The Great Internet Tax Debate

Should the states get a slice of every e-commerce dollar or should cyber-sales be free of any tax burden?

The battle over whether to tax the Internet could be dubbed the Americans like to think that feisty colonists tossed British tea into Boston Harbor in 1773 in righteous protest over the unfairness of taxation without representation. But the rebels were also upset because a special interest--Britain's cash-strapped East India Co.--enjoyed lucrative tax subsidies that its rivals didn't.

Now, consumers and businesses are embroiled in a high-tech version of a similar controversy. This time, the special interest is that darling of the New Economy, the Internet. Main Street retailers have to collect sales tax from their customers. But many online merchants don't. And they are trying to keep it that way. They insist that taxing e-sales would destroy the greatest job-creating engine America has ever known, stifle innovation, and all but return the Republic to the days of quill pens and wax seals. "E-commerce presents nothing less than a second Industrial Revolution," says Representative John R. Kasich (R-Ohio), who would ban all state and local taxes on Internet sales. "The biggest threat to this growth is government treating the Internet like a cash cow."

Governors and traditional merchants retort that untaxed e-sellers are just a 21st century version of that old British trading company, using lucrative government handouts to win a competitive advantage over rivals. A ban on sales taxes for Internet purchases will devastate schools, they say. And bricks-and-mortar shopping will wither as well. "I don't see why they should get a special break," says Ron Romero, who owns Schaeffer's TV & Appliance Center in Lincoln, Neb. "It puts us at a very big disadvantage."

How this debate gets resolved will profoundly affect the way Americans shop and how retailers do business. It could permanently alter relations between Washington and the states. It's even possible that as more and more merchants find ways to avoid collecting sales taxes, the levy could disappear within a decade. That would force a radical reworking of the way Americans are taxed. "I believe the sales tax can survive," says Utah Governor Michael O. Leavitt, "but not under existing conditions."

Today, the 45 states that have sales taxes (Alaska, Delaware, Montana, New Hampshire, and Oregon don't) rely on retailers to collect the levies. But they can force e-tailers to do so only if those companies have a physical presence, such as a store or warehouse, in their jurisdiction. When Internet sellers don't collect, customers are supposed to pay a parallel levy, called a use tax. Most don't. In fact, Kentucky Governor Paul Patton jokes that this year, his state will collect more. Why? "Because I'm going to pay mine," he says.

"FLAT IMPOSSIBLE." If the sales tax does fade away, how will states and cities replace the nearly $200 billion it generates? On average, the sales tax accounts for one-third of state tax revenues and one-quarter of the total state and local take. But in some states, it is far more. In George W. Bush's no-income-tax Texas, for instance, sales taxes represent more than half of all revenues. "It's a pretty untenable situation," says Donald J. Boyd, director of the Center for the Study of the States, "and there are no pleasant alternatives."

How about spending cuts? With 34% of state spending going to education and another third to health and welfare, it's hard to see where such deep cuts would come from. "Reducing expenditures at the margin is probably doable," says Maryland Governor Parris N. Glendening, "but by 40%--that's flat impossible." The issue has shredded normal partisan boundaries. Conservative Republicans such as Kasich argue that Washington should preempt the most powerful tool governors have--the right to tax. And liberal Democrats such as Glendening find themselves defending the sales tax, though it is often criticized as being unfair to the poor. The debate is taking a particular toll on the GOP--where Republican governors such as Leavitt of Utah and John Engler of Michigan are going toe-to-toe with their political brethren, like James S. Gilmore III of Virginia. And it is splitting business, with some e-tailers angling for the subsidy and others preferring to see all merchants collect. John W. Sidgmore, vice-chairman of MCI Worldcom, scoffs at the notion that taxing online sales will crush the Web. "If we are going to have sales taxes, we should not favor one form of distribution over another," he says.

But the impact of a taxless Internet remains unclear. While one study has found that taxes would cut online sales by 25% to 30%, most economists think the effect would be far less devastating. So Sidgmore, a member of the Internet tax commission that is scheduled to make recommendations to Congress by Apr. 21, advocates keeping the status quo for a few more years. That would give sellers and governments more time to resolve their disputes and economists a better shot at figuring out the impact.

Faced with such uncertainty, businesses are reacting in very different ways. Specialty bricks-and-clicks retailers, which enjoy relatively high margins, are willing to collect the tax for all online sales. "The high ground for companies like us is to collect the tax," says Shelley Nandkeolyar, vice-president for e-commerce at kitchen-goods retailer Williams-Sonoma Inc.

But where margins are narrower, there is pressure to avoid charging the tax. After all, a 6% tax can be the difference between making or losing a sale. Many bricks-and-clicks retailers, such as Williams-Sonoma "are showing restraint now [by continuing to collect tax]," says Michael Mazerov, an e-tax expert at the Center on Budget & Policy Priorities, a Washington think tank. "But at some point, the dam will burst." In fact, more and more retailers are ducking the responsibility. Take the hypercompetitive business of consumer PCs. Dell Computer Corp. has refused to collect sales taxes. In contrast, competitor Gateway Inc. had been adding the levy to all of its sales. But in October, it split its Internet and catalog operations from its storefront business. Now, it collects for online and catalog sales only in a handful of states, such as Missouri and South Dakota, where its remote sales operations are located.

Bookseller Barnes & Noble has taken a similar tack. Although the chain is located in every state, it has created Inc. as a separate entity. As a result, its lawyers argue, the Web seller must collect taxes only in those few states where its warehouses are located. Wal-Mart Stores Inc. has recently done the same. Says Peter Lowy, president of shopping-center developer Westfield America Inc.: "You can drive a truck through the current system."

So far, though, the battle has been more about potential dollars than real ones. Despite the hype, e-tailing accounts for less than 1% of all retail sales. And, according to Forrester Research Inc., a Cambridge (Mass.) market-research firm, states lost just $525 million, or barely 0.3% of all sales-tax revenues last year, as the result of untaxed Net purchases. Still, states are not taking the challenge lightly. California and Connecticut are quietly warning businesses that they expect them to collect, even for e-sales. The next step could be a crackdown on scofflaws. Other states, such as Michigan, are reminding consumers that they are responsible for paying a use tax, if a sales tax was not collected at the time of purchase. Michigan's 1999 income tax return includes a new line for use-tax payments and a full-page notice reminding taxpayers what the tax is and how to pay it.

That's probably a losing battle, though, because the use tax will never replace the crumbling sales tax. Some governors, led by Utah's Leavitt, think the sales levy can be saved. They want to see states dramatically simplify their current rules--and they hope that technology will ease business' task of figuring the taxes for all sales. But other tax experts are exploring alternatives if the sales tax continues to erode. Says Richard Prem, a partner at accountant Deloitte & Touche: "If we can't agree on a system that buys some certainty and creates a more level playing field, people are going to have to start asking: `What system should we be looking at?"'

One possibility raised by economist Kevin Hassett, who was a top adviser to Senator John McCain (R-Ariz.), is to solve the sales-tax mess through broad-based federal income-tax reform. How? The flat tax and related federal reforms are really just consumption taxes. They take all income, subtract savings and investment, and tax the rest. The idea, which has also generated interest at such organizations as the U.S. Chamber of Commerce, is that a federal flat tax would replace the sales tax; states would piggyback their own version of a flat tax on a reformed federal system.

Such reform would take years, however. While the wonks deliberate, Internet sales will continue to grow, smart lawyers will find new loopholes in the current law, and state sales-tax revenues will gradually begin to fade away. State and local officials are not facing a crisis just yet. But then, in 1773, neither were the British.

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