The Tax Man Cometh - How will he handle the Internet?

Should we tax the Internet? This is a question that sets Republican governors against Republican congressmen, a question that pits traditional retailers against emerging e-businesses, a question that has been debated by commissions and journalists.

It is also the wrong question. The debate over Internet taxes does not concern whether e-businesses should get special tax treatment-almost nobody argues they should-but rather whether states should revamp their tax systems to tax e-businesses more effectively. And while most people think of this as a "high-tech issue," in reality it has dramatic implications for both federalism and tax reform as well. State and local officials say that they want nothing more than to defend their traditional prerogatives in the Internet age. But the proposal they favor would radically expand the power of state governments.

Bear in mind that companies doing business over the Internet are already subject to various taxes. Congress passed the "Internet Tax Freedom Act" in October 1998, but that didn't exempt e-businesses from taxation. All it did was impose a three-year moratorium on "multiple and discriminatory" taxes imposed by states and localities. As a result, a state can't levy taxes on access to the Internet, and it can't tax sales over the Internet at a higher rate than other types of sale (unless the state was already doing those things before October 1998). E-businesses still pay property taxes and corporate income taxes where they are headquartered, just like every other company.

Sales taxes, meanwhile, are applied to Internet commerce just as they are to catalogue orders-which is to say, spottily. When someone from Maryland buys clothes via catalogue from L. L. Bean in Maine, the company has no obligation to collect Maryland's sales tax because it has no physical location in Maryland and receives no services from its government. The Supreme Court has repeatedly ruled that states can't press companies elsewhere into service as tax collectors. It's up to the consumer to pay the tax. Nobody does, of course, but states have not found it worthwhile to crack down.

State officials have never been happy with this situation, and the National Governors' Association has supported several attempts in the courts and in Congress to expand the states' taxing authority. The rise of e-commerce has now made state and local officials more determined than ever to keep revenues from slipping out of their reach, even though state revenues have been growing quite quickly during the Internet-fed boom. Governors and mayors are probably also overestimating how much revenue they can squeeze from the Internet.

Complaints have grown, too, about the unfair advantage that e- businesses have over their competitors. Governors speak mournfully of the plight of the mom-and-pop store (though the rather more impressive lobbying muscle of large traditional retailers such as Wal-Mart, J. C. Penney, and Radio Shack is behind the campaign to collect more taxes from the Internet). They further claim that higher taxes on the Internet would advance tax reform by leveling the playing field for different kinds of businesses. Conservatives who favor moving toward a tax system based more on consumption and less on income, they say, should want to tax the consumption that takes place over the Net.

The governors claim to have the moral high ground on federalism as well as on tax reform. They say that the tax moratorium passed by Congress infringes on the states' right to run their own tax systems. They oppose an extension of the moratorium, which the House has just passed and the Senate is debating.

But the governors' solution is to let states and localities reach beyond their borders to collect revenues, and that solution is hardly federalist. The National Governors' Association plan, enthusiastically backed by Republican governors Mike Leavitt of Utah and John Engler of Michigan, would essentially create an embryonic national sales tax. Companies that make sales over the phone, through the mail, or on the Internet would have to collect sales taxes and pay them to the customers' states and localities. This is called a "destination-based" sales tax.

The huge number of taxing jurisdictions in America would make this tax enormously complex. So the governors would have accounting firms with sophisticated software-to be called, apparently unironically, "Trusted Third Parties"-figure out what tax to pay whom. The medieval practice of tax farming would thus be revived for the cyber age.

The accounting firms would, of course, need to know where the customer lives. Once this elaborate system were established, there would be a great temptation to apply it to every sale everywhere. If you get some groceries while on vacation, the store could have its firm calculate the sales tax you would pay at home and arrange for its remittance, all while processing your credit card. South Dakota governor William Janklow, a Republican, said last year that under the governors' plan, when products sold online are shipped, "the bottom line is ultimately we're going to start stopping little brown trucks and going to start examining these packages." (Lest there be a misunderstanding, I should point out that Janklow was testifying for the plan.)

The plan is a travesty of federalism. The federalism enshrined in the Constitution insists on free trade among the states, which implies competition: If you don't like Massachusetts taxes, you can take your business to New Hampshire. What the governors propose is something different: a cartel, run by the states, to trap consumers who live under high-tax regimes. In order to help state governments, states would be empowered to poach on one another's economy. Businessmen, meanwhile, would have to send taxes to faraway places where they have no substantial presence and no vote. True federalism helps to ensure that government remains both limited and representative. The governors' plan subverts both objectives.

There are free-market advocates of a national sales tax, and some of them envision greater taxation of the Internet as part of their ideal tax system. But they want to see their tax enacted after a repeal of the income tax, not piled on top of it. Even so, the governors' plan should make those free-marketeers think again about their support of the sales tax.

The case for applying sales taxes more vigorously to e-commerce is based on the idea of tax neutrality: The tax code should not discriminate among different sorts of economic activity and should not artificially make some transactions more attractive than others. But as it stands, the sales tax comes nowhere close to neutrality. Many states exempt necessities such as clothing and food; services go untaxed, which is one reason there are more lawyers and consultants than there ought to be. In some states, BusinessWeek recently reported, plain doughnuts are tax-free while jelly doughnuts are taxed. Sales taxes hit less than half of all consumption.

The government, moreover, doesn't need sales taxes to have a consumption-based tax system. If the income tax exempted savings, as Dick Armey's flat tax would do, it would be a tax on consumption. (Income minus savings equals consumption.) If we adopt the most extreme anti-Internet-tax proposal-John Kasich and John McCain have bills to exempt e-commerce from all sales taxes-it might have the salutary effect of keeping sales taxes on regular commerce from going too high.

A sensible compromise is also available. The Heritage Foundation and the Cato Institute-the two leading free-market think tanks in Washington-have proposed an "origin-based" sales tax. Under this proposal, Amazon.com's sales would be subject to Washington State's taxes rather than those of the customer's state. The governors' association protests that Washington State would not have much incentive to hurt its own company's sales, but that's part of the point: It's a good thing for a state's taxes to be constrained by a concern for economic health.

Adam Thierer, a policy analyst at the Heritage Foundation, advocates the origin-based sales tax as a simple solution that promotes tax neutrality. But he is pessimistic that this solution will prevail, largely because it would entail severe constraints on governors and mayors-a powerful lobby.

Fortunately, these state and local officials have been kept in check on this issue by the fact that e-taxes are very unpopular. Exit polls taken during the primaries found strong opposition to taxing e-commerce among both Republicans and Democrats (even when the question was posed in the usual crude terms). That's why the House vote to extend the tax moratorium was quite lopsided-352 to 75-despite the governors' opposition. And that's also one reason Leavitt, the governor most actively trying to increase Internet taxes, has been facing a rebellion in the Utah Republican party.

The governors would probably have gotten their way by now, even in the face of public opposition, if not for Virginia governor James Gilmore. Gilmore, a Republican, is chairman of the federal commission on Internet taxation, and he has taken the free-market line. But his fellow governors view him as a traitor to his class; even most of his Republican peers remain committed to taxing sales outside their states. Antitax activists count themselves lucky that George W. Bush and Jeb Bush, the governors of Texas and Florida, have merely refrained from joining the clamor. W. won't take a firm position for fear of alienating the governors who support him, but on each vote that comes up he sides with the anti-taxers.

Grover Norquist, an antitax activist who served on the federal commission, thinks that the battle will turn on whether the Senate approves the extension of the moratorium. If the governors can threaten to introduce new taxes soon, he warns, they will be able to pressure e- business leaders to cut a deal that would pave the way for the adoption of the governors' broader plan. It's up to Congress to fulfill its responsibility to keep interstate commerce free of interference-and up to conservatives to understand their stake in making sure Congress does its duty.