Governors Should Scrap Internet Tax Plan

Copley News Service, 02/11/2000

In the titanic clash under way between Old World thinking and New, the greatest debate is over Internet taxation. The fundamental question is whether to allow state governors to impose a uniform sales tax on on-line purchases nationwide. Congress has empaneled 19 corporate executives, policy experts and public officials to make recommendations by April.

In early 2000, close to 120 million Americans use the Internet, up from 65 million in mid-1998 and 84 million at the end of 1998. Between a quarter and a third of U.S. economic growth in the 1990s was information-technology related. Internet revenues are expected to reach $1.2 trillion by 2002, rivaling health care as the nation’s largest industrial sector.

The nation’s governors are determined, however, not to let the new economy get in the way of their state treasuries’ static revenue projections. For years, state officials have chafed under court rulings that the Constitution prohibits them from forcing mail-order companies with no significant presence inside their borders to collect sales and use taxes on sales made within the state. The National Governors’ Association now fears that those same court rulings will permit consumers to avoid paying sales and use taxes on e-commerce transactions. Hence, NGA has come up with a “voluntary” plan to circumvent current law and at the same time to expand states’ taxing authority.

In reality, the new system of “financial incentives and penalties” proposed by the NGA would force states to join a 50-state entity that would force businesses — Internet and otherwise — to collect sales taxes and remit them to the state where the purchaser lives. A “consensus board” would harmonize state tax laws and limit the ability of states to tailor their own tax laws as their citizens desire — all without any say from Congress.

The NGA plan violates several constitutional provisions. In the cases Virginia vs. Tennessee and U.S. Steel Corp. vs. Multistate Tax Compact, the Supreme Court ruled that compacts and agreements among states may not “tend to increase the political powers of the contracting states or to encroach upon the just supremacy of the United States” without the consent of Congress. The NGA “solution” probably violates these tests and would impose several new layers of taxation on American businesses and consumers.

One must also ask whether the governors’ premise that states stand to lose massive amounts of revenue because of the Internet is even true. The Internet economy is largely responsible for many new business starts, and this computer-based economy contributes greatly to our current high levels of employment, productivity and economic growth.

Even as e-commerce explodes, state governments continue to enjoy annual sales tax revenue growth and total revenue growth of close to 6 percent each. California, the nation’s most Internet-friendly state, enjoyed record sales tax revenue growth of 9 percent last year. Further calculations suggest that state and local budget surpluses as a percentage of state and local revenue will continue to outpace federal surpluses as a percentage of federal revenue.

In their short-sighted lust for more revenues, governors risk hobbling the very invention that is enriching their state treasuries. They should learn from the experience of Congress in the early 1990s, when it increased a variety of federal excise taxes only to discover that people’s purchases of the taxed items (yachts, for example) fell off so significantly that excise tax revenues actually declined and the U.S. boat industry was practically destroyed in the process. That is precisely what one could expect to happen if states were to succeed in placing new taxes on the Internet.

There is much we still don’t know about the Internet and our dynamic new economy, but of three things we can be certain: (1) the Internet is a driving force in the American and world economies; (2) the current federal tax code is a confusing and corrupting burden on our economy; and (3) certain factions are seeking to impose a new national framework of Internet taxation that may contain the same flaws as the current federal code and that may be unconstitutional.

When we consider the unknown upsides of the Internet economy, the likely prospect we can achieve real tax reform within a few years and the fact that the leading “pro-Internet tax” alternative is flawed, it is apparent that achieving a unified national sales tax system at this time is premature.

The debate over Internet taxation comes down to this: Should we expand the power of state governments to allow them to conscript entrepreneurs and business owners as agents of the state to extract more taxes from consumers, even though those businesspeople receive no public services from the states receiving the revenue? Or should we overhaul the tax system in a way that accommodates and complements the efforts of new-economy consumers, workers and investors?

If the governors search deep within themselves, I believe they know the right answer.

Kemp is co-director of Empower America and Distinguished Fellow of the Competitive Enterprise Institute.