Executive Summary: The NGA's Misguided Plan to Tax the Internet and Create a New National Sales Tax

A heated showdown over the taxation of the Internet is taking place within the Advisory Commission on Electronic Commerce (ACEC), appointed by Congress under the Internet Tax Freedom Act of 1998 to study the feasibility of taxing the Internet and electronic transactions. The commission's final report to Congress is due in late April. So far, however, members have been unable to reach meaningful consensus on substantive recommendations, and they remain bitterly divided on the central issue: Should sales taxes be applied to electronic commerce?

Members of Congress therefore must prepare once again to address the issue of Internet taxation. As they do so, they should remember their constitutional obligation to protect both the sovereignty of state and local governments and the free flow of interstate commerce. The ACEC and Congress can achieve these objectives by adopting a plan that:

• Does not impose discriminatory or burdensome taxes on interstate commerce;

• Eliminates or radically reforms existing telecommunications sector taxes;

• Protects constitutional principles and Supreme Court precedents of fair taxation;

• Adopts a sound "nexus" standard that makes it clear which forms of sales taxation are legitimate;

• Encourages vigorous jurisdictional tax competition;

• Does not violate individual or corporate privacy; and

• Allows the Internet to continue to grow and thrive.

On each of these counts, the leading plan currently before the ACEC moves in the opposite direction. Offered by the National Governors' Association (NGA), this plan encourages the states to devise a system for the extraterritorial collection of sales taxes on Internet sales and, eventually, all forms of retail commerce. It is economically illogical and constitutionally suspect because it:

• Creates a new de facto national sales tax cartel;

• Violates constitutional first principles regarding tax fairness and commercial union;

• Upsets existing Supreme Court commercial jurisprudence;

• Threatens America's federalist structure of government by discouraging jurisdictional tax competition;

• Creates a "Trusted Third Party" tax collection system that could compromise individual and corporate privacy;

• Is unnecessarily complex and could be extremely costly to implement;

• Is not "voluntary" as the NGA claims; and

• Is at odds with the Clinton Administration's proposed "global free trade zone" for international commerce and could threaten American sovereignty.

The NGA plan is premised on two myths: that the Internet is a massive drain on state and local tax revenues and that it is unfair to exempt interstate vendors of commerce from taxes that Main Street businesses must pay. In reality, state and local tax revenues and budget surpluses are at an all-time high thanks to a high-tech Internet economy that has fueled unprecedented levels of economic growth and job creation. Additionally, out-of-state vendors of electronic commerce, though subjected to the same tax burdens that Main Street vendors must bear, would receive no benefits for the taxes they paid to state and local governments where they did not reside. This amounts to a form of taxation without representation.

The NGA proposal would subject Internet vendors--and all retail commerce--to an unprecedented, unconstitutional, and economically illogical system of sales tax administration. ACEC members and congressional policymakers would be wise to examine the NGA plan and others like it in light of a question posed by Federal Trade Commissioner Orson Swindle during the commission's New York City meeting: "Should policymakers apply a Depression-era tax system to the economy of the 21st Century?"

Because this is exactly what the NGA plan would do, both the ACEC and Congress should reject it and seek instead to establish a plan that allows state and local governments to impose sales taxes only on those Internet companies that have a physical presence or "taxable nexus" within their jurisdictions. Such an ­origin-based system of sales tax administration would be consistent with the Constitution and Supreme Court jurisprudence. It also would eliminate any perceived need to create the sort of inefficient and burdensome national sales tax system that has been proposed by the National Governors' Association.

Adam D. Thierer is a former Alex C. Walker Fellow in Economic Policy in the Thomas A. Roe Institute for Economic Policy Studies at The Heritage Foundation.