TO TAX OR NOT TO TAX: Tax Freedom or Free Ride?

By some accounts, the volume of Internet commerce is expected to reach $327 billion in the next five years. Due to the sudden explosion of e-commerce, debates are raging as to whether and how Internet commerce should be taxed.

The stakes could be enormous. A report to Congress by the Advisory Commission on Electronic Commerce says that if Internet commerce is exempt from sales tax, state and local governments could lose $3.5 billion dollars by 2003. Other estimates predict $8 billion a year in lost revenue by 2004. Though this accounts for only 2% of total sales tax proceeds, The National Tax Journal reports it could reach 10% by 2007. As a result, some experts warn that state and local governments might be forced to reduce spending on social services and education and then raise property taxes to make up the loss.

The hard questions include not just whether e-commerce vendors should pay sales tax--but who should collect it? In principle, the old rule of "nexus" applies. If the seller has a store in the state where the buyer lives, the seller must collect sales tax. But if the seller has no store in the buyer's state, the buyer is responsible for paying sales tax--called a "use tax" in this situation--to their state and local governments.

TAX "FREE"

In 1992, the U.S. Supreme Court case Quill v. North Dakota limited the states' right to collect sales tax from mail order companies. The court ruled that as long as the seller doesn't reside in the same state as the buyer, the seller isn't required to collect sales tax.

The growth of the Internet and e-commerce intensified the debate. The Internet crosses state boundaries, so state and local governments have no jurisdiction. The seller is a computer server and easily moved. It may have no legal address, so its physical presence is elusive.

Meanwhile, the buyer's state government can t tax an out-of-state seller. Grover Norquist, president of Americans for Tax Reform and former economist with the U.S. Chamber of Commerce, notes that taxing out-of-state sellers amounts to taxation without representation. "You cannot allow Alabama politicians to impose taxes on businesses in Maine and New Hampshire because there is no limit to the abuses that can follow," he says. "They can go kick your door in and levy sales taxes on things you bought over the Internet."

Legally, Internet commerce is not tax free because buyers are supposed to pay the use tax. But it may as well be tax free for all practical purposes because few if any buyers actually pay it. David McClure, president and CEO of the U.S. Internet Industry Association, says states tried to resolve this dilemma by imposing taxes of their own, which often conflicted with each other.

In 1998, Congress tried to eliminate the contradictory taxes by enacting the Internet Tax Freedom Act. The law prohibits "taxes on Internet access... and multiple and discriminatory taxes on Internet commerce" until October 2001. The Act also formed an...