Why Not Tax The Internet?

The internet is one of those subjects that make normally sensible people go squishy in the brain. Witness the debate over Internet taxes. We're told not to tax the Internet, and we're not supposed to wonder why. It's obvious. The Internet is the future. Don't kill it with taxes. This skillfully sidesteps the basic question: why shouldn't the Internet be taxed like everything else? The answer is that it should.

Exempting e-commerce (items sold over the Internet) from sales taxes makes no sense. It's a disguised subsidy that favors one type of business over another and could make tax avoidance a permanent feature of the Internet society. Ideally, the Internet ought to compete with traditional stores on an equal footing. People would buy online if e-commerce offered lower prices, more choices or greater convenience. They would not buy simply to avoid taxes.

We are now subsidizing the Internet in precisely this way. All but five states (Alaska, Delaware, Montana, New Hampshire and Oregon) have sales taxes. The typical rate is 5 percent. States raise about a third of their revenues (roughly $156 billion in 1998) from sales taxes. Most, though not all, products sold over the Internet can escape sales taxes--a situation that only Congress can change. Some e-commerce depends on this hidden subsidy.

How much? Economist Austan Goolsbee of the University of Chicago has estimated that if people had to pay sales taxes, e-commerce might be 30 percent lower. People think they're simply shopping for the best price, but lower taxes allow lower prices. Obviously, this matters most for big-ticket items. On a $1,500 computer, the absence of a 5 percent sales tax is worth $75. (Goolsbee based his estimate on a survey of Internet buyers; people with similar incomes bought more online if they faced high local sales taxes.)

Goolsbee's estimate doesn't mean that e-commerce would collapse without the tax subsidy. It's now growing faster than 30 percent a year. But some e-commerce clearly depends on the subsidy, which--like most subsidies--promotes waste. Superficially, consumers get cheaper products. The trouble is that the cheap price comes at the expense of otherwise strong competitors (which lack the tax advantage) or governments (which lose tax revenues). A simplified, though exaggerated, example shows why.

Suppose Company A can sell widgets profitably for $100 and must charge the sales tax. Assume the tax is 30 percent. Company A's price is $130. Company B sells over the Internet. It can sell widgets profitably for $110 and is exempted from the tax. Its price is $110. Although less efficient, Company B drives Company A out of business. The result: society will use more resources (people, machinery) to make widgets than before. If government belatedly taxes Company B, widgets will cost $143 ($110 plus the $33 tax). As a result, people can afford fewer widgets. If government doesn't tax Company B, people will get fewer government services.

Despite its growth, e-commerce is still small enough that economic and tax distortions are modest. (In 1999 Forrester Research puts business-to-consumer e-commerce at $20 billion; of that, about $13 billion was taxable and lost state sales taxes were an estimated $525 million.) We ought to create sensible Internet rules before too much business becomes based on stupid rules. In 1998 Congress established an advisory commission--headed by Virginia Gov. James Gilmore and composed mainly of industry and government officials--to do this. Its proposals are due in April. As yet, it's shown few signs of reaching useful conclusions.

One reason is hypocrisy. The Internet's titans champion "the free market" but also want to keep their tax (a.k.a. government) subsidy. Another reason is ideology. Generally, people on the political right regard the Internet as a way to shrink government. The growth of e-commerce (it's thought) will corrode the sales tax and compel state and local governments to retrench. Naturally, those on the left object and warn that local services (schools, police) will suffer. They want e-commerce taxed.

Let's pause and ask: do these debaters know what they're doing? Conservatives like decentralized government. By squeezing states, they may (perversely, from their perspective) create pressures to expand national government and taxes. As for liberals, they dislike the sales tax--which falls more heavily on the poor--and prefer big national government. Maybe they should let the sales tax wither?

The point is that the political consequences of Internet taxation are unpredictable. We ought to ignore this debate and focus on ensuring fair competition. Fortunately, there's a way both to avoid subsidizing e-commerce and to encourage the Internet.

Contrary to popular myth, the Internet is now taxed. There are longstanding taxes on "telecommunications services"--once ordinary phone service--that apply to lines that connect with the Internet. The taxes are steep. The federal government has a 3 percent excise tax. States and localities impose a baffling array of fees and taxes that average 18 percent, reports the Committee on State Taxation. The taxes are discriminatory; they usually exceed the local sales tax. They're also outdated. Cable TV is typically taxed more lightly. As cable, phone and Internet services become "bundled," what's to be taxed? How much? Finally, the taxes make it harder for low-income families to connect with the Internet, affecting the so-called digital divide between rich and poor.

There's an obvious bargain. Under a 1992 Supreme Court decision, states cannot impose sales taxes on most products sold by out-of-state mail-order houses. The same prohibition covers Internet sellers. Congress could (and should) lift this ban. But it should do so only for states that dramatically reduced--or even eliminated--their hefty telecommunications taxes. Presto: connecting to the Internet would be cheaper; e-commerce competition would be fairer.

Perhaps the Gilmore Commission will reach this common-sense conclusion. But it seems to be striving to avoid it. Gilmore has done much shouting about shielding the Internet from taxes. This is a good slogan--and squishy thinking.