CONGRESS OF THE UNITED STATESCONGRESSIONAL BUDGET OFFICE

A

CBO
PAPER
OCTOBER 2003

© Digital Vision

Economic Issues
in Taxing
Internet and
Mail-Order
Sales

A

CBO
PAPER
Economic Issues in Taxing
Internet and Mail-Order Sales
October 2003

The Congress of the United States O Congressional Budget OfficePrefaceT

he collection of state and local sales and use taxes when individuals purchase items overthe Internet or from other remote sources is an issue that is now before the Congress. The
Internet Tax Freedom Act of 1998 established an Advisory Commission on Electronic
Commerce to make recommendations about Internet taxation, including whether to require
retailers to collect sales taxes on Internet purchases. But the commission made no formal
recommendations, and the issue has remained unresolved. This Congressional Budget Office(CBO) paper—prepared at the request of the Senate Finance Committee—uses an economic
framework to evaluate the various arguments that have been advanced by proponents andopponents of remote collection of sales taxes. In keeping with CBO’s mandate to provide
objective analysis, the report makes no recommendations.
Dennis Zimmerman of CBO’s Tax Analysis Division prepared the paper under the supervisionof G. Thomas Woodward and Roberton Williams. The paper benefited from comments byreviewers outside of CBO, including Thomas Neubig of Ernst & Young and William Fox of
the University of Tennessee. Within CBO, Robert Dennis, Theresa Gullo, Roger Hitchner,
Arlene Holen, Deborah Lucas, David Moore, Robert Murphy, Jennifer Smith, and John
Sturrock provided helpful suggestions.
Leah Mazade edited the manuscript, and Christine Bogusz proofread it. Denise Jordan-Williams
and Simone Thomas typed early drafts of the paper. Lenny Skutnik produced the printed copies,
and Annette Kalicki prepared the electronic versions for CBO’s Web site (www.cbo.gov).

Douglas Holtz-Eakin
Director
October 2003

Contents
Summary vii
An Overview of the Remote Sales Taxation Issue 2
States’ Inability to Collect Tax on Remote Sales 2
The Growth of E-Commerce 3
The Magnitude of Uncollected State and Local Use Tax Revenue 4
The Debate: Whether to Require Remote Sellers to Collect Use Taxes 6
The Economic Trade-Off That Remote Collection Presents 7
Nonneutral Taxation of Commodities 8
Administrative and Compliance Costs 9
Current Efforts to Reduce Compliance Costs 11
Other Economic Issues in the Remote Collection Debate 13
Network Externalities and Market Failures 14
The Size of the Public Sector 16
International Considerations 18
Remote Collection and Fairness 18
Fiscal Autonomy of States and Local Governments 20

vi ECONOMIC ISSUES IN TAXING INTERNET AND MAIL-ORDER SALES

Tables1.

State and Local General Sales Tax Rates andState General Sales Tax Revenue

4

Sales Tax Revenue for Selected Local Governmentswith Populations of 200,000 or More, 2000

61.

Origin-Based Versus Destination-Based Sales Tax Systems

13

2.

Taxing Digital Goods

14

2.

Boxes

SummaryAll of the 45 states, as well as the District ofColumbia, that levy retail sales taxes on purchases madewithin their borders (local sales) also impose an equivalent “use” tax on their residents’ purchases of items outof state (remote sales). Local governments also impose
sales and sometimes use taxes. (However, because statesin many cases administer those taxes, the general
discussion that follows uses “states” for simplicity’s saketo mean both states and local governments.) Previously,
those out-of-state purchases were mainly catalog andtelephone sales. But the growth of on-line, or “e”(electronic), commerce over the past several years has
increased remote sales by billions of dollars.
States rely on retailers to collect sales taxes from consumers on their local purchases and to remit them to thestates, an approach with relatively low administrative
costs and a relatively high rate of collections. But decisions by the Supreme Court have established that states
do not have the authority to require out-of-state sellers
to collect and remit use taxes on remote sales unless theseller has established a connection, or “nexus,” with thepurchaser’s state—in this instance, a physical presence(an office or other place of business, property, or an
agent). As a result, states rely on the use tax, which ispaid directly by purchasers and whose administrative
costs are relatively high and rate of collections quite low.
Estimates of uncollected use taxes from all remote sales
in 2003 range from $2.5 billion to $20.4 billion. Projections for 2011 of uncollected taxes from on-line commerce also vary widely, ranging from $4.5 billion to$54.8 billion.
In addition to its holding on nexus, the Court stated that
the Congress could permit states to require remote sellers
to collect use taxes, a conclusion that has led many
jurisdictions to look to the federal government to conferthat authority on them. A federal advisory committeestudied the question but was unable to reach a consensus

and thus issued no formal recommendations. Opponents
and proponents of granting such authority to states haveadvanced a variety of arguments; however, the central
economic issue is the magnitude of two kinds of costs
related to taxation: the distortions (referred to as excess
burden) that come from taxing goods unevenly and theadministrative and compliance costs of collecting
revenue.
Remote-seller collection of use taxes would eliminate theuneven taxation of identical goods purchased from a
local seller and a remote seller and thereby reduce the lossof national income that results when such tax differentials cause people to make purely tax-motivated decisions
about consumption and production. Consumers may bewilling to purchase a good remotely even if the total costof production and delivery exceeds the comparable instate cost because the money they save in taxes compensates them for the money they pay in shipping costs.
Similarly, producers may be willing to construct facilities
in locations where production and shipping costs arehigh to avoid nexus and the need to charge their customers sales taxes. The more unevenly a tax is applied, themore producers and consumers waste resources in efforts
to avoid it—thereby reducing economic efficiency. And
if a greater fraction of sales escapes taxation over time,states may seek to maintain the same level of receipts byraising tax rates, which would increase the tax system’s
excess burden.
While taxing remote sales could permit lower overall tax
rates and reduced administrative costs, it is also likely toincrease the burden of compliance costs imposed onretailers doing business in many states compared with theburden borne by local sellers doing business in one state.
In addition to the 45 states that impose sales taxes, local
governments in most of them may impose such levies.
A firm engaged in business nationwide could thus bedealing with more than 6,000 tax regimes, many with

viii ECONOMIC ISSUES IN TAXING INTERNET AND MAIL-ORDER SALES

different tax bases (the goods and services to which the
tax applies), tax rates, and rules about who is subject totax. Evidence suggests that the cost of complying withthat multiplicity of tax systems, particularly for smallerfirms, will exceed compliance costs for local sellers
dealing with a single sales tax system.
Those two economic costs arising from taxation—
distortion costs and compliance costs—represent a loss
to society. That loss constitutes the social costs of taxation (costs in excess of the revenue collected). Requiring
remote sellers to collect and remit use taxes would haveunclear effects on social costs: distortion costs would
probably be reduced, but compliance costs would probably increase. The decision by policymakers to either
grant or withhold from states the authority to collect use
taxes on remote sales involves a trade-off between those
two costs. Several proposals to grant that authority havebeen introduced in the 108th Congress.
Federal action is not the only source of policy changes that
could affect that trade-off. As of August 2003, more than
30 states had developed and 20 adopted the Streamlined
Sales and Use Tax Agreement (SSUTA). The SSUTA isintended to reduce the compliance costs imposed onremote sellers by implementing three strategies: (1)adopting computer technology and institutional arrangements to enable vendors to comply more cheaply withmultiple tax laws and taxing authorities; (2) adopting
common tax-base definitions for categories of consumption, similar tax bases, and similar tax-filing andaudit procedures; and (3) compensating vendors for thecompliance costs that remain after the first two strategies
have been implemented.
Proponents and opponents of remote collection raise otherissues as part of the debate. Opponents have argued that
effectively exempting Internet purchases from sales taxes
is a means of inducing more people to use the Internet
and stimulating the growth of e-commerce. The growthof Internet use is desirable because the Internet exhibits“network externalities”—a person’s joining the network
benefits not only him- or herself but also other participants, by adding to the total number of participantsin the network. Too few people use the Internet whenthose external benefits are not reflected in the price ofaccess to it. Providing a subsidy would thus increase useof the Internet and benefit society.
Network externalities, however, exist mainly in the earlystages of a network’s growth. For that reason, it is difficult
to justify incentives for a network such as the Internet,
which was used by 56 percent of the U.S. population
above the age of eight in 2001. And even if such externalities are present, not collecting use taxes on remotepurchases is an indirect and unevenly targeted means ofencouraging more people to use the Internet (and in statesthat have no sales tax, no incentive at all). Thus, such an
approach may not increase overall efficiency, whereas amore direct incentive for Internet use or access might.
Some opponents of remote-seller use tax collection agree
that nonneutral, or uneven, taxation of commodities canlead to higher tax rates and excess burden. But they also
argue that collecting use taxes on remote sales will nonetheless increase the social costs of taxation if, as somepeople believe, governments have an inherent tendency
to be too large. If taxes are costly to collect, that cost canhelp constrain government spending. Reducing the costsof collecting use taxes, therefore, may not result in lower
rates on other taxes and a lessening of distortion costs but
instead will encourage larger government and increase thesocial costs of taxation. Those analytic possibilities notwithstanding, the empirical evidence regarding such claims
is mixed. And regardless of the issue of remote collection,
concerns about the magnitude of government spending
could be addressed through the political process as wellas with a variety of tax and spending controls that havebeen adopted by some states and local governments.
Tax equity, another issue in the remote collection debate,has been used as the basis for some proponents’ arguments. They contend that not collecting use taxes violates
principles of fairness in that two individuals who purchase
identical goods may pay different taxes because one ofthem buys the good over the Internet. Proponents further
maintain that because Internet access—as well as the useof credit cards and other instruments typically used toshop on-line—tends to rise with income, the effective
exemption of e-commerce from taxation causes state sales
tax systems to be more regressive than they would be
without such an exemption.

ECONOMIC ISSUES IN TAXING INTERNET AND MAIL-ORDER SALES

Both arguments represent value judgments about how
taxes should be levied. As a result, one cannot evaluate theeffect that the violation of those equity norms has on
economic well-being as one can evaluate the effect ofviolating the efficiency standard. Consumers who buy thesame goods through different channels choose to do so
and in other ways are not identical; comparing them toassess fairness is thus problematic. As for the differential
effects on consumers with different income, the potential
for e-commerce to make the sales tax more regressive
diminishes as Internet access becomes more nearly
universal.
Opponents of requiring remote sellers to collect use taxes
raise a different fairness issue—one related to businesses
that receive no benefits or services from a jurisdiction
because they are located elsewhere. Those opponents argue
that such businesses should not have to pay taxes insupport of those benefits and services. But the “tax” inquestion is a levy on consumers that is merely collectedby firms, and any impact on those businesses appears ascompliance costs, a burden that could be lightened bycompensation. To the extent that issues of tax equity arise,

they are centered on the effects on residents of a taxing
jurisdiction who purchase goods and services remotely.
Another concern expressed by opponents of remote-seller
tax collection is the question of states’ fiscal autonomy.
Granting the authority to collect use taxes on remote sales
in exchange for simplifying sales tax regimes, they argue,
would limit states that have sales taxes in tailoring their
tax to their citizens’ preferences. To the extent that stateschoose well on behalf of their residents, those choices
presumably increase well-being. As a general matter,
however, the issue is beyond the scope of economic
analysis.
Of the various arguments related to efficiency and fairness,nonneutral taxation and compliance costs appear to be
central to the issue of remote sales tax collection. However,even the gains from eliminating nonneutral taxation would
depend on the degree to which international differences
in taxing remote sales persisted and the ability to track
and tax digital goods (for example, digitized music). The
gains from reducing compliance costs have yet to be
demonstrated.

ix

Economic Issues in Taxing
Internet and Mail-Order Sales

S

tates and local governments that levy taxes onretail sales have long faced the issue of the cost ofcollecting that revenue when their residents purchase items
by mail or telephone from retailers that are located outof their jurisdictions—so-called remote sellers. Retail sales
over the Internet, known as electronic, or “e,” commerce,have boosted remote sales and increased states’ and local
governments’ interest in collecting taxes on those purchases. The uncollected revenue from the e-commerceshare of such sales is expected to continue to increase, but
projections of its magnitude vary widely—for example,
for 2011, they range from $4.5 billion to $54.8 billion.1

States and local governments require merchants to collectsales taxes at the point of sale and remit them to the government. That system works well when the sale takes
place within the taxing jurisdiction (local sales). But
those governments have limited authority to require
sellers outside their jurisdictions to collect tax onpurchases made by their residents. As a result, all of thestates that levy sales taxes have adopted a companion“use” tax, to be collected from residents, that applies togoods purchased from out-of-state vendors that are“used” at home. The use tax is intended to reduce the
incentive for residents to purchase goods from retailers
located in lower-tax (or no-tax) jurisdictions. But theadministrative costs of collecting use taxes are relatively
high. As a result, governments tend to avoid those costs
and rely primarily on residents to voluntarily pay the
1. The lower estimate appears in Peter A. Johnson, A Current
Calculation of Uncollected Sales Tax Arising from Internet Growth (NewYork: Direct Marketing Association, March 11, 2003); the higher
estimate is from Donald Bruce and William F. Fox, State and Local
Sales Tax Revenue Losses from E-Commerce: Updated Estimates (Knoxville, Tenn.: Center for Business and Economic Research, University of Tennessee, September 2001).

taxes. Relatively little revenue is collected, however.2
Consequently, the underlying economic issue is notwhether sales over the Internet (or by mail or telephone)
are to be subject to tax—they already are. The issue israther the cost of collecting such taxes.
Under the Constitution, the Congress could reduce theadministrative costs of collecting sales and use taxes bygiving states and local governments the authority torequire remote sellers to collect them. Such a requirement would eliminate some tax differentials among
commodities and reduce the loss of national income that
results when that uneven taxation causes people to decide
whether to consume or produce something on the basisof the taxes that apply. The costs arising from the “distortion” of those decisions are sometimes referred to as
excess burden. But the requirement would also impose
higher compliance costs on remote sellers, who would
have to keep track of a complex system of tax bases (seethe discussion below) and rates imposed by the 45 states
and thousands of local jurisdictions that levy sales anduse taxes.
Those two effects—distortion costs and compliance costs—represent a loss to society and constitute the social
costs of taxation (costs in excess of the revenue collected).
A decision to require remote sellers to collect and remit
2. Enforcement of the use tax is practical only for consumer goods(such as automobiles and boats) that must be registered in a stateand for purchases made by businesses that are otherwise subject
to audit. The use tax accounts for about 10 percent of total sales
and use tax collections, according to John F. Due and John L.
Mikesell, Sales Taxation: State and Local Structure and Administration (Washington, D.C.: Urban Institute Press, 1994), p. 246.
Most of that use tax revenue comes from business-to-business sales
that are subject to compliance review (unlike most business-toconsumer sales).

2

ECONOMIC ISSUES IN TAXING INTERNET AND MAIL-ORDER SALES

use taxes would have conflicting effects on social costs:
it would reduce excess burden but increase administrativeand compliance costs. As a result, federal policymakers
face a difficult choice. In the Internet Tax Freedom Act
of 1998 (Public Law 105-277), the Congress establishedthe Advisory Commission on Electronic Commerce todevelop recommendations about taxation related to theInternet, including recommendations on expanding theduty of retailers to collect taxes on remote sales. But thecommission was unable to reach a consensus and issued
no official recommendations.

hensive nor uniform. For example, sales tax bases
typically exclude most services and intangible products,
such as medical, legal, financial, and education services.
Many jurisdictions also exempt some categories oftangible goods, such as food and medicine, to lighten theburden of the tax on lower-income taxpayers. In contrast,
the base includes a substantial amount of goods purchased by businesses—which means that those commodities are effectively taxed twice under the sales tax, once
as an input in a production process and once as part of
the final good that is produced.4

Thus, the Congress still faces the question of whether toact on this issue and, if so, what action to take. This
Congressional Budget Office paper examines in moredetail the trade-off between distortion costs and administrative and compliance costs.3 It also evaluates several
other claims that have been advanced as part of thedebate about whether to grant states the power to require
remote sellers to collect use taxes. Those claims concern
the effect of that power on the growth of the Internet andon the growth of government. In addition, the claims
raise issues of fairness (who pays taxes) and of states’ fiscal
autonomy (the freedom to determine their tax policy
without interference from the federal government).

The general sales tax finances a substantial portion ofstates’ public services, accounting in 2002 for 33.5 percent of states’ total tax revenue (see Table 1 on pages 4
and 5). Among the states, that share varies considerably:
it accounts for more than 50 percent of tax revenue in
Arizona, Florida, Nevada, South Dakota, Tennessee,
Texas, and Washington and, as expected, for none of therevenue in the five no-sales-tax states—Alaska, Delaware,
Montana, New Hampshire, and Oregon. Thirty-fivestates also allow local governments to levy sales taxes.
(However, in many cases, the states administer those
local taxes.)

An Overview of the Remote
Sales Taxation Issue
General sales taxes were first adopted in the 1930s.
Today, 45 states, the District of Columbia, and many
local governments levy sales and use taxes, imposing theirown tax rates and choosing their own definitions of the“base”of goods and services to which the tax applies.
Sales taxes were originally conceived as a levy on all retailsales with sellers acting as collection agents; however, thebase of the tax in most jurisdictions is neither compre3. The “optimal tax” framework for commodity taxes with an explicit
trade-off between excess burden and administrative and compliancecosts is developed in Shlomo Yitzhaki, “A Note on Optimal
Taxation and Administrative Costs,” American Economic Review,
vol. 69, no. 1 (1979), pp. 475-480. An analysis of the optimal
tax literature and electronic commerce is presented in Donald
Bruce, William F. Fox, and Matthew Murray, “To Tax or Not toTax? The Case of Electronic Commerce,” Contemporary Economic
Policy, vol. 21, no. 1 (2003), pp. 25-40.

Sales tax revenue is a far smaller part of the finances of
local governments, accounting for about 12.2 percent of
total local tax revenue in 2000. That average masks considerable variation, however. Sales tax revenue accounted
for 18.1 percent of total tax revenue in 2000 for local
governments whose population exceeded 200,000 andthat levied a general sales tax (see Table 2 on page 6).

States’ Inability to Collect Tax on Remote Sales
As mail-order businesses have expanded, states havesought ways to maintain their revenue base in the face of
4. Raymond L. Ring Jr., in his article “Consumers’ Share andProducers’ Share of the General Sales Tax” (National Tax Journal,
vol. 52, no. 1, 1999, pp. 79-90), estimated that 41 percent of thesales tax base in 1989 entailed purchases by businesses, governments, and nonprofit organizations. Ring could not estimate
specific shares for each category, however. Double taxation does
not occur in cases in which taxable purchases are inputs fornontaxable services. Information also is not available to determine
whether the share of the tax base that is made up of purchases bybusinesses, governments, and nonprofit organizations has changed
over the past decade.

ECONOMIC ISSUES IN TAXING INTERNET AND MAIL-ORDER SALES

a growing volume of out-of-jurisdiction purchases. In
that pursuit, they tested their authority to require remotesellers to collect the use tax applicable in the customer’s
state. But the Supreme Court invalidated those statutes
as unconstitutional constraints on interstate commercein cases in which the remote sellers had an insufficientconnection to the taxing states.
For instance, in 1967, in National Bellas Hess, Incorporated, v. Department of Revenue for the State of Illinois,
the Court struck down an Illinois statute that required
remote sellers to collect use taxes on their sales to Illinois customers.5 National Bellas Hess was a Missouri
mail-order business whose only connection with customers in the state of Illinois was through the U.S.
Postal Service or common carriers (for example, United
Parcel Service). The Court held that under the Constitution’s commerce and due process clauses, the firmlacked the requisite physical presence in Illinois—or“nexus” with the state—either to justify the burden thatthe statute imposed on interstate commerce or to overcome the statute’s “offense” to due process.6

In a more recent case, the Court signaled its view ofwhere resolution of the issue of remote sales taxation
might be pursued. In Quill Corporation v. North Dakota,
the Court was again faced with a state statute that required remote sellers to collect use taxes on their sales toout-of-state customers.7 The Quill Corporation, a Delaware-based remote seller, was connected to customers inNorth Dakota only by common carrier or the mail. The
Court found that Quill’s “minimum contacts” with thestate satisfied the requirements of due process but thatthe firm nevertheless lacked what the judges now termeda “substantial nexus” with the state as required under thecommerce clause. The Court thus upheld the standard
it had expressed in National Bellas Hess and concluded
that Quill lacked the requisite physical presence in North
Dakota to justify the burden that the state statute imposed on interstate commerce. The Court noted that theunderlying issue of taxing remote sales was “not only one
that Congress may be better qualified to resolve but also
one that Congress has the ultimate power [under theConstitution] to resolve.”

The Growth of E-Commerce
The Court used the firm’s costs for complying withsuch statutes to illustrate the burden that the Illinois
statute imposed on interstate commerce. It concluded
that if the Illinois statute was upheld, the decision
could potentially subject National Bellas Hess’s interstate business to the tax rates, exemptions, and recordkeeping requirements of every political subdivision in
the country. The result, according to the Court, would
be to “entangle National’s interstate business in a virtual welter of complicated obligation to local jurisdictions who would have no legitimate claim that they
were imposing ‘a fair share of the cost’ of government.”

5. National Bellas Hess, Incorporated, v. Department of Revenue for theState of Illinois, 386 U.S. 753 (1967).
6. In due process jurisprudence, the relevant inquiry is framed aswhether a defendant has had minimum contacts with thejurisdiction “such that the maintenance of the suit does not offend
traditional notions of fair play and substantial justice.” SeeInternational Shoe Co. v. Washington, 326 U.S. 310 (1945), quoting
Milliken v. Meyer, 311 U.S. 457 (1940).

Determining the rate of growth of e-commerce overmore than a few years is difficult. The federal government first published complete data on total e-commercefor 1999. The value of Internet sales grew by more thanhalf over the next two years, rising from $660 billion in1999 to just over $1 trillion in 2001. More than 93 percent of that latter amount was attributable to business-tobusiness transactions for “manufacturing shipments” and“merchant wholesale trade sales,” categories of economic
activity that the Bureau of the Census uses in its e-commerce surveys.8 Business-to-consumer transactions appear
in two other categories: “retail trade sales” and “service
revenue.” (The term “total e-commerce” covers bothbusiness-to-business and business-to-consumer transactions.)

7. Quill Corp. v. North Dakota, 504 U.S. 298 (1992).
8. The Census Bureau’s e-statistics are available at www.census.gov/
eos/www/ebusiness614.htm.

3

4

ECONOMIC ISSUES IN TAXING INTERNET AND MAIL-ORDER SALES

Table 1.

State and Local General Sales Tax Rates and State General Sales Tax Revenue
Total State Tax
State Tax Top Combined State Revenue, 2002
Rate, 2003 and Local Tax Rate, (Millions of(Percent)
2003 (Percent)dollars)
Alabamaa
Alaskaa
Arizonaa
Arkansasa
Californiaa
Coloradoa
Connecticut
Delaware
Floridaa
Georgiaa
HawaiiIdahoaIllinoisa
Indiana
Iowaa
Kansasa
KentuckyLouisianaa
Maine
Maryland
Massachusetts
MichiganMinnesotaa
Mississippia
Missouria
Montana
Nebraskaa
NevadaNew Hampshire

4
0
5.6
5.125
6
2.9
6
0
6
4
4
5
6.25
6
5
5.3
6
4
5
5
5
6
6.5
7
4.225
0
5.5
6.5
0

11
7
8.6
9.875
8.5
7.9
6
0
7.5
7
4
8
9.25
6
7
8.3
6
9.5
5
5
5
6
7.5
7.25
8.35
0
7
7.25
0

6,879
1,090
8,477
5,034
77,755
6,923
9,033
2,174
24,816
13,7723,421
2,271
22,460
9,995
5,006
4,808
7,975
7,346
2,627
10,821
14,82021,864
12,936
4,729
8,679
1,443
2,993
3,945
1,884

State General Sales Tax Revenue, 2002
In Millions
As a Percentage ofof Dollars
Total State Taxes
1,747
0
4,289
1,918
23,793
1,904
3,044
0
14,418
4,834
1,611
795
6,424
3,798
1,747
1,798
2,313
2,329
835
2,694
3,690
7,784
3,739
2,341
2,855
0
1,069
2,071
0

25.4
0
50.6
38.1
30.6
27.5
33.7
0
58.1
35.1
47.1
35.0
28.6
38.0
34.9
37.4
29.0
31.7
31.8
24.9
24.9
35.6
28.9
49.5
32.9
0
35.7
52.5
0
(Continued)

Retail sales statistics give some indication of the growthof e-commerce over the past decade. The Census Bureau
collects time-series data on the retail component of total
e-commerce in its “Monthly Retail Survey”; the category“electronic shopping and mail-order houses”covers all
remote retail sales (mail order, telephone, and e-commerce). Those sales have grown rapidly, rising from$35.1 billion in 1992 to $109.7 billion in 2001 and$116.6 billion in 2002. The e-commerce share of thosesales cannot be identified for 1992, but data for 1999 to2001 show the share almost doubling, from 16.6 percent
to 31.3 percent.

The Magnitude of Uncollected State andLocal Use Tax Revenue
The concerns of states and local governments about
uncollected use tax revenue (from both business-toconsumer and business-to-business transactions) predate
the rise of sales on the Internet. Uncollected revenue
from remote sales in 1994 reached $3.3 billion according
to the Advisory Commission on Intergovernmental
Relations, or 2.5 percent of states’ sales and use tax col-

ECONOMIC ISSUES IN TAXING INTERNET AND MAIL-ORDER SALES

Table 1.

Continued
Total State Tax
State Tax Top Combined State Revenue, 2002
Rate, 2003 and Local Tax Rate, (Millions of(Percent)
2003 (Percent)dollars)

State General Sales Tax Revenue, 2002
In Millions
As a Percentage ofof Dollars
Total State Taxes

New Jersey
New Mexicoa
New Yorka
North Carolinaa
North Dakotaa
Ohioa
Oklahomaa
OregonPennsylvaniaa
Rhode Island
South Carolinaa
South Dakotaa
Tennesseea
TexasaUtaha
Vermonta
Virginiaa
Washingtona
West Virginia
Wisconsina
Wyominga

6
5
4
4.5
5
5
4.5
0
6
7
5
4
7
6.25
4.75
5
3.5
6.5
6
5
4

6
7.25
8.5
7.5
7.5
7
9.85
0
7
7
7
6
9.75
8.25
7
6
4.5
8.9
6
6
6

18,3293,628
43,262
15,535
1,117
19,617
6,053
5,139
22,136
2,128
5,749
977
7,798
28,662
3,925
1,534
12,781
12,6293,552
11,814
1,094

5,994
1,339
8,609
3,216
335
6,395
1,531
0
7,327
732
2,334
524
4,679
14,560
1,499
215
2,799
7,906
963
3,698
445

32.7
36.9
19.9
20.7
30.0
32.6
25.3
0
33.1
34.4
40.6
53.6
60.0
50.8
38.2
14.0
21.9
62.6
27.1
31.3
40.7

Memorandum:
United States

n.a.

n.a.

533,435

178,939

33.5

Source: Congressional Budget Office using rates and revenue figures from the Federation of Tax Administrators, available at www.taxadmin.org.
Note: n.a. = not applicable.
a. States in which local governments also levy sales taxes.

lections and 0.8 percent of their total tax revenue.9
Perhaps because many observers expected evolving
computer technology to increase remote sales and uncollected use tax revenue, the policy debate is often described as being about taxation of sales over the Internet.
But, as noted earlier, the relevant issue is the cost ofcollecting tax revenue from all remote sales rather than
the increase in such uncollected revenue caused by ecommerce. Any policy requiring remote sellers to collectand remit use taxes levied on e-commerce would proba9. Advisory Commission on Intergovernmental Relations, Taxationof Interstate Mail-Order Sales: 1994 Revenue Estimates (1994). The
commission’s original report on mail-order sales, State and Local
Taxation of Out-of-State Mail-Order Sales (May 1986), discusses
the related economic issues more fully.

bly be applied to mail-order and telephone sales as well(assuming that all types of remote sellers would bearsimilar compliance costs).
The General Accounting Office in 2000 projected upperand lower bounds for uncollected revenue from remotesales for 2003.10 Its upper-bound estimate was $20.4 billion, or 7.9 percent of projected state and local generalsales tax revenue of $256.4 billion, and its lower-boundestimate was $2.5 billion. Those projections are probably
too high because they predated the recent recession (total
10. General Accounting Office, Sales Taxes: Electronic Commerce
Growth Presents Challenges; Revenue Losses Are Uncertain, GAO/GGD/OCE-00-165 (June 2000).

56ECONOMIC ISSUES IN TAXING INTERNET AND MAIL-ORDER SALES

Table 2.

Sales Tax Revenue for Selected Local Governmentswith Populations of 200,000 or More, 2000
Local Government
Albuquerque, N.M.
Anaheim, Calif.
Bakersfield, Calif.
Chicago, Ill.
Denver, Colo. (City and county)
Houston, Tex.
Kansas City, Mo.
Los Angeles, Calif.
Montgomery, Ala.
New Orleans, La.
New York, N.Y.
Norfolk, Va.
Oklahoma City, Okla.
Philadelphia, Pa.
Phoenix, Ariz.
San Diego, Calif.
San Francisco, Calif. (City and county)
St. Paul, Minn.
Tampa, Fla.
Tulsa, Okla.
Washington, D.C.

Sales Tax Revenue(Thousands of dollars)
96,36757,34337,582
181,834
361,349
313,864
141,243
442,148
58,778133,490
3,525,610
24,321
204,073
104,328
278,731372,785
270,274
11,04911,402
202,108
640,212

Total Tax Revenue(Thousands of dollars)

Sales Tax as a Percentage
of Total Tax

200,847
159,718
69,764
1,910,382
649,534
1,072,223
512,680
2,300,418
110,280
359,037
22,547,398
273,002272,439
1,918,632
618,214855,886
1,511,562
129,068
158,761
246,359
3,215,766

48.0
35.9
53.9
9.5
55.6
29.3
27.5
19.2
53.3
37.2
15.6
8.9
74.9
5.4
45.1
43.6
17.9
8.6
7.2
82.0
19.9

Source: Congressional Budget Office based on unpublished data from the Census Bureau’s “2000 Annual Survey of State and Local Government Finances.”

sales tax revenue for the year ending June 2003 was only
$228 billion). But the wide range of the estimates reflects
the uncertainty arising from shortcomings in the data
available to quantify uncollected revenue from remotesales. Factors that must be estimated include the rate of
growth of e-commerce; the proportion of e-commercethat is not part of the sales tax base; the share of e-commerce that is part of the tax base but that represents
purchases by exempt entities; and the proportion of
taxable e-commerce on which tax is already being collected and that replaces other forms of remote sales. A
series of assumptions must be made to adjust for thosefactors in estimating total sales over the Internet.
More-recent estimates of uncollected tax revenue fromall remote sales are not available. But two forecasts ofsuch revenue from the e-commerce share of remote sales
for 2006 and 2011 assign different values to each of thefactors contributing to overall uncertainty and consequently reach very different conclusions. According to

one set of estimates, uncollected state and local revenue
would be $45.2 billion in 2006 and $54.8 billion in
2011, losses that would represent 5.6 percent of state tax
revenue in 2006 and 5.4 percent in 2011.11 The share of
local tax revenue lost would be 1.8 percent in both years.
Another set of estimates is considerably lower—$3.2
billion in 2006 and $4.5 billion in 2011, or less than
1 percent of state and local tax revenue in both years.12

The Debate: Whether to Require
Remote Sellers to Collect Use Taxes
The potential loss of revenue stemming from states’ andlocal governments’ inability to efficiently collect use taxes
on remote purchases has generated a policy debate over
11. Bruce and Fox, State and Local Sales Tax Revenue Losses from ECommerce.
12. Johnson, A Current Calculation of Uncollected Sales Tax Arising fromInternet Growth.

ECONOMIC ISSUES IN TAXING INTERNET AND MAIL-ORDER SALES

whether vendors should be required to collect use taxes
in their stead. The Supreme Court’s decision in Quill
Corporation v. North Dakota makes it clear that only theCongress can give states the authority to require remotesellers to collect use taxes. In fact, that policy role is thefederal government’s only stake in the Internet sales tax
debate; the issue has no direct federal budgetary implications.
The proponents and opponents of such regulation callon principles related to economic efficiency, fairness, andstates’ fiscal autonomy to support their respective positions. According to one side or the other in the debate,requiring remote sellers to collect use taxes will:#

Have opposing effects on the social costs of taxation—decrease the loss of national income that
results when the differential taxation of commodities causes tax-motivated decisions about consumption and production (excess burden) and increase
the compliance costs that would be imposed onremote sellers to collect and remit use taxes;#

Increase the size of government and eliminate a tax
advantage that is helping the Internet grow to its
economically desirable size;#

Distribute the burden of sales taxes more equitably
and treat people in equal circumstances equally;#

Impose a tax burden on remote sellers who, unlike
local sellers, receive no compensating public service
benefits (for example, fire and police protection);or#Compromise the fiscal autonomy of states and local
governments, which is guaranteed by the Constitution, if standardization of tax bases and rates is required to reduce compliance costs.

Faced with competing demands involving e-commerce,
the Congress considered legislation in 1998 to tax Internet access (the fees paid to be connected to theInternet) and require remote sellers to collect taxes on
Internet sales. Policymakers eventually enacted theInternet Tax Freedom Act (ITFA), which allowed existing taxes on Internet access to remain in effect but im-

posed a three-year moratorium on new federal, state,
and local access levies. In addition, it allowed existingtaxes on sales over the Internet to remain in effect andpermitted governments to impose new taxes on suchsales as long as they applied equally to sales made byother means, but it prohibited discriminatory taxes on
Internet sales. The law did not give states and local governments the authority to require that remote sellers
collect sales taxes.
The ITFA, as noted earlier, also established the Advisory Commission on Electronic Commerce, which was
to report to the Congress in April 2000 with recommendations about Internet taxation, including sales
taxes. However, the commission was unable to achieve
the two-thirds majority (13 of 19 members) required toissue official findings and recommendations about remote sellers’ expanded duty to collect sales taxes.13
Policymakers were split into two major camps: those
who would make the Internet a tax-free zone and those
who would allow collection of use taxes on remote sales
provided state and local governments met certain requirements for simplifying and standardizing their tax
bases or rates (or both). In November 2001, a compromise of sorts was reached by policymakers’ extension of
the ITFA for two years. The extension’s pending expiration in 2003 makes it likely that the current Congress
will address the issue.

The Economic Trade-Off That
Remote Collection Presents
In general, the economic issue involved in collecting
use taxes on remote sales (in short, remote collection) is
fairly straightforward, notwithstanding the variety of
economic arguments advanced by both sides in the policy debate. Remote collection reflects a trade-off between two kinds of social costs that arise from taxation:
the loss of national income from nonuniform taxationand the loss from incurring administrative and compliance costs for collection. The desirability of remote collection depends on the magnitudes of those two kindsof costs.
13. See Advisory Commission on Electronic Commerce, Report toCongress (April 2000).

78ECONOMIC ISSUES IN TAXING INTERNET AND MAIL-ORDER SALES

Nonneutral Taxation of Commodities
Virtually all taxes impose costs in the form of reduced
economic efficiency. That is, the loss to taxpayers paying the tax is greater than the value of the taxes collected because taxes distort decisions about private consumption and production and lead to less efficient use
of national economic resources. Research indicates thatto raise a given amount of tax revenue, those distortions, or excess burden, can be minimized by taxing allcommodities uniformly up to the point that taxing an
additional commodity will increase the costs of administering the tax by more than it reduces excess burden.14
Within that framework, a larger public sector will require a higher tax rate to raise more revenue. Because
the loss of economic well-being from a tax increases
more than proportionately with the rise in the tax rate,
the outcome will be added inefficiency from the higher
rate on taxed goods.
It is the violation of the standard of uniform tax rates
that supporters of remote-seller tax collection cite aspart of their concern about e-commerce. Under current
arrangements, the tax-inclusive price that a consumer
pays for a good varies depending on whether the consumer purchases it locally and pays tax on it or buys itover the Internet without complying with the use tax.
That kind of price differential causes some decisions
about both consumption and producers’ locations to be
motivated by taxes rather than by the cost of the resources used to produce and sell the good.
For example, a consumer might choose to purchasebooks over the Internet for $100 inclusive of the shipping cost, pay no sales tax, and fail to comply with theuse tax rather than purchase the same books at a local
bookstore for $102 inclusive of a local $5 sales tax. The
real resource cost of the books (including profit) pur14. Were individuals’ preferences known, tax rates could be set to vary
among commodities according to how closely each good’s use wastied to leisure and other activities that cannot be taxed and how
sensitive consumers were to a change in the good’s price. But
individuals’ preferences cannot be known, and policymakers havesettled instead for establishing uniform tax rates across commodities
as a way to minimize excess burden. For a discussion of the historyof that policy process, see Joel Slemrod, “Optimal Taxation and
Optimal Tax Systems,” Journal of Economic Perspectives, vol. 4,
no. 1 (1990), pp. 157-178.

chased from the Internet seller is $100; that is, the“market” values the resources that are used to produce
and deliver those books at $100. The real resource costof the same books (including profit) available for salefrom the local bookseller is $97; the portion of thebooks’ cost that is sales tax ($5) is a transfer from theconsumer to the government and uses no resources.
Thus, the tax differential that results from the consumer’s noncompliance with the use tax causes thisconsumer to make a choice that increases the production cost of books by $3. That money represents a lossof economic well-being to society because those $3
worth of resources could have been used to produce $3
worth of other goods or services.
The same circumstances can be used to show how a tax
differential may affect decisions about production. Suppose the Internet bookseller located its East Coast distribution center in jurisdiction A, a small state that has
few potential customers and in which distribution costs
for the book order discussed above are $10, rather thanin jurisdiction B, a large state that has many potential
customers and in which distribution costs are $7. The
bookseller made that decision because by choosing jurisdiction A, it avoided a physical presence in jurisdiction B and the requirement to collect jurisdiction B’s$5 sales tax from customers who live there. The bookseller thus uses $10 of resources for distribution andcharges a jurisdiction B customer $100 (with no salestax) rather than using $7 of resources for distribution
and charging $102 (inclusive of sales tax).
Regardless of whether the effect comes through decisions about consumption or production, the potential
for distortion costs arises when differing taxation causes
the price of a good to vary according to whether it ispurchased locally or remotely. In addition, empirical
work confirms that tax differentials do matter. Studies
have shown that retail prices rise when a sales tax is imposed;15 research also indicates that differences in sales
tax rates along state borders cause consumers to switch
15. James M. Poterba, “Retail Price Reactions to Changes in State andLocal Sales Taxes,” National Tax Journal, vol. 49, no. 2 (1996),
pp. 165-176; and Timothy J. Besley and Harvey S. Rosen, “Sales
Taxes and Prices: An Empirical Analysis,” National Tax Journal,
vol. 52, no. 2 (1999), pp. 157-178.

ECONOMIC ISSUES IN TAXING INTERNET AND MAIL-ORDER SALES

their purchases from the higher-tax to the lower-tax
jurisdiction.16 Some evidence even suggests that taxing
tangible goods but not services may have contributed to
growth in the consumption of services relative togoods.17 Other research shows that reduced economic
well-being can result when consumers alter theirchoices of what to buy because of differential taxes oncommodities.18
In sum, avoiding a situation in which residents of agiven state face differential taxation on the same goodtends to minimize distortions. Not collecting use taxes
on e-commerce amplifies the differential taxation thatis already occurring through mail-order, telephone, andcross-border sales. Short of eliminating all sales taxes,
policymakers cannot correct the losses from such nonneutral taxation by adopting an alternative approach.

Administrative and Compliance Costs
Every tax system must be administered; tax laws must
be enforced, and taxpayers—both individuals and businesses—must spend time and money to comply withthose laws. Administrative costs can be thought of as
the expenses incurred by the tax authorities, the stateand local agencies charged with collecting taxes. Compliance costs are borne by others, typically those who
pay a tax, such as the individual taxpayer in the case of
an income tax. In the case of the general sales tax, however, those costs fall not on consumers directly but
rather on retailers who must collect the tax and remit itto the state or to the local government. Of course, some
16. William F. Fox, “Tax Structure and the Location of Economic
Activity Along State Borders,” National Tax Journal, vol. 39, no. 4(1986), pp. 387-440; and Michael J. Walsh and Jonathan D. Jones,“More Evidence on the ‘Border Tax’ Effect: The Case of West
Virginia, 1979-84,” National Tax Journal, vol. 41, no. 2 (1988),
pp. 261-265.
17. David Merriman and Mark Skidmore, “Did Distortionary Sales
Taxation Contribute to the Growth of the Service Sector?” National
Tax Journal, vol. 53, no. 1 (2000), pp. 125-142.
18. Charles L. Ballard and John B. Shoven, “The V.A.T.: The
Efficiency Cost of Achieving Progressivity by Using Exemptions,”in Michael J. Boskin, ed., Modern Developments in Public Finance:
Essays in Honor of Arnold Harberger (Oxford, England: BasilBlackwell, 1985), pp. 109-129, Table 6.7.

compliance costs may be passed on to the consumer inthe form of higher prices for retailers’ goods.19 (As discussed later, consumers would also bear compliancecosts indirectly in their role as taxpayers if tax authorities compensated retailers for those costs out of collected revenue.)
Administrative and compliance costs, therefore, represent the other major social cost of taxation. Like distortion costs, they are a cost above and beyond what iscollected and transferred from the private sector to governments for public use. Consequently, all else being
the same, it is desirable to minimize the costs of administering and complying with a tax. Although precise
information on such costs for different taxes is largely
unavailable, states and local governments nonethelessappear to design their tax structures to account forthem. For example, some services are excluded from theexisting sales tax base because they are thought to entail
higher-than-usual administrative costs per dollar ofrevenue collected.20
High administrative costs help explain why states andlocal governments seldom enforce use taxes for mostbusiness-to-consumer remote sales. Consider the example of Connecticut’s Operation Equity program. The
program pays other states 50 percent of the first year’s
use tax that Connecticut collects as a result of information provided by those states’ sales tax audits. The sizeof that percentage suggests that the cost of achieving
compliance by other means—for example, by pursuing
individual Connecticut taxpayers—is high.

19. When general sales taxes differ across products or locations, whichis the situation with respect to e-commerce, consumers in the hightax jurisdiction are likely to reduce their purchases from local
retailers and cause those retailers to bear some of the cost of thetax.
20. The role of administrative costs in the structure of sales and use
taxes is discussed in John L. Mikesell, “The Future of American
Sales and Use Taxation,” in David Brunori, ed., The Future of State
Taxation (Washington, D.C.: Urban Institute Press, 1998), pp. 1532. See Joel Slemrod, “Optimal Taxation and Optimal Tax
Systems,” for a more general discussion of how the considerationof administrative costs can change policymakers’ judgments about
the optimal tax system.

910 ECONOMIC ISSUES IN TAXING INTERNET AND MAIL-ORDER SALESOne way to reduce administrative costs is for the federal government to give states the authority to require
remote sellers to collect use taxes on those sales and remit them to the purchaser’s state of residence, a mandate that would eliminate costly collection efforts by
the states. From the perspective of state authorities,
such a policy would unambiguously reduce the social
costs of taxation—administrative costs and perhaps distortion costs as well. From the perspective of federal
policymakers, the effect on social costs is less certain.
Under that approach, the reduction in a state’s or local
government’s administrative costs would be accompanied by an increase in remote retailers’ compliancecosts. Those costs would probably be higher for remotesales than for local sales. Vendors making remote sales
would be dealing with the varied tax bases, rates, andaudit procedures of as many as 45 states (those that levy
sales taxes) and an unknown number of local jurisdictions that impose their own sales tax and do not rely on
the state to administer it. In contrast, vendors making
only local sales usually face one definition of the base towhich the sales tax applies and at most two rates (onestate and one local).21
Thus, the size of vendors’ compliance costs relative tothe distortion costs of sales taxes appears to be central
to the question of whether it is efficient to require remote sellers to collect use taxes. Yet few data exist formeasuring those costs. A recent analysis for the state ofWashington found that compliance costs ranged from0.97 percent of the state’s sales tax revenue collected bylarge firms (defined as having at least $1.5 million in
annual gross sales) to 6.47 percent of the revenue collected by small firms (firms with at least $150,000 but
less than $400,000 in annual gross sales).22 Robert J.
21. The available data indicate that more than 7,500 jurisdictions levy
a sales tax. However, as of 1994, state and local tax bases werevirtually identical within each of the 29 states that administer thetax for local governments. Even in the states that allow local
administration, local governments tend to follow the broad outlinesof the state tax bases. See Due and Mikesell, Sales Taxation: State
and Local Structure and Administration, pp. 279-292.
22. Washington State Department of Revenue, Retailers’ Cost ofCollecting and Remitting Sales Tax (December 1998). For a discussion of the conceptual framework that the state used in measuring
the costs of tax compliance, see Bin Tran-Nam and others, “TaxCline and Thomas S. Neubig, in a study for Ernst &Young, used Washington’s figures to estimate the compliance costs that remote sellers would incur for collecting and remitting the use tax in three cases: one state,
15 states, and 45 states plus the District of Columbia.23
They concluded that compliance costs as a share of revenue collections would rise as the number of states inwhich a firm did business increased and the size of thefirm decreased; their estimates of costs ranged from
1 percent of tax revenue for a large firm collecting taxes
in one state to 48 percent or 87 percent of revenue for a
medium-sized or small firm doing business in 45 states.
Lorrie Jo Brown, the author of the Washington state
study, has suggested that those adjustments to the
Washington state estimates grossly overstate the likely
compliance costs, but she has provided no comparable
estimate for multistate retailers.24
Despite the lack of specific estimates, the available
evidence taken as a whole suggests that the compliancecosts from collecting use taxes will constitute a substantially greater burden for vendors’ remote sales than thecosts attached to local sales. Moreover, such costs figure
prominently in the opposition to remote collection.
Opponents of requiring vendors to collect use taxes on
remote sales suggest that those increased costs would
outweigh the reduction of distortion costs from eliminating differential taxation. Consequently, federal policythat is focused on reducing the social costs of taxationmust consider compliance costs carefully, and state tax
authorities must find a way to reduce those costs if they
are to obtain the authority to collect taxes remotely.

Compliance Costs: Research Methodology and Empirical Evidence
from Australia,” National Tax Journal, vol. 53, no. 2 (2000),
pp. 229-252.
23. Robert J. Cline and Thomas S. Neubig, Masters of Complexity and
Bearers of Great Burden: The Sales Tax System and Compliance Costs
for Multistate Retailers (Washington, D.C.: Ernst & Young,
September 8, 1999).
24. See Lorrie Jo Brown, “Sales Tax Compliance Costs for E-Tailers
Revisited: A Critique of the Ernst and Young Study,” State Tax
Notes, vol. 18, no. 4 (January 24, 2000), pp. 315-317.

ECONOMIC ISSUES IN TAXING INTERNET AND MAIL-ORDER SALES 11

Current Efforts to Reduce Compliance Costs
Federal legislation to permit states and local governments to collect use taxes on remote sales would impose
high compliance costs on remote sellers, costs thatwould tend to offset the gains in economic efficiency
from reducing distortion costs. However, states andlocal governments are working to lower those compliance costs, specifically through the Streamlined Sales
Tax Project (SSTP), set up in 2000. More than
30 states have joined together to design a voluntary
sales and use tax system. By encouraging businesses tovoluntarily collect use taxes, the project may help states
and local governments increase their revenue even in
the absence of federal legislation. The system is intended to demonstrate how tax simplification, theadoption of computer technology, and compensation
can reduce costs and thereby increase the likelihood ofCongressional action to require remote collection.
By November 2002, 34 states and the District of Columbia had agreed on the administrative characteristics
of such a system and submitted the Streamlined Sales
and Use Tax Agreement (SSUTA) to states for adoption by their legislatures and governors.25 The agreement was to go into effect for adopting states when it
was enacted by at least 10 states that together constituted at least 20 percent of the total population of thestates imposing a sales tax. Both thresholds wereachieved by August 2003; at that point, 20 states hadenacted legislation that aligned their sales tax systems
with the provisions of the agreement.26 Most of thosechanges are to take effect by July 1, 2004.
The states adopting the SSUTA will now review eachstate’s law to ensure that it complies with the agree25. The Streamlined Sales and Use Tax Agreement was adopted on
November 12, 2002, and is available at www.geocities.com/
streamlined2000/.
26. Three of the 20 adopting states have made changes in theagreement, which may cause them to be judged as not being inconformance with it. Texas and Washington would continue tohave vendors remit sales tax on local purchases to the jurisdictionof the origin of the sale rather than to the jurisdiction of theresidence of the purchaser. Minnesota has chosen an alternative
definition for food. The population threshold would still be met
even if the three states were judged not to be in compliance.

ment. Once the 10-state and 20-percent-populationthresholds have been verified, the agreement will go
into effect, and a governing board with one vote perstate will be established. That board, which will include
participation by businesses, will respond to questions
and resolve disputes, judge states’ compliance with theagreement, and consider amendments to it.
Under the SSUTA, remote sellers’ compliance costs
would be reduced in several ways. The agreement
would lessen the complexity and diversity of the sales
tax structures faced by sellers by simplifying bases andrates and imposing uniform sourcing rules (for identifying the purchaser’s residence). It would require theuse of computer technology to simplify the process bywhich sales and use taxes are computed, remitted, andaudited. And it would require states to compensate remote sellers for many of the remaining compliancecosts.
Although states’ compensation of retailers’ costs forcollecting sales and use taxes would remove a principal
objection to requiring remote collection, compensation
is not a substitute for the other two cost-reducing options. Instead of diminishing the resources devoted tocollecting taxes that would result from improvements
in technology and simplification, compensation would
shift those costs from retailers and consumers to thestate’s taxpayers. From a federal policy perspective,compensation would not reduce the social costs of taxation.
Simplifying Sales Tax Bases and Rates and Handling
Other Administrative Matters. The SSUTA would simplify but not standardize the structures of the various
states’ sales taxes, allowing considerable differences intax bases among but not within the states that impose
such taxes. Under the system, the states would jointly
define the items included in major categories of goods
and services (for example, food, clothing, automobiles,
and service groups) that were subject to sales taxation,and each state would compose its base from among
those categories. Local governments that levied sales
taxes would have to use the same base as the state’s. The
result would be a system that was currently limited to
46 tax bases (assuming that all states with existing sales
taxes plus the District of Columbia adopted it); the12 ECONOMIC ISSUES IN TAXING INTERNET AND MAIL-ORDER SALES

bases would differ by the sales categories they included,
but for any given category, the items it covered would
be identical among all the states.
Under the terms of the SSUTA, all items in a state’s tax
base would be subject to the same sales tax rate—with
the exception of food and drugs, to which a different
rate (possibly zero) might apply. The agreement would
permit no more than one local rate, and all local sales
taxes would be administered by the state. The SSUTA
would establish uniform rules for the frequency of tax
filings and for changes to tax bases and rates, andwould simplify the procedures by which purchasers
could obtain tax exemptions. It would also shift the
responsibility for validating those exemptions from theseller to the state. Furthermore, the agreement would
impose uniform sourcing rules that relied first on thedestination of the good—the purchaser’s location—which would be determined by using shipping instructions or an address gleaned from the seller’s business records (including the address associated with thepurchaser’s payment instrument, such as a credit card).
If that information was lacking, sourcing would revert
to the origin of the good, determined by the addressfrom which tangible property was shipped or, in thecase of a digital good, the location at which it was firstavailable for transmission. (Box 1 discusses origin-based
versus destination-based sales taxes and the social costsof taxation.) Devising a reliable and simple system forsourcing digital goods remains a thorny issue for states
and local governments (see Box 2).
Simplifying the Process of Computing and Remitting
Taxes. The very force that has increased uncollected use
tax revenue from e-commerce—rapid technological
growth in the computer industry—may also have created tools to reverse that trend. Software purchased by
vendors or operated at off-site centralized computer
centers could significantly reduce remote sellers’ costsof coping with the complexity of numerous tax bases,
rates, and auditing procedures. Those programs could
determine, in real time (during the transaction), thesales tax status of a product on the basis of the state andlocal tax law in the purchaser’s jurisdiction. Information on the amount of the tax and the jurisdiction towhich it was to be remitted could be stored (again, on
or off site) in an audit file set up for each remote seller.

Under the computer strategy spelled out in the SSUTA,
remote sellers could choose to contract with a certified
service provider (CSP) that would handle all the seller’s
sales and use tax functions, including filing all tax returns and being the focal point for audits. CSPs would
be certified by the states and would have to use a certified automated system (CAS) for those functions. (Thestates would certify that the software met all requirements for identifying the taxable status of the purchaser, the tax base and rate, the good’s source, andother necessary factors.) Remote sellers could also deal
with their sales and use taxes on their own, using aCAS. Alternatively, sellers with sales in at least fivestates and totaling a minimum of $500 million could
use their own system for that task, provided that it had
been approved by the project’s member states.
Compensation. Simplifying tax structures and adopting
computer technology would each reduce compliancecosts to some degree, although estimates of those reductions are not available.27 Regardless, under the SSUTA,
some compensation would be provided for those costs.
A CSP’s costs would be paid from the sales tax revenue
it collected. In addition, the CSP would receive a bonus
each year for two years based on a percentage of the tax
revenue generated by a seller, with the expectation that
the CSP would share that revenue with the seller as an
inducement to participate in the system. Sellers who
decided to handle their own sales and use tax functions
by employing a CAS or proprietary software would receive a percentage of the revenue collected for a periodof two years plus any compensation currently provided
by the seller’s state. After two years, compensation
would come only from the seller’s state.

27. As of 1998, 26 of the 45 states levying sales taxes compensatedvendors at least to some degree for their compliance costs. Howthat compensation compares with actual compliance costs in moststates is not known; however, the state of Washington estimatedthat a large firm is compensated for 65 percent of its compliancecosts and a small firm, for 11 percent. See Washington State
Department of Revenue, Retailers’ Cost of Collecting and Remitting
Sales Tax (December 1998), pp. 39-40. The SSTP has begun astudy of the SSUTA’s potential for reducing compliance costs.

ECONOMIC ISSUES IN TAXING INTERNET AND MAIL-ORDER SALES 13

Box 1.

Origin-Based Versus Destination-Based Sales Tax Systems
Use taxes on remote sales are difficult to collect because sales and use tax systems are “destination based.”That is, a state imposes its tax on the basis of thedestination of the purchased item; if the purchaser
resides in the state, the tax is incurred. By contrast, inan “origin-based” system, the tax is levied at the sourceor origin of the item being sold; if the seller is in thestate, the tax is incurred. Thus, under an origin-based
sales and use tax system, the difficulty of collecting
taxes on remote sales does not arise because remotesales are not taxable.
Some observers have argued that shifting to an originbased system could improve sales tax compliance.1 For
merchants, the advantage of an origin-based system isthat retailers deal only with the sales tax system in thejurisdiction in which their firm is located. The advantage for states and local governments is that an originbased system does not depend as heavily as a destination-based system does on the voluntary complianceof individuals; under an origin-based framework, all1.

An origin-based system is discussed in Aaron Lukas, Tax Bytes:
A Primer on the Taxation of Electronic Commerce (Washington,
D.C.: Cato Institute, December 17, 1999), pp. 19-20; andWade Anderson and Andrew Wagner, “Guidelines for
Establishing an Origin-Based Sales Tax,” State Tax Notes,
vol. 18, no. 12 (March 20, 2000), pp. 915-918. The article
by Anderson and Wagner suggests using an interstate revenuesharing agreement to distribute the revenue collected inconformance with a destination-based tax.

An industry monitoring group, the Council on State
Taxation (COST), has praised the SSUTA as a move inthe right direction.28 However, COST suggests that theagreement lacks enforcement provisions, is vague about
how closely compensation would be tied to actual com28. Council on State Taxation, Report Card on the Streamlined Sales
Tax Implementing States’ Agreement (Washington, D.C.: Council
on State Taxation, October 11, 2002).

the use taxes paid under a destination-based system
would be collected as sales taxes by vendors whosebusinesses would all lie within the taxing jurisdiction.
The effect on states’ and local governments’ revenue ofmoving to an origin-based system would vary byjurisdiction. A jurisdiction would lose the revenue
from remote sales to its residents but gain the revenue
from sales by its merchants to out-of-state buyers. As
a result, implementing an origin-based system could
increase interstate tax competition. Lower-tax states
would have some advantage in attracting retailers whomarketed their goods and services in other, higher-tax
states. However, the net consequences for efficiency are
not clear. Tax competition could tend to reduce jurisdictions’ revenue from the sales tax relative to what
they would derive from a destination-based system, an
outcome that would affect either the composition ofrevenue or the jurisdiction’s overall spending, or both.
Under an origin-based system, consumers could avoid
sales taxes by buying from an out-of-state merchant.
Merchants thus would have incentives to locate inplaces that allowed their customers to avoid the sales
tax. The overall economic efficiency that resulted
would depend on the efficiency of the sales tax relative
to the efficiency of the kind of tax that replaced any
reduction in sales tax revenue, and on the overall sizeof the public sector. How retailers reacted to thedifferences in taxes and how states and local governments responded to retailers’ decisions about where tolocate their businesses would help determine an originbased system’s impact in each state.
pliance costs, and is missing a federal monitoring mechanism that should be incorporated before the authority torequire remote sellers to collect and remit use taxes isprovided by the Congress.

Other Economic Issues in the
Remote Collection Debate
Both opponents and proponents of remote collection cite
additional economic considerations beyond distortion

14 ECONOMIC ISSUES IN TAXING INTERNET AND MAIL-ORDER SALES

Box 2.

Taxing Digital Goods
If states are given the authority to require remote sellers
to collect and remit use taxes, each sale must be“sourced”; that is, the seller must determine where thegood will be used. (Most often, in the case of a purchase by a consumer, that use will occur at the residence of the buyer.) For tangible goods, sourcing is amanageable problem. The good must be shipped to alocation, which is a reasonable approximation of where
it will be used, and the opportunities for businesses andconsumers to behave in ways that minimize their taxes
are not that great. A buyer located on the border of two
states with very different tax rates might be able to havethe purchase shipped to the lower-tax jurisdiction(using a post office box, for example, or the address ofa friend or relative) and not incur costs for transportation that exceeded what he or she saved in taxes. That
type of strategy would be particularly useful for expensive goods, but such opportunities are limited.
Digital goods are not subject to similar constraints. For
example, Apple Music’s iTunes Music Store does notcollect use tax on its on-line sales of digitized music.
Even if the sellers of such goods decided to collect it,buyers (particularly consumers, whose purchases are lesseasily tracked than businesses’ purchases) could concosts and administrative and compliance costs in theirarguments—in particular, network externalities, the sizeof government, horizontal and vertical equity, unfair
taxation of remote sellers, and states’ fiscal autonomy. In
general, however, reflection suggests that those issues areless central to the debate over remote collection of use
taxes than are social costs.

Network Externalities and Market Failures
One argument advanced by opponents of remote collection is that excluding Internet sales from taxation provides a desirable stimulus to the growth of the Internet
and e-commerce. Underlying that contention is thenotion that the Internet is characterized by “externalities”
that cause too few people to become part of the networkand that leave it at less than its desirable (that is, efficient)size. Such a contention is consistent with economic
theory but does not appear to be consistent with people’s

ceivably have the digital product “shipped” to a computer in any location and pay for the product with acredit card whose billing address listed a state without
a sales tax. Indeed, the possibility of avoiding a destination-based tax on digital goods appears to be substantial. One approach proposed by the Streamlined Sales
and Use Tax Agreement would be to revert to originbased taxation (as described in Box 1, a tax assessed on
the basis of the seller’s location) in cases in which ashipping address and the customer’s financial information were not adequate to to determine the customer’s
residence for a transaction. Of course, the digital natureof the goods makes it entirely possible that the identifiable seller’s location may be chosen to minimize sales
and use taxation.
The taxing of digital goods thus presents difficulties,
and no technical solution grounded in current technologies appears to be imminent. As a result, requiring
remote sellers to collect and remit use taxes is likely togenerate less revenue from digital goods than many
people expect. To the extent that taxes on such goods
were avoided or minimized, the gains and losses in efficiency discussed in this analysis would be moderated.

current use of the Internet. More than 136 million of the241 million people in the United States above the age ofeight (56 percent) used the Internet in 2001.29 That
degree of use suggests that the Internet and e-commerce
have probably expanded beyond the network’s criticalmass phase (see the discussion below).
Externalities occur when a transaction imposes economic
effects on third parties that are not reflected in the priceestablished between the buyer and seller of a good. Not
taking those effects into account leads to the incorrect
amount of the good being bought and sold—or, moreaccurately, to the incorrect amount of the external effect
29. See Department of Commerce, A Nation Online: How Americans
Are Expanding Their Use of the Internet (February 2002), Table 2-2,
p. 26.

ECONOMIC ISSUES IN TAXING INTERNET AND MAIL-ORDER SALES 15

being provided. If there are positive externalities, an
incentive that reduces the price of a good by an amountequal to the external benefit that society receives from thetransaction will increase output to a level that morenearly reflects both the benefits received by private
citizens (the buyers and sellers) and the external benefits
received by all citizens. In that case, the market’s failure
to take all benefits into account would be corrected.
In the context of taxing purchases made over theInternet, opponents of such taxes have cited “network
externalities” as part of the rationale for their position.30
The Internet is, of course, a communications network
and, like all such structures, tends to be characterized
by network externalities; that is, when a person joins a
network, he or she receives benefits from being able tocommunicate with its other members. If the network’s
services are provided competitively, the price that a newmember pays accurately reflects the value of those benefits. But the other members of the network each receivea benefit as well—that of being able to communicate
with the new participant. Because potential members
do not take those network (external) benefits into account when deciding whether or not to join, the possibility arises that too few people will participate and the
network will be too small. The market in that case is inefficient because the benefits derived from adding moremembers to the network still exceed the cost of the resources that would be expended to add them. Opponents of requiring remote sellers to collect use taxes argue that exempting e-commerce from that collection
responsibility is desirable because it acts as an incentivethat can help correct that inefficiency.
Any economic advantage from providing a tax-based
subsidy, or preference (in this instance, the “preferential” treatment of not collecting use taxes), to e-com30. The discussion here concentrates on direct network externalities;
also relevant but not discussed are indirect network externalities
and learning network externalities. The reasoning behind thediscussion of direct network externalities is basically identical tothat underlying the others. See George R. Zodrow, “Network
Externalities and Indirect Tax Preferences for Electronic Commerce,” International Tax and Public Finance, vol. 10, no. 1 (2003),
pp. 79-97. Zodrow concludes that network externalities provide
no justification for not taxing remote sales.

merce sales depends, among other things, on the extent
of the network’s development relative to its optimal
size.31 No network can exist until the price of joining it
falls to a level that induces a critical mass of people topurchase the network’s services. Those initial participants tend to be “high-demand individuals” who not
only value the services highly but whose intense interestin the technological wizardry of the new network makes
them provide high levels of benefits (in the form of advice and troubleshooting) to the network’s other participants. As costs continue to fall over time, people withsuccessively less demand for network services and possessing less technological expertise are induced to join.
Those new entrants generate ever-smaller benefits forother participants, for two reasons.
First, the probability that existing network members
will communicate with one more entrant decreases;
even if each new member is just as technically competent as those who came before, the new entrant’s value
as a communications partner falls because so many others are already available. Second, the new entrant’s decreased technological ability relative to previous entrants makes him or her less valuable as a source of advice. A network reaches an economically efficient size
when the cost of joining exceeds the value placed onparticipating in the network by those who have yet tojoin. Those always-potential entrants would have provided relatively few benefits to other participants—andthey might have imposed costs in the form of congestion on a network that had become stable in size.
An incentive during the early stages of the Internet’s
development and the rise of e-commerce could arguably have increased economic efficiency. But permanently exempting e-commerce from sales taxation whenmore than 50 percent of the population who conceivably might use the Internet already does so risks providing an incentive in exchange for few or no offsetting
external benefits, thereby increasing rather than reduc31. The time path is discussed in Nicholas Economides, “TheEconomics of Networks,” International Journal of Industrial
Organization, vol. 14, no. 6 (1996), pp. 673-699; and Zodrow,“Network Externalities.”

16 ECONOMIC ISSUES IN TAXING INTERNET AND MAIL-ORDER SALES

ing a distortion.32 Even if external benefits from newentrants remained significant, the object of an incentive
would be to stimulate the growth of the network, notof e-commerce per se.33
Opponents of remote collection proffer another argument to support their position: that it is not the size ofthe network that needs to be subsidized but rather the
e-commerce business model. In effect, the argument
here is that e-commerce is an infant industry and needs
to be subsidized to enable it to compete with traditional
forms of commerce until its scale increases to a size thatallows its production costs to decline enough to make itcompetitive. Yet the industry’s sales exceeded $1 trillion
in 2001 (including both business-to-business andbusiness-to-consumer sales), and more and more socalled bricks-and-mortar firms are expanding their useof e-commerce to complement their traditional modeof selling. The e-commerce model thus hardly seems
endangered. Furthermore, a standard problem withsubsidizing an infant industry is knowing when toeliminate the subsidy. Unless a clearly articulated casecan be made for the future benefits that will be offered
by a mature industry, the passage of time becomes anargument for eliminating the subsidy, whether or not
the industry is competitive. (If the industry is not competitive, then subsidization was not successful; if it is,then subsidization was successful but is no longer necessary.)ernment spending is constant. But that is not necessarily the case if the difficulty or ease of collecting taxes
influences the size of the public sector. Public-sector
goods and services—the output of government—are
like other goods and services. The incentives to provide
them can become distorted, resulting in the productionof too many or too few goods and services and, as aconsequence, a reduction in economic well-being.
Some analysts suggest that the incentives confronting
elected officials and bureaucrats cause the political process to provide more public services than taxpayers desire.34 If that depiction accurately describes the functioning of governments, a dollar that was reallocatedfrom the private to the public sector would generate
public consumption whose value was less than the valueof the private consumption that it replaced. That outcome would mean a loss of economic well-being forsociety, even if it were possible to collect taxes without
imposing efficiency costs.
Some opponents of requiring remote sellers to collectuse taxes argue that it might lead to a larger public sector and a loss of economic well-being. Their argument
is essentially that the cost of collecting taxes influences
how much in total taxes will be collected and therefore
how big the government will be (or how much in
public-sector goods the government will provide). The
issue of collecting use taxes from remote sellers is relevant to the total cost of collecting taxes and the public
sector’s size in two ways.

The Size of the Public Sector
The basic principles of efficiency and neutral taxationthat guide tax policy partly depend on the proposition
that the size of the government is independent of decisions about how to collect taxes—that is, overall gov-

First, the difficulty of getting purchasers to comply
with the use tax on remote sales raises the cost of collecting sales taxes. It raises that cost directly, throughthe administrative costs associated with collecting taxes

32. In fact, the Internet in its infancy did receive an incentive. But thesubsidy was not given directly to users; it took the form of federal
financing for development of the giant supercomputers that act
as the highway for the Internet. That subsidization reduced costs
to a level that enabled a critical mass of high demanders to starta network.

34. Those relationships are developed in Geoffrey Brennan and James
Buchanan, The Power to Tax: Analytical Foundations of a Fixed
Constitution (Cambridge, England, and New York: Cambridge
University Press, 1980), and have come to be referred to as the“Leviathan” model. An overview of the public-choice theory andliterature and its relationship to tax policy appears in a three-article“Symposium on Public Choice” in the National Tax Journal(vol. 51, no. 2, 1998). See, specifically, Randall G. Holcombe, “TaxPolicy from a Public Choice Perspective,” pp. 359-371; Stanley L.
Winer and Walter Hettich, “What Is Missed If We Leave Out
Collective Choice in the Analysis of Taxation?” pp. 373-389; andJames M. Poterba, “Public Finance and Public Choice,” pp. 391396.

33. Users of the Internet receive an incentive if they use a telephoneline to connect to it because the price of local phone access is
subsidized. See Robert W. Crandall and Leonard Waverman, Who
Pays for Universal Service? When Telephone Subsidies Become
Transparent (Washington, D.C.: Brookings Institution Press,
2000), p. 157.

ECONOMIC ISSUES IN TAXING INTERNET AND MAIL-ORDER SALES 17

on remote sales, and indirectly, through higher tax rates
on other tax bases (to finance the government’s spending decisions) and therefore through the economic efficiency costs that must be imposed to garner a given
level of receipts. As those costs mount, states and local
governments may find it difficult to raise as much revenue as they could have otherwise, and their growth may
be constrained.
Thus, rapid growth in the share of remote sales makes
the sales tax less and less effective in generating revenue.
From the perspective of overall efficiency, the very factthat effectively exempting some activities from taxation
causes inefficiency could be an advantage if it kept the
government from spending more resources on lessvaluable output from the public sector. That view corresponds to the notion that it is worth imposing someefficiency costs in order to create incentives to reduceother efficiency costs. Which inefficiency effect waslarger would depend on how state and local officials
responded to increased revenue from a use tax, as wellas on whether an inherent bias toward a larger-thanoptimal public sector really exists in the first place.
In sum, both opponents and proponents of remotesales tax collection may agree that e-commerce is significantly increasing uncollected revenue from use taxes
and making it more costly—in terms of economic efficiency—to raise a given amount of revenue. Proponents of remote collection focus on that inefficiency as
harmful, whereas opponents who argue that the public
sector is too large regard that same inefficiency as beneficial because it creates incentives that help reduce another form of inefficiency.

higher taxes than their neighbors do—a penalty thattakes the form of lost tax base and less tax revenue asretailers move their activities to lower-tax states.
The findings of the literature on tax competition are
ambiguous.36 Clearly, if the move to simplify sales anduse taxes meant pushing states to impose the samerates, it would undoubtedly reduce the potential scopeof interstate tax competition. But the thrust of current
simplification efforts is to require states to have similarly defined bases, leaving jurisdictions free to compete
on the basis of rates. The SSUTA is directed at bases
because the greatest concerns about compliance costs
have focused on multiple and divergent bases and basedefinitions.37
To summarize, remote collection could influence thesize of the public sector by reducing the cost of collecting taxes. However, if the authority to collect use taxes
was granted to the states, other means of constraining
the public sector’s size would still be available throughthe political process. Competition could also proceedon the basis of other taxes, such as those on income andproperty, and explicit fiscal restraints could be adopted
to produce lower levels of spending or taxes. Such restraints include enacting more-effective balanced budget requirements, limiting taxes or spending (or both),requiring supermajorities for the enactment of tax in-

A second way in which mandated collection of use
taxes is relevant to the issue of the public sector’s size isthat it may reduce fiscal competition in which states
essentially use lower taxes to bid for taxpayers.35 Because states and local governments can have different
tax systems, they can compete to attract economic activity. That competition raises the cost of collecting
revenue by imposing a penalty on jurisdictions that levy

36. The effect of fiscal centralization (and tax competition) on the sizeof state and local governments has been a subject of considerable
empirical interest. A series of articles on the topic appeared in theAmerican Economic Review: see Wallace E. Oates, “Searching for
Leviathan: An Empirical Study,” vol. 75, no. 4 (1985), pp. 748757; and Jeffrey S. Zax, “Is There a Leviathan in Your
Neighborhood?”; Kevin F. Forbes and Ernest M. Zampelli, “Is
Leviathan a Mythical Beast?”; and Wallace E. Oates, “Searchingfor Leviathan: A Reply and Some Further Reflections,” all invol. 79, no. 3 (1989), pp. 560-583.

35. See Aaron Lukas, Tax Bytes: A Primer on the Taxation of Electronic
Commerce (Washington, D.C.: Cato Institute, December 17,1999), pp. 10-11.

37. Cline and Neubig, Masters of Complexity and Bearers of Great
Burden, pp. 9-10. The authors illustrate that complexity withflowcharts of the tax status of nine types of groceries and11 categories of shoes in a sampling of states.

18 ECONOMIC ISSUES IN TAXING INTERNET AND MAIL-ORDER SALES

creases, and instituting voter referenda for bond issues.38

lecting use taxes from abroad. Those costs depend on
treaties, which are negotiated by the federal government.

International Considerations
Remote sales include not only purchases from merchants in other states but also purchases from sellers inother countries. A concern raised by opponents of remote collection is that if remote sellers are required tocollect use taxes, they will lose business to foreign sellers
that are beyond the reach of states’ taxing authorities.
Parties interested in the issue of remote collection havecalled on policymakers to ensure that any alteration incollection authority takes into account the need to expand the approach to an international context.
To the extent that foreign sellers gain an advantage over
U.S. retailers because use taxes cannot be collected on
their sales, virtually all the same economic issues thatare part of the current domestic debate are raised. The
effective exemption of purchases abroad would tend to
generate additional uncollected use taxes and reduce
economic efficiency.
The prospect of international sales generating these
problems raises questions about the degree to which
they can be resolved by remote collection within the
United States. Essentially, international sales provide a
possible venue for avoiding the use tax, even if states are
granted the authority to collect it from remote sellers,
because that authority might not extend to vendors
abroad.
The amount of uncollected use taxes that might be generated by buying from foreign firms is difficult to assess. For many goods, the shipping costs from suchgreat distances will exceed the avoided sales taxes. But
in the case of digital goods moving over the Internet,
shipping would not be a factor. The other aspect of theissue is the states’ inability to influence the cost of col38. Therese J. McGuire, in “Proposition 13 and Its Offspring: For
Good or for Evil?” National Tax Journal, vol. 52, no. 1 (1999),
pp. 129-138, reviews the literature on property tax limitations andfinds that they have been effective in changing fiscal decisions.
James M. Poterba, in “Balanced Budget Rules and Fiscal Policy:
Evidence from the States,” National Tax Journal, vol. 48, no. 3(1995), pp. 329-336, reviews the literature on state balanced budget
rules, which appear to affect public spending.

Worth noting, however, is the European Union’s(EU’s) treatment of sales of digital goods. Specifically,on July 1, 2003, the EU imposed on non-EU remotesellers a more costly compliance system for collecting
and remitting the value-added tax (VAT) on digital
goods than it imposes on EU remote sellers. A remoteseller established within the EU collects and remits the
VAT under an origin-based system, thus treating theseller as a U.S. state treats a local seller. U.S. remotesellers who have established a company within the EU
are entitled to be treated as an EU company; those whohave not done so must collect the VAT on the basis of acustomer’s residence and remit the tax to one EU
member state, which then distributes the revenue
among the other EU states. (As an alternative, a remoteseller can register separately with each EU country andcomply with each country’s national VAT legislation.)
At this point, the EU appears to be relying on voluntary compliance for enforcement.

Remote Collection and Fairness
Both opponents and proponents of remote collection
have raised the issue of fairness in the debate overwhether to grant states that authority. Opponents argue
that it is unfair to require merchants to pay taxes tostates from which they receive no benefits. Proponents
contend that to exempt out-of-jurisdiction sales fromuse taxes favors people who are economically better off
and who are more likely to have Internet access, andtreats otherwise equivalent consumers differently on thebasis of the means by which they purchase identicalgoods.
Those arguments derive from two distinct perspectives
on fairness, or tax equity. One view calls for distributing the tax burden according to each taxpayer’s ability
to pay; the other would distribute the tax burden according to the benefits each taxpayer received. Any discussion of fairness that focuses on a single tax inevitably
suffers from considering that tax in isolation, since
whatever one’s standard for fairness may be, it must
ultimately be applied to the distribution of the burden
from all taxes.

ECONOMIC ISSUES IN TAXING INTERNET AND MAIL-ORDER SALES 19

The Ability-to-Pay Principle. The equity principle
based on a taxpayer’s ability to pay breaks down further
into two dimensions: horizontal and vertical equity.
Horizontal equity is the standard that people in equal
circumstances should be taxed equally. Vertical equity
says that people in better circumstances—usually measured in terms of income—should be taxed moreheavily than those whose situations are less advantageous. Both concepts represent value judgments about
how taxes should be levied. As a result, one cannot evaluate the effect that the violation of those equity norms
has on economic well-being as one can evaluate the effect of violating the efficiency standard.
A mechanical application of the horizontal equity principle suggests that Internet sales should be treated thesame way that non-Internet sales are treated—either by
eliminating the sales tax, enforcing the use tax, or having remote sellers collect the use tax. Otherwise, twoconsumers who purchase the same items, one on-line
and one from bricks-and-mortar establishments, aretreated differently. Yet the proper measurement of horizontal equity is problematic. By definition, if both consumers have equal access to the Internet, they arechoosing to not purchase the same “bundle” of goods
and services. Presumably, each consumer has reasonsfor his or her choice of shopping arrangements, leading
their equivalent situations to produce different outcomes. Whether horizontal equity, properly measured,is violated is not immediately obvious.
Vertical equity expresses society’s value judgments
about how people in unequal circumstances should betaxed, and it is usually measured in terms of the distribution of the tax burden among income groups. A regressive tax extracts more tax—as a proportion of current income—from lower-income taxpayers than fromhigher-income ones. A progressive tax takes moretaxes—as a proportion of current income—as income
rises.
Access to computers (whether at home, school, work,or the library) and the Internet is directly related to income. Proponents of requiring remote sellers to collectuse taxes argue that not collecting taxes benefits people
who are better off and makes the sales tax more regressive. In 1997, 9.2 percent of individuals with family

income below $15,000 used the Internet, comparedwith 44.5 percent of those with income exceeding$75,000. However, over the next several years, Internet
use grew among people in all income groups; in 2001,
it was 25 percent and 78.9 percent, respectively, forthose in the lowest and highest income categories. Because the rate of growth of Internet use has been higher
for people in the lower-income groups, access to theInternet is becoming more evenly distributed overtime.39
Some observers believe that the issue of vertical equity
in remote sales taxation goes beyond the ownership anduse of computers and the Internet. Purchases over theInternet (as well as over the phone) often require credit
cards. If lower-income groups have limited access to
those payment media, some vertical inequity from nottaxing remote sales might persist unless cash on delivery
became a generally available payment option.
There are several other ways to overcome such inequity
if lower-income groups continue to find themselves
limited in their access to the Internet for retail purchases or if the types of goods they generally buy are
not sold on the Internet. Policymakers could fashionother tax policies to achieve the desired after-tax distribution of income—for example, by adjusting the structure of state income tax rates or providing incometested refundable sales tax credits for the state income
tax.40
The Benefit Principle. The benefit principle of equity
in taxation requires that the tax burden be distributedin accordance with the benefits each taxpayer receives
39. Department of Commerce, A Nation Online, Table 2-2, p. 26. The
coefficient of inequality in Internet use by income category has
declined substantially, from .309 in 1998 to .270 in 2001. (Acoefficient of zero would indicate that each income group’s
proportion of Internet users was identical to its proportion of all
family income.) See Table 9-1, p. 89.
40. In the executive summary of its report, the Advisory Commission
on Electronic Commerce suggested a less direct and less reliableapproach to compensation. The commission recommended in its
majority proposals that surpluses in the Temporary Assistance for
Needy Families fund be spent “to provide needy families accessto computers and the Internet, and to provide training in computers
and Internet use” (p. 4).

20 ECONOMIC ISSUES IN TAXING INTERNET AND MAIL-ORDER SALES

from public spending. Some opponents of requiring
remote sellers to collect use taxes argue that in-state sellers that collect sales tax revenue receive benefits in theform of public services in exchange for collecting thetax. In contrast, if remote sellers were required to collect and remit use taxes to another state, they would not
be compensated with such benefits.41 Thus, opponents
argue, taxing e-commerce would be inconsistent withthe benefit principle of taxation.

Fiscal Autonomy of States and Local Governments

The equity of a tax on retail sales is not usually evaluated on the basis of the benefit principle, for two reasons. First, the benefit principle is generally applied to
the financing of spending programs whose beneficiaries
are an identifiable subset of the population—for example, airports that are financed through taxes assessed oneach airline ticket. Second, governments usually assess
the tax on those identifiable beneficiaries as a functionof their use of the service—hence the tax’s common
name of “user charge.” Sales tax revenue fits neither of
those circumstances. Many of the programs it finances
provide mostly collective consumption (that is, of public services) that benefits everybody rather than an identifiable subset of the population. In addition, the sales
taxes a person pays are related to his or her consumption of private, not public, services.

The federal system of government gives almost total
freedom to states and local governments to determine
their tax systems. The only major constraint on that
autonomy is that state and local taxes may not impedeinterstate commerce, which generally means that taxes
must not discriminate according to a taxpayer’s state ofresidence or a good’s place of production. A state may
not impose an import tariff on clothing, for example,
but it can impose an excise tax that applies uniformly
to sales of clothing within the state—whether the clothing is produced by in-state or out-of-state firms.

The concern of opponents to remote-seller tax collection is not relevant to the tax itself but rather to the lackof compensation for the compliance costs that sellers
incur in their role as collection agents. Many states either do not compensate retailers for those costs or compensate them inadequately, in effect shifting part of thesocial costs of taxation to retailers who may be unablein turn to shift their compliance costs to consumers in
the form of higher prices. Some observers might be lessconcerned about the lack of compensation for local sellers, who receive some public service benefits, than for
remote sellers, who do not—although that concern
may find no abatement if local sellers are paying for
those benefits through other business taxes.
41. “When a business . . . remits sales taxes to the state in which it islocated, there is a plausible linkage among the taxes paid, theservices provided, and legislative representation . . . [t]he remoteseller does not benefit from most of the services that distant stateor those local governments provide” (Lukas, Tax Bytes, p. 13).

A final concern raised by opponents of remote collection arises less from the task itself than from compromises associated with the process’s simplification,
which are necessary for remote collection authority to
be granted. They argue that the fiscal autonomy ofstates and local governments will be diminished by thechanges in the tax system that may be required to obtain that authority.

State and local governments have chosen to structure
their general sales and use taxes to conform to a varietyof policy objectives and voter preferences. Some governments make a considerable effort to exclude items
from the tax base to distribute the burden of sales anduse taxes in a particular way (usually to soften their impact on lower-income groups); other jurisdictions
choose to use a broader tax base and achieve distributional objectives through the structure of the income
tax. Some states include a considerable amount ofbusiness-to-business sales in the base. Some include avariety of services. And some governments compensate
sellers for at least a portion of the costs they incur ascollection agents.
The issue before the Congress is whether to grant stateand local governments the authority to require remotesellers to collect use taxes. As discussed earlier, that authority might impose substantial compliance costs onremote sellers. If applying enhanced computer technology to the process of collecting taxes cannot by itself
reduce those costs to a level acceptable to the Congress,
then resolution of the issue of whether to collect use
taxes on Internet sales may require states and local governments to simplify their sales tax bases or rates (orECONOMIC ISSUES IN TAXING INTERNET AND MAIL-ORDER SALES 21both)—that is, essentially give up some of their fiscal
autonomy.
Opponents of e-commerce taxation argue that the federal government will compromise that autonomy if it
specifies the changes in tax structure to be made (toreduce compliance costs) in exchange for the authority
effectively to collect taxes on remote sales.42 Much ofthat concern focuses on the political and social consequences that might result from rearranging the delicate
balance of power that now exists between the federal
and state and local levels of government. However,states that have voluntarily embraced such a solution
are willing to trade reduced fiscal autonomy for the authority to require remote collection.
42. See Adam Thierer, The Governors’ Misguided Plan to Tax theInternet and Create a New National Sales Tax, Heritage Foundation
Backgrounder (Washington, D.C.: Heritage Foundation, January 3,2000), p. 12.

Fiscal autonomy is not just a roadblock to those favoring the requirement for remote-seller tax collection.
The current moratorium on new Internet access taxes
also diminishes fiscal autonomy, as would the proposal
put forward by the Advisory Commission on Electronic
Commerce (but not adopted in the renewal of theInternet Tax Freedom Act), which calls for states toexempt from sales taxation the intrastate sale of digitalproducts (for example, music) and their tangible counterparts (CDs).
In the end, economic analysis can do little to evaluate
trade-offs involving fiscal autonomy. It remains forstate and local policymakers to judge the costs of trading that autonomy for the potential benefits identified
in the preceding discussion of economic effects. And it
is left to federal policymakers to judge whether thechanges states make to obtain those benefits satisfy theirconcerns about compliance costs.

This publication and others by CBO
are available at the agency's Web site:www.cbo.gov