Old Post: On Taxing Online Sales

[Originally posted December 2005]

It takes discipline and intelligence for legislators to forgo today’s revenue for tomorrow’s growth. This brief exhorts you to exercise that discipline and intelligence and oppose any measures to tax Internet sales. Such a tax would be logistically challenging, philosophically antithetical to the nature of the medium, and fiscally incorrect. Most importantly, it would be detrimental to economic growth because it would hinder, rather than help, a technology that effectively catalyzes innovation, entrepreneurship, and productivity.

To be sure, it is certainly tempting to want to support such a tax. Forrester Research reports that B2B and B2C transactions in the US totaled almost $3 trillion in 2004. It is not surprising that states, which generate a large portion of their revenues from sales taxes, are beginning to wonder why such a large and growing proportion of commercial transactions taking place within their borders is tax-exempt. In fact, this summer 18 state tax collectors met to call for an end to the moratorium on Internet sales taxes, a moratorium first instituted by a 1992 Supreme Court ruling prohibiting out-of-state retailers from collecting sales taxes.

Nevertheless, taxing the Internet is not a good idea. We’ll save the most important consideration, economic growth, for last. First, let’s consider a number of other perspectives:

• Logistically, it is an enormous challenge to calculate and collect taxes on transactions for which the physical location of buyer and seller are irrelevant (and in some cases, impossible to determine) and in which multiple states (and thus multiple tax rates) are involved

• Legally, the US Supreme Court already established the “physical presence” standard when they ruled on mail-order catalogs in 1992, and e-commerce has not been seen as different

• Philosophically, the Internet is open-source by nature and consumer purchasing data is private information; excessive government intrusion would violate both principles

• Fiscally, states should be decreasing and not increasing their reliance on sales tax revenue, since the source is highly volatile and is more regressive than other taxes

The most important reason to oppose taxing the Internet, though, is that such a tax would trade tomorrow’s growth for today’s revenue. Although the dotcom mania’s promises of new paradigms and the death of old economy firms were inflated, the Internet’s ability to radically transform our economy has not been lost. In fact, even relatively early in its life cycle, the Internet has already had a noticeable impact on productivity and growth, by driving down transaction costs, increasing the efficiency of managing value chains, and improving the lot for both buyers and sellers through better information and greater competition. It is estimated that these factors contribute half a percentage point annually to US Gross Domestic Product.

Bear in mind what this economic growth is that we all seek. It can be defined as steadily rising productivity, or sustainable increases in output per capita. Transformative technologies like the Internet can exponentially increase the amount of output that can be produced with the same input because by nature they make possible the “new combinations” that economist Joseph Schumpeter argued were necessary for innovation, entrepreneurship, and growth. In particular, the Internet has sparked the development of new products, accelerated the opening of new markets, and transformed the management of production processes and supply chains.

Taxing the Internet, while providing some immediate revenue for states, would diminish the Internet’s role in achieving these new combinations and in stimulating innovation and growth. States that tax the Internet may find themselves with a new source of revenue, but at the cost of being seen as (and of being) a place that is not about new combinations, innovation, and entrepreneurship. These states, relative to others that are more accommodating to technology and entrepreneurship, will enjoy less economic growth as a result.

Perhaps I am divulging my party affiliation in putting it this way, but whatever you tax you provide a disincentive for, and whatever you subsidize you provide an incentive for. Because of the Internet’s role in catalyzing economic growth, it is a medium that ought to be subsidized, not taxed. The states that are clamoring for taxation of Internet sales have, to date, focused on streamlining the logistical process of calculating and collecting the tax itself. While this is certainly an important challenge to overcome, it misses the point that the problem with taxing Internet sales is not fundamentally an administrative one, but rather one of economic growth. Such a tax might net some revenue today, but at the expense of growth tomorrow.

(A useful background read on the subject of the Internet and economic growth is Robert Litan and Alice Rivlin’s Beyond the Dotcoms: The Economic Promise of the Internet. Litan and Rivlin understand that the transformative potential of the Internet was never about selling pet food online, but rather about catalyzing the kind of frictionless commerce and technological innovation that is necessary for economic growth to take place. Litan and Rivlin’s book was used heavily in preparing this brief.)

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