After the Net Tax Commission: The Gregg-Kohl Nexus Solution

Report Technology

After the Net Tax Commission: The Gregg-Kohl Nexus Solution

April 25, 2000 15 min read
Adam Thierer
F.M. Kirby Research Fellow in National Security Policy

After a year of contentious hearings, extensive testimony, debate, and seemingly endless political grandstanding, the congressionally appointed Advisory Commission on Electronic Commerce submitted its final report to Congress on April 12, just before the deadline required by the Internet Tax Freedom Act of 1998.2 Although the commission was unable to generate the two-thirds supermajority vote required by the act to send a "formal" recommendation to Congress on the subject of taxing electronic commerce, a simple majority of its 19 members did agree on a fairly comprehensive plan that addresses many Internet and telecommunications tax policy issues.

As the debate over Internet taxation shifts back to Capitol Hill, Congress would be wise to study the commission's final report closely, culling from its thoughtful analysis many important principles and recommendations. Specifically, lawmakers should look to establish firm rules for how the government levies taxes on this vibrant sector in the Information Age. One bill, the New Economy Tax Simplification Act (S. 2401), has been introduced to do just that. It would establish a set of ground rules for determining the types of activities that would be subject to state and local sales and use taxes.

Establishing such ground rules is vitally important because it would codify, extend, and clarify long-standing principles of fair and constitutional taxation that the Supreme Court has supported for many years. These "nexus" guidelines would preserve the taxing authority of state and local governments while simultaneously keeping the interstate electronic marketplace free of inefficient and potentially unconstitutional tax burdens. S. 2401, the nexus proposal introduced by Senators Judd Gregg (R-NH) and Herbert Kohl (D-WI), adheres to these principles. It would apply the Founding Fathers' governing tenet of "no taxation without representation" to the thorny issue of Internet taxation by clarifying that taxes should be levied only on those companies that have a substantial physical presence in a taxing jurisdiction.


The bipartisan Advisory Commission on Electronic Commerce sought to examine all sides of the Internet taxation issue but in the end was able to achieve only a simple majority for most of the items upon which it voted. The commission's final public meeting, which took place in Dallas, Texas, in late March, demonstrated the difficulty: It became bogged down in parliamentary procedure and the obstructionist efforts of some members who hoped to discourage consensus. Most troubling were the actions of the three members appointed by the Clinton Administration who consistently abstained from voting on salient matters.

Under the Internet Tax Freedom Act (ITFA) of 1998, a formal recommendation on Internet taxation could be presented to Congress only if it was approved by a supermajority vote of 13 of the commission's 19 members. The most important and comprehensive proposal debated by the commission in Dallas, generally known as the business caucus proposal, received 11 votes. This proposal recommended:

  • Extending the current ITFA moratorium on Internet taxes for five years;

  • Prohibiting the taxation of digitized goods and products and their non-digitized counterparts;

  • Banning all taxes on Internet access;

  • Abolishing the 102-year-old federal excise tax of 3 percent that Congress imposed on telephone calls in 1898 to fund the Spanish-American War;

  • Encouraging state and local governments to reform industry-specific telecommunications taxes;

  • Establishing firm "nexus" rules for electronic commerce to make it clear when state and local governments could levy taxes on vendors of interstate commerce;

  • Encouraging state and local officials to work together to simplify their sales tax collection systems and make them more uniform; and

  • Establishing a new Advisory Commission to monitor these ongoing efforts and to determine whether states and localities should be allowed to collect taxes on out-of-state Internet vendors once tax code simplification is complete.

Many critics of the business caucus proposal, however, claimed that it represented "special interest politics" that would starve governments of sales tax revenue and hurt Main Street businesses.3 Subsequently, many politicians and business groups that want Internet commerce to be taxed labeled the commission's effort a failure and vowed to fight to stop any of its recommendations from being implemented by Congress.4

Despite such acrimony, the commission's proceedings helped widen public awareness of the issue and provided an exceptional framework for debating complex tax issues. Moreover, the business caucus proposal represents a very balanced and generous compromise among the commission's members, since it provides a mechanism whereby state and local officials eventually could tax Internet sales if they simplified their tax systems to minimize compliance costs for vendors.

The opposition to the commission's report among many state and local tax officials typifies a "tax first, reform later" mentality that the majority of the commission's members rejected. As stressed by several members, the burden of proof rests on the shoulders of state and local governments to show that their tax systems and policies would not unduly burden interstate commerce; only then should they be allowed to expand their tax collection authority over interstate transactions. The pro-tax forces, by arguing against the commission's compromise, apparently want government at all levels to be free to impose any tax scheme on interstate commercial activity regardless of the impact it would have on consumers or companies.

Finally, with state and local surpluses and Main Street retail business revenues at an all-time high, it is difficult to accept the "sky is falling" logic of the proponents of Internet taxes.5 For example:

  • The National Trust for Historic Preservation's recently released 1999 National Main Street Trends Survey finds that sales for historic Main Street districts are booming and that the overall number of retail stores locating in historic downtown areas is growing. Moreover, it finds that the Internet is helping to drive this dramatic growth--increasingly, historic Main Street businesses are using the Internet to reach both new and existing customers.6

  • Similarly, recent U.S. Department of Commerce aggregate retail sales figures have shown that retail activity has grown so much in recent months that the Federal Reserve is contemplating taking steps to ensure that the economy does not overheat.7


Although it is unlikely that the business caucus proposal will be adopted in its entirety by Congress,8 elements of the plan have been introduced as legislation by various Members. The most common proposals currently on the table either would extend the Internet Tax Freedom Act's existing moratorium on "multiple and discriminatory taxes" on the Internet for another three to five years or would make that moratorium permanent.

Although this rather uncomplicated approach has broad bipartisan support in Congress, it unfortunately would do very little to help resolve the more complicated issue of how state and local consumption taxes will be levied on sales made over the Internet. The reason: A moratorium on "multiple and discriminatory taxes," whether temporary or permanent, would do nothing to prohibit state and local officials from moving forward with plans to tax electronic commerce. Congress could take the more radical step of banning all state and local sales and use taxes on Internet transactions to solve this matter, but that approach probably would meet with stiff political opposition and raise a number of constitutional concerns regarding outright federal preemption of state and local taxing authority.

The Gregg-Kohl nexus clarification proposal offers a practical, yet very principled, solution to this problem. S. 2401 would allow state and local governments to impose tax collection obligations on interstate vendors only when they have a "substantial physical presence" in their jurisdictions.

As the commission recommended in the business caucus proposal, S. 2401 also would create a series of sales tax "safe harbors" or "bright line tests" for interstate vendors to clarify when they were required to remit taxes. For example, under the Gregg-Kohl proposal, the following activities would not, in and of themselves, establish tax nexus for interstate vendors of electronic commerce:

  • The solicitation of orders or contracts for tangible or intangible property or services that are approved outside a state and are fulfilled from a point outside the state;

  • The presence or use of intangible property in a state, such as patents, copyrights, trademarks, logos, securities contracts, money, deposits, electronic or digital signals, and Web pages;

  • The use of the Internet to maintain a Web site accessible by customers in a state;

  • The use of an Internet service provider (ISP), on-line service provider or other type of Internet access provider, or World Wide Web hosting services, to maintain, take, or process orders via a Web page site or server located in a state;

  • The use of any service producer for transmission or communication by cable, satellite, radio, telecommunication, or similar systems;

  • The affiliation with a person located in a state unless the person is an "agent" of the business entity who meets the substantial physical presence standard; and

  • The use of independent contractors or representatives for warranty or repair services.

What makes the Gregg-Kohl nexus clarification effort so important is that it provides legal certainty for companies and consumers engaged in interstate commerce, regardless of what channel they use (such as the Internet, catalogs, mail order, and 800 numbers). By codifying firm principles of fair taxation, it essentially modernizes the Founding Fathers' tenet of "no taxation without representation" by making it clear that there will be no taxation without physical presence for vendors engaged in interstate commerce.

Some Members of Congress may be reluctant the engage in a debate over nexus matters because of the issue's legal complexity, or they may believe that the courts are better able to handle such matters. Such reluctance, however, would be a serious mistake. Federal legislators cannot continue to rely on the courts to do their job for them. Although legislative debate over nexus will be challenging, Congress accomplished a similar task after debating income tax nexus policy. Moreover, continuing to rely on court-based interpretations of nexus is tantamount to a dereliction of duty and invites endless and costly litigation to resolve what is, at its core, a congressional responsibility--the regulation of interstate commerce.

For policymakers who fear that a debate over nexus will invite a heated showdown with state and local governments, it is important to stress that the codification of nexus principles by Congress would not prohibit all forms of Internet taxation by states and localities. S. 2401, for example, would provide state and local officials with clear guidelines on what is constitutional in taxing interstate goods, services, and technologies. Once these nexus rules of the road for electronic commerce were in place, states could choose to tax sales made over the Internet, but they also would be restricted to levying taxes only on activities that met the bright-line nexus standards established under S. 2401's guidelines.

These nexus rules would, in turn, encourage the states to adopt a clear and constitutional "sourcing" rule for the taxation of electronic commerce. In other words, by making it clear that extraterritorial taxation would be prohibited in virtually all cases, S. 2401 would encourage state and local governments to adopt an "origin-based" tax methodology under which they would levy sales taxes only on companies whose principal place of business resided within their taxing jurisdiction. Sourcing all sales to the location of origin instead of the destination of sale would enable state and local governments to impose taxes on Internet (and catalog) sales in the same way they impose them on traditional Main Street retail sales.

Unreliable and increasingly unenforceable use taxes could be completely extinguished under this system, since governments would tax only transactions that originated in their states.9 Such an origin-based system of electronic commerce would level the playing field with traditional retail merchants and also fit squarely within the confines of the Constitution and nexus rules, since it would meet the requirement that the business must have a "substantial presence" within a jurisdiction before it can be taxed. Moreover, it would encourage vigorous state-by-state tax competition, since governments would need to be wary of the burdens their tax systems imposed on their companies and citizens.10

Other states might reject product-based sales taxation altogether and instead opt to tax consumption through an income tax. In other words, instead of trying to continue the increasingly difficult process of tracing the movement of goods in order to tax individual consumption, states could adopt a savings-exempt income tax that excludes all savings from taxation and taxes the consumption portion of individual or corporate incomes. This would allow state and local government to continue to impose consumption taxes while at the same time scrapping their increasingly unworkable and inefficient sales and use tax systems.11

Keeping in mind the commission's conflict-ridden proceedings and findings, as well as a legislative calendar abbreviated by this year's presidential elections, the most prudent course of action for Congress would be to:

  • Make permanent or extend the existing ITFA moratorium on multiple and discriminatory taxes;

  • Codify firm nexus ground rules that clarify how states and localities may impose taxes on electronic commerce; and

  • Abolish the 3 percent federal excise tax, a century-old "tax on talking" whose repeal has achieved broad bipartisan support.

This is a reasonable agenda for Congress this year and, if necessary, next year. Once the foundation has been established, state and local officials can decide for themselves what types of tax reforms, if any, they need to undertake within their jurisdictions.


A simple extension of the Internet Tax Freedom Act's current moratorium on Internet taxes will not be sufficient to resolve the Internet tax impasse policymakers face today. Firm rules of the road, in the form of codified nexus rules for the economy in the evolving Information Age, offer the most optimal resolution of this issue.

A nexus proposal of the sort found in the Gregg-Kohl legislation would apply clear principles of fair taxation to the world of electronic commerce. S. 2401 would not prohibit all forms of Internet taxation, but it does demonstrate the principle that there should be "no taxation without representation." Just as this principle guided America's founding, so too should it govern
policymaking for today's high-tech economy.

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


1. For a general overview of the Internet tax debate, see Adam D. Thierer, "The NGA's Misguided Plan to Tax the Internet and Create a New National Sales Tax," Heritage Foundation Backgrounder No. 1343, February 4, 2000.

2. Advisory Commission on Electronic Commerce, Report to Congress, April 2000, at

3. David Cay Johnson, "Governors Criticize Internet Tax Panel," The New York Times, April 12, 2000, p. C6.

4. Paul Gigot, "GOP Governors Join the E-Tax Lobby," The Wall Street Journal, April 14, 2000, p. A18.

5. See Thierer, "The NGA's Misguided Plan to Tax the Internet," pp. 16-19.

6. National Trust for Historic Preservation, "1999 National Main Street Trends Survey," March 26, 2000, at

7. Yochi J. Dreazen, "Retail Sales Increased 0.4% in March, Raising Specter of Aggressive Fed Action," The Wall Street Journal, April 14, 2000, p. A2; Claire Mencke, "Hot Retail Seems to Cinch Rate Hike Even as Producer Prices Tame," Investor's Business Daily, April 14, 2000, p. A1.

8. Recent press reports have indicated that Representative Henry Hyde (R-IL), chairman of the House Judiciary Committee, may introduce legislation that would implement most of the recommendations in the commission's final report. See Alison Bennett, "Hyde in Final Stages of Developing Bill to Implement ACEC Majority Proposals," Bureau of National Affairs, BNA Daily Report for Executives, No. 73, April 14, 2000, p. G10.

9. Use tax enforcement traditionally has been riddled with problems, and increased use tax oversight is likely to breed discontent among the increasingly privacy-conscious American public. As Dana Mayton, a member of Kentucky's state revenue department, has noted, "People really feel that use-tax compliance is Big Brother at its finest." Richard Wolf, "Status of Use Tax Likely to Rise," USA Today, April 11, 2000, p. A4.

10. See "Debate: NGA's Shafroth, Heritage's Thierer on Streamlined Proposal, Origin-Basing for E-Commerce," State Tax Notes, Vol. 18, No. 4 (January 24, 2000), pp. 279-290; Terry Ryan and Eric Miethke, "The Seller-State Option: Solving the Electronic Commerce Dilemma," State Tax Notes, October 5, 1998, pp. 881-892; Andrew Wagner and Wade Anderson, "Origin-Based Taxation of Internet Commerce," State Tax Notes, July 19, 1999, pp. 187-192.

11. See Murray Weidenbaum, "Taxing E-Sales Without Hindering the `Net,'" Christian Science Monitor, January 20, 2000, at; Hal R. Varian, "Taxation of Electronic Commerce," Internet Policy Institute, April 2000, at


Adam Thierer

F.M. Kirby Research Fellow in National Security Policy