerce.net/resources/work/StatesBehavingBadly.pdf.

76. American Legislative Exchange Council, “APolicy Guide for the Internet and ElectronicCommerce,” State Factor 25, no. 1 (Winter 1999): 5.

77. Example taken from “If I’m So Empowered,Why Do I Need You?”

78. Ibid.

79. Figure cited in Harry Tennant & Associates,“Sales Tax, Use Tax and Internet Transactions,”1997, http://www.htennant.com/hta/askus/salestax. htm.

80. Robert J. Cline and Thomas S. Neubig,“Masters of Complexity and Bearers of GreatBurden: The Sales Tax System and Comp-

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liance Costs for Multistate Retailers,” Ernst &Young, September 8, 1999, http://www.ey.com/ecommerce.

81. See, for example, Shaffer v. Heitner, 433 U.S. 186(1977) at 197.

82. Thomas W. Bonnett, “Is the New GlobalEconomy Leaving State-Local Tax StructuresBehind?” National League of Cities Report no.3701, January 1998.

83. Inset Systems Inc. v. Instruction Set Inc., 937 F. Supp.161 (D. Conn. 1996); and E-Data Corp. v. MicropatentCorp., 989 F. Supp. 173 (D. Conn. 1997).

84. See “1998 Developments in . . . ,” ConnecticutLaw Tribune, December 21, 1998.

85. For additional constitutional analyses, seeAdam D. Thierer, “Why Congress Must Save theInternet from State and Local Taxation,” HeritageFoundation Executive Memorandum no. 488,June 23, 1997; and Dan L. Burk, “How StateRegulation of the Internet Violates the CommerceClause,” Cato Journal 17, no. 2 (1998): 147.

86. Stephen Moore and Dean Stansel, “A FiscalPolicy Report Card on America’s Governors:1994,” Cato Institute Policy Analysis no. 203,January 28, 1994.

87. Michael de Courcy and Erik Eckholm,“80’sLegacy: States and Cities in Need,” New YorkTimes, December 30, 1990.

88. For a full analysis, see Stephen Moore, “StateSpending Splurge: The Real Story behind theFiscal Crisis in State Government,” Cato InstitutePolicy Analysis no. 142, May 23, 1991.

89. Stephen Moore and Dean Stansel, “A FiscalPolicy Report Card on America’s Governors:1996,” Cato Institute Policy Analysis no. 257, July26, 1996, p. 8.

90. Ibid., p. 9.

91. Stephen Moore and Dean Stansel, “A FiscalPolicy Report Card on America’s Governors:1998,” Cato Institute Policy Analysis no. 315,September 3, 1998, p. 7.

92. National Association of State BudgetOfficers, “The Fiscal Survey of the States:December 1998,” http://www.nasbo.org/pubs/fiscsurv/fs1298.htm.

93. From 1992 to 1998, state tax revenues grew by45 percent, while population growth and infla-tion rose by a combined 22 percent.

94. Dana Milbank, “For Republican Governors,Spending Isn’t a Dirty Word Anymore,” Wall StreetJournal, February 17, 1998.

95. Dean Stansel and Stephen Moore, “The StateSpending Spree of the 1990s,” Cato PolicyAnalysis no. 343, May 13, 1999.

96. John Simons, “States Chafe As Web ShoppersIgnore Sales Taxes,” Wall Street Journal, January 26,1999.

97. “Now in Session: Nevada Lawmakers Convenein Carson City,” Las Vegas Review-Journal, January31, 1999.

98. “Gulotta’s Fine Mess,” Newsday, February 4, 1999.

99. David Ammons, “Spending Limits Law: StillKickin’ after Five Years,” Associated Press State &Local Wire, January 23, 1999.

100. Ben Wildavsky, “The Governors Are on aRoll,” U.S. News & World Report, February 1, 1999,pp. 28, 30.

101. Kaye K. Caldwell, Letter in Upside, July 1999,p. 28. For more on CommerceNet, see http://www. commerce.net.

102. Fox and Murray.

103. See David E. Hardesty, “Struggling to TaxE-Commerce,” Siliconindia, September 1998.

104. U.S. Department of the Treasury, “Selected TaxPolicy Implications of Global Electronic Com-merce,” November 1996, http://www.fedworldgov/pub/tel/internet.txt.

105. The United States leads the world by a widemargin in Internet hosts; installed PCs; Web sites;and spending on IT hardware, software, and services.See World Information Technology and ServicesAlliance, “Digital Planet: The Global InformationEconomy,” Vienna, Virginia, October 1998.

106. OECD Observer, no. 208 (October 1997): 19.

107. The Global Information InfrastructureCommission, “E-Commerce Taxation Principles:A GIIC Perspective,” GIIC Focus, http://www.giic.org/focus/ecommerce/ectax.html.

108. Marc Bacchetta et al., Electronic Commerce andthe Role of the WTO (Geneva: WTO Publications,1998), p. 39.

109. Organisation for Economic Co-operationand Development, Harmful Tax Competition: AnEmerging Global Issue (Paris: OECD, 1998).

45

110. Michael Hardy and Frances Horner,“Billabongs, Dugongs, Internet and Tax,” OECDObserver, no. 215 (January 1999): 15.

111. Organisation for Economic Co-operation andDevelopment, Harmful Tax Competition, para. 89.

112. Arthur Cordell and Thomas Ran Ide, “TheNew Wealth of Nations,” Paper prepared for theClub of Rome, November–December, 1994.

113. Luc Soete and Karin Kamp, “The ‘BIT TAX’:The Case for Further Research,” Draft paper,August 12, 1996, http://www.ispo.cec.be/hleg/bittax.html.

114. Cordell and Ide.

115. Soete and Kamp speculate that a bit tax wouldrequire “the introduction of ‘bit measuring’ equip-ment on all communications equipment.”

116. Soete and Kamp.

117. Ibid.

118. Arthur J. Cordell, “New Taxes for a NewEconomy,” Government Information in Canada/Information gouvernmentale au Canada, vol. 2,no. 4, http://www.usask.ca/library/gic/v2n4/cordell/cordell.html.

119. Quoted in ibid.

120. Bacchetta, p. 41.

121. Judith Miller, “Globalization Widens Rich-Poor Gap, U.N. Report Says,” New York Times, July13, 1999.

122. Office of the President of the United States,“Framework for Global Electronic Commerce,” July1, 1997, http://www.ecommerce.gov/framewrk.htm.

123. “Electronic Commerce: Internet Exemptfrom Customs Duties but Not from VAT,”European Report no. 2318, May 27, 1998.

124. Organisation for Economic Co-operationand Development, “Dismantling the Barriers toGlobal Electronic Commerce,” OECD DiscussionPaper, September1997, http://www.oecd.org//dsti/sti/it/ec/prod/dismantl.htm.

125. For a more complete discussion of this prob-lem, see Bacchetta, p. 50.

126. Ibid., p. 33.

127. Double taxation is defined by the OECD asthe imposition of comparable taxes in two (or

more) states on the same taxpayer in respect ofthe same subject matter and for identical periods.

128. Internal Revenue Service, U.S. Tax Treaties,Internal Revenue Service Publication 901, May1998, p. 40.

129.Organisation for Economic Co-operationand Development, “Electronic Commerce: TheChallenge to Tax Authorites and Taxpayers,”OECD Discussion Paper, November 1997.

130. Ibid.

131. David Hardesty, “Treasury Comments onInternational Taxation of Digital Products,”November 11, 1998, http://www.mshb.com/EC/110998.htm.

132. See the discussion in “Electronic Commerce:The Challenge to Tax Authorites and Taxpayers.”

133. The OECD is reportedly planning to discussthat possibility in the forthcoming “Commentaryon the Model Tax Convention.”

134. Michael P. Boyle et al., “The EmergingInternational Tax Environment for ElectronicCommerce,” Tax Management International Journal,June 11, 1999, p. 357.

135. U.S. Department of the Treasury, “SelectedTax Policy Implications,” sec. 7.2.5.

136. Michael R. McEvoy, “Feds Suggest Policiesfor Internet Commerce,” Rochester Business Journal,December 13, 1996.

137. Global Information Infrastructure Commis-sion, “E-Commerce Taxation Principles.”

138. Organisation for Economic Co-operationand Development, “Electronic Commerce: ADiscussion Paper on Taxation Issues,” OECD,September 17, 1998, para. 56.

139. U.S. Department of the Treasury, “SelectedTax Policy Implications,” sec. 7.1.5.

140. Ibid.

141. Walter B. Wriston, “Dumb Networks andSmart Capital,” Cato Journal 17, no. 3 (1998): 342.

142. For an example of an online casino located ina tax haven, see http://www.omnicasino.com.

143. See McLure.

144. For example, according to the UnitedNations Development Project, “HumanDevelopment Report 1999,” South Asia has 23

46

percent of the world’s population but less than 1percent of the world’s Internet users.

145. Bacchetta, p. 15.

146. Organisation for Economic Co-operationand Development, Harmful Tax Competition, para.137.

147. Organisation for Economic Co-operationand Development, “Electronic Commerce: ADiscussion Paper on Taxation Issues,” para. 57

148. Joseph Guttentag, Testimony before theAdvisory Commission on Electronic Commerce(independent commission), Williamsburg, Vir-ginia, June 22, 1999.

149. April 1998 Forrester Research cited in Boyle.

150. Bacchetta, p. 33.

151. Australian Taxation Office ElectronicCommerce Project Team, “Tax and the Internet,”Discussion Report, August 1997, p 85.

152. Graeme Ross, “The Revenue Net and theInternet,” Times (of London), October 8, 1998.

153. Statistics cited in Boyle.

154. “Electronic Commerce and Canada’s TaxAdministration: A Response by the Minister ofNational Revenue to His Advisory Committee’sReport on Electronic Commerce,” Ottawa,September 1998, pp. 15–16.

155. Nick Huber, “Taxation; Euro VAT ‘Not Fit forWeb Age,’ ” Accountancy Age, May 13, 1999, p. 4.

156. Organisation for Economic Co-operationand Development, “Electronic Commerce: ADiscussion Paper on Taxation Issues,” para. 42.

157. For example, the Australian Tax Office dis-cusses that possibility in “Tax and the Internet.”

158. Richard Baron, “Cyberspace’s New TaxConundrum,” Accountancy Age, November 12, 1998.

159. Fox and Murray.

160. Elinor Harris Solomon, Virtual Money (NewYork: Oxford University Press, 1997), p. 70.

161. Organisation for Economic Co-operationand Development, “Electronic Commerce: ADiscussion Paper on Taxation Issues,” para. 66.

162. The idea of blocking Web pages for tax col-lection purposes was suggested to me in an e-mailexchange with David Hardesty, author of Electronic

Commerce: Taxation and Planning (New York:Warren Gorham & Lamont, 1999). For moreinformation, see http://www.ecommercetax.com.

163. “Electronic Commerce: Commission SetsOut Guidelines for Indirect Taxation,” EU Busi-ness, June 17, 1998, http://www.eubusiness.com/finance/980617co.htm.

164. Quoted in Hardesty, “Treasury Commentson International Taxation of Digital Products.”

165. See Article 12 of the OECD Model Treaty,October 1998.

166. “Classification of Certain TransactionsInvolving Computer Programs,” Internal RevenueService Prop. Reg 1.861-18.

167. For a more detailed discussion of VAT placeof supply rules, see Organisation for EconomicCo-operation and Development, “Dismantlingthe Barriers to Global Electronic Commerce,”paras. 58–68.

168. Global Information Infrastructure Commis-sion, “E-Commerce Taxation Principles.”

169. McLure used this phrase to describe the con-sequences of taxing sales at their origin (testimo-ny before the Advisory Commission on ElectronicCommerce on June 22, 1999).

170. “Consumption Tax Issues Briefs,” Fun-damental Tax Reform, Deloitte & Touche LLP, 1996,http://www.dtonline.com/TAXREF/trissue.htm.

171. Tino Eggermont, “The Commission’s WorkProgramme for the Gradual Introduction of theNew Common VAT System,” European Commis-sion, 1998, http://www.ecu-activities.be/1998_2/eggermont.html.

172. The National Gambling Impact StudyCommission, Final report, http://www.ngisc.gov.For an analysis supporting the legalization ofInternet gambling, see Tom W. Bell, “InternetGambling: Popular, Inexorable, and (Eventually)Legal,” Cato Institute Policy Analysis no. 336,March 8, 1999.

173. For more information, see Solveig Singleton,Testimony before the House Banking and Finan-cial Services Committee on the Bank SecrecyAct and Privacy Policy, 106th Cong., 1st sess.,April 20, 1999, http://www.cato.org/testimony/ct-ss042099. html.

174. Christine Sanderson, “Taxing a BorderlessWorld,” International Tax Review 10, no. 1

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(December 1998–January 1999): 35.

175. For an analysis of how the suppression of digi-tal cash could impede the growth of electronic com-merce, see Eric Hughes, “Effects of the RegulatorySuppression of Digital Cash,” in Economic Casualties,ed. Solveig Singleton and Daniel T. Griswold(Washington: Cato Institute, 1999), pp. 63–75.

176. Organisation for Economic Co-operation

and Development, “Electronic Commerce: ADiscussion Paper on Taxation Issues,” para. 33.

177. David Post, “E-Cash: Can’t Live with It, Can’t Livewithout It,” American Lawyer, March 1995, p. 116.

178. Richard Rahn, “The New Monetary Universeand Its Impact on Taxation,” in The Future ofMoney in the Information Age, ed. James A. Dorn(Washington: Cato Institute, 1997), p. 84.

Board of Advisers

James K. GlassmanAmerican EnterpriseInstitute

Douglas A. IrwinDartmouth College

Lawrence KudlowSchroder & CompanyInc.

William H. Lash IIIGeorge Mason UniversitySchool of Law

José PiñeraInternational Center forPension Reform

Razeen SallyLondon School ofEconomics

George P. ShultzHoover Institution

Walter B. WristonFormer Chairman andCEO, Citicorp/Citibank

Clayton YeutterFormer U.S. TradeRepresentative

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Scholars at the Cato trade policy center recognize that open markets mean wider choicesand lower prices for businesses and consumers, as well as more vigorous competition thatencourages greater productivity and innovation. Those benefits are available to any countrythat adopts free trade policies; they are not contingent upon “fair trade” or a “level playingfield” in other countries. Moreover, the case for free trade goes beyond economic efficiency.The freedom to trade is a basic human liberty, and its exercise across political borders unitespeople in peaceful cooperation and mutual prosperity.

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CENTER FOR TRADE POLICY STUDIES