Taxing the Internet

March 20, 2000

by Pete du Pont

Mr. Chairman, thank you for the opportunity to testify before the Commission today on the issue of Internet taxation. Whatever this Commission decides to do will unquestionably shape the debate for years to come. You are to be congratulated for the thorough job you and the other members are doing in this important area.

You have already heard from many witnesses who have discussed the constitutional, economic and policy implications of Internet commerce for all levels of government. In general, to my reading, the testimony seems very polarized. On the one hand, it is said that taxation of Internet commerce will kill the goose just as it begins to lay golden eggs. On the other hand, there are predictions that state and local government revenue bases will dry up unless Internet sales are subject to the same taxes which apply to traditional bricks-and-mortar businesses.

I come at this issue as the former Governor of a state, Delaware, which has never had a general sales tax. Nor in all my years in that state have I ever heard a serious proposal to impose one. We decided long ago that there were better ways to raise the necessary revenue for government without taxing every purchase made by our citizens.

I raise this fact to note that it is possible to live and prosper without a sales tax. And, of course, Delaware is not alone. Several other states have also done quite well without a sales tax. I would also add that the United States as a whole has done remarkably well as the only major nation on earth without a national sales tax of some sort.

The point I am making is that the real question we need to confront in the future is not whether or how to apply state and local sales taxes to Internet commerce, but whether the sales tax can or should survive in an Internet world. Rather than fight to make the sales tax effective, perhaps we should recognize that as currently constituted the sales tax might no longer make economic sense.

I realize that this is a radical proposition. Many of you no doubt are thinking, "Where am I going to get the money to replace my single largest revenue source?" Others may be thinking that they will have to pare back a wide range of spending programs if sales tax revenues disappear.

My purpose is not to suggest that sales taxes should be immediately repealed. My goal is to suggest another way of looking at the problem faced by this commission, one that I believe economic forces are going to force all governments to face in the future whether they like it or not.

The problem is that historically the vast bulk of goods and services people consumed were purchased in their immediate vicinity, and so a sales tax made economic sense. Of course there have always been problems with across-border and mail order sales, but these have not proven to be large enough in magnitude to undermine the general effectiveness of state and local sales taxes.

However, two important developments are rapidly altering this basic assumption upon which the sales tax rests. First, obviously, is the Internet. Not only can people order goods over the Internet and have them delivered to their homes, a sort of turbo-charged mail-order sale, but also increasingly they can have the product actually delivered through the Internet itself. Such things as software, music and airline tickets are now commonly sold and delivered in this way. In the future, many other products, such as books, may also be available digitally.

It is simply impossible to tax goods that can be downloaded from the Internet. Even if some sort of national sales tax could be implemented that encompassed all domestic sellers, sales would simply shift off shore. As long as people can make international phone calls they will find a way to outsmart the sales tax collectors.

The second important economic development that undermines the future of the sales tax is the increasing shift away from goods toward services. This is important because goods are the principal base of sales taxes. Most states exempt the vast majority of services, except for a few things like hotel rooms. This has been done for two reasons. First, when the sales tax was established in the 1930s, services were a much smaller share of the economy. Second, by their nature, services are more difficult to tax than goods because there is no invoice trail for auditors to follow. It's hard to tax the local garages that repair your muffler, the house painter who is paid in cash, or the advice you get from your brother's law firm. Already many people receive legal, medical and other services over the Internet and the list undoubtedly will grow in the future.

So not only do sales taxes now exempt the fastest growing part of the economy, they are also failing to tax the one that is most amenable to delivery via the Internet.

I think that the failure to tax services in more than a token way is a far more serious threat to the future base of the sales tax than is the Internet. Yet as I mentioned, it is hard by their nature to tax services, and so states have generally not tried. I think the same is true of the Internet. Efforts to tax Internet purchases are just not viable. It doesn't really matter what the Federal government does in this area, the nature of the Internet itself makes it largely immune from taxation.

I think what is frightening many governors are the projections of vast Internet sales in the future. Multiplying their state sales tax rates times these sales projections yields large supposedly lost revenues. If one assumes that Internet sales replace conventional sales dollar-for-dollar, then the conclusion must be that state sales tax revenues will collapse unless Internet sales are taxed.

But I don't believe that is what is happening or is likely to happen in the future. First, state tax revenues are growing rapidly - much faster than inflation. There is no crisis in state revenue. Second, a quart of milk needed for dinner is not going to be bought over the Internet. Neither are paper towels, newspapers or detergents. Phone calls will still be made and taxed. Local commerce is not going to disappear, so neither is local sales tax revenue. Many state excise taxes - on gasoline or liquor, for example - will remain viable. Low cost discounters - Walmart and Costco - will remain; so will high-end, full service retailers like Nordstrom's.

Second, much of what is sold over the Internet is over and above traditional sales, not in lieu of them. Much of what is sold on e-Bay, for example, I think would not have been sold at all except for the Internet.

Third, the vast bulk of everything else sold on the Internet would also be free of state sales taxes even if such taxes could be collected. The fastest growing segment of Internet commerce is business-to-business sales, which are always free of sales taxes because they fall only on the final consumer. The next largest categories of Internet commerce are stock sales and airline tickets, both of which are also tax-exempt under current law in every state.

Finally, much Internet commerce is either inherently untaxable, as I have mentioned, or comes at the expense of mail order sales rather than local sales. So for many states, revenue is being lost from one source they cannot tax to another source they also cannot tax. So the losses may be illusory.

And I do not need to remind the Commission that the single greatest barrier to taxing mail order sales is the Supreme Court. There is simply no constitutional way for a state to tax businesses without a nexus in that state. Congress cannot change that fact simply by statute.

In conclusion, I think that the Internet is simply speeding up economic changes that have been under way for years that make the future of the sales tax very bleak. So instead of trying to patch together something of possibly dubious constitutionality to try to keep it alive for a few more years, why not embrace the future and simply get rid of the sales tax altogether? There are a number of potential advantages.

First, those states quickest to embrace a sales taxless future will gain at the expense of those that continue to cling to the outmoded sales tax. Those states without sales taxes now, like Oregon, are already outpacing those with sales taxes as the location of choice for Internet merchandisers. I predict that in the near future one or more states will abolish their sales taxes for this very reason. This will place enormous competitive pressure on the rest to at least lower their sales tax rates.

Second, as it becomes increasingly clear that the Internet is a worldwide phenomenon, those jurisdictions without sales taxes will gain on those with them. In this respect, I think that the United States will become an even more dominant force in the world economy as our competitors in Europe and Asia struggle in vain to apply national sales taxes to the Internet. The European Union is already at work trying to force the U.S. to collect their VAT taxes for them. Consumers worldwide will turn increasingly to U.S. sources to download music, software and other Internet-compatible goods and services.

Of course, it is easy for me to say that the sales tax is dead when I am no longer in a position where I have to deal with the unpalatable alternatives. Some states will have to change their tax systems, never an easy task politically. Others may find it necessary to restrain government spending. That, too, can be politically painful. However, I would stress that my suggestion of eliminating the sales tax is an evolutionary one that can be implemented over time, and will not require immediate action in most cases.

But even so, I think there are alternatives to the drastic raising of other taxes or the slashing of services. I would suggest one or more of the following:

States should privatize and contract out as much as they can. In every state there are vast numbers of governmental services that are delivered quite well by the private sector: food service in state hospitals, port facilities management, welfare caseload administration, and prison administration, for example. Groups such as the Reason Foundation in Los Angeles have enormous amounts of material on this issue. Not only does this reduce the need for taxation, but it shifts the burden of collecting revenue from government to the private sector. A recent example is the study reported in the March 7th Investors Business Daily regarding privatizing the Atlanta airport. Selling it would purportedly reduce each Atlanta resident's taxes by $13,500.

By the same token, try and shift toward fee-based government services rather than tax-based. There are many things governments do where a fee could be collected from the user rather than requiring broad-based tax funding. Highway tolls are a familiar example, so are park access fees, trash collection fees, and so forth.

Embrace the Internet for yourselves. There are many ways the Internet can lower the cost of delivering government services, or expanding quality and access at no additional cost. Hunting and fishing licenses come to mind. So do purchase of supplies and the filing of tax returns, the registration of motor vehicles, and on and on.
Finally, elimination of a state sales tax may, in fact, induce businesses to locate in a state, and soon the taxes on that business and its employees will exceed the lost sales tax revenues. A case in point is Delaware's experience: over the past twenty years, top personal income tax rates have been reduced 70%. Yet income tax receipts have increased 53% and overall inflation-adjusted state revenues have nearly doubled. Why? Because a strong economic climate has led to enormous job expansion. More people paying a lower rate generate more tax revenue than fewer people paying a higher rate.

In the end, there is no single solution to the problem of replacing revenue from an eroding sales tax. Some states may simply find that it is better to get whatever revenue it generates rather than pursue any of the alternatives. That is fine, but there is no global fix that is going to keep the sales tax from eroding more and more as time goes by.

In conclusion, I would ask the commission to think not just about the narrowly defined question of how or if Internet commerce should be taxed, but about the changing nature of the national and world economies and whether the sales tax is really the best way to raise future revenue. This may be somewhat outside your scope, but abolishing the sales tax altogether over time may ultimately be the only viable solution to the problem this commission was formed to deal with.

Neither Pete du Pont nor the National Center for Policy Analysis have received any federal government grants or contracts in the current or prior two fiscal years.