CONGRESS OF THE UNITED STATES

CONGRESSIONAL BUDGET OFFICE

A

CBO

PAPER

OCTOBER 2003

Economic Issues

in Taxing

Internet and

Mail-Order

Sales

© Digital Vision

CBO

A

P A P E R

Economic Issues in Taxing

Internet and Mail-Order Sales

October 2003

The Congress of the United States O Congressional Budget Office

Preface

The collection of state and local sales and use taxes when individuals purchase items over

the 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 and

opponents 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 supervision

of G. Thomas Woodward and Roberton Williams. The paper benefited from comments by

reviewers 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

Tables

1. State and Local General Sales Tax Rates and

State General Sales Tax Revenue 4

2. Sales Tax Revenue for Selected Local Governments

with Populations of 200,000 or More, 2000 6

Boxes

1. Origin-Based Versus Destination-Based Sales Tax Systems 13

2. Taxing Digital Goods 14
Summary

A ll of the 45 states, as well as the District of

Columbia, that levy retail sales taxes on purchases made

within their borders (local sales) also impose an equivalent “use” tax on their residents’ purchases of items out

of state (remote sales). Local governments also impose

sales and sometimes use taxes. (However, because states

in many cases administer those taxes, the general

discussion that follows uses “states” for simplicity’s sake

to mean both states and local governments.) Previously,

those out-of-state purchases were mainly catalog and

telephone 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 the

states, 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 the

seller has established a connection, or “nexus,” with the

purchaser’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 is

paid 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 confer

that authority on them. A federal advisory committee

studied the question but was unable to reach a consensus

and thus issued no formal recommendations. Opponents

and proponents of granting such authority to states have

advanced 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 the

administrative and compliance costs of collecting

revenue.

Remote-seller collection of use taxes would eliminate the

uneven taxation of identical goods purchased from a

local seller and a remote seller and thereby reduce the loss

of national income that results when such tax differentials cause people to make purely tax-motivated decisions

about consumption and production. Consumers may be

willing to purchase a good remotely even if the total cost

of 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 are

high to avoid nexus and the need to charge their customers sales taxes. The more unevenly a tax is applied, the

more 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 by

raising 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 to

increase the burden of compliance costs imposed on

retailers doing business in many states compared with the

burden 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 be

dealing 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 to

tax. Evidence suggests that the cost of complying with

that multiplicity of tax systems, particularly for smaller

firms, 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 have

unclear 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 have

been 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 is

intended to reduce the compliance costs imposed on

remote sellers by implementing three strategies: (1)

adopting computer technology and institutional arrangements to enable vendors to comply more cheaply with

multiple tax laws and taxing authorities; (2) adopting

common tax-base definitions for categories of consumption, similar tax bases, and similar tax-filing and

audit procedures; and (3) compensating vendors for the

compliance costs that remain after the first two strategies

have been implemented.

Proponents and opponents of remote collection raise other

issues 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 growth

of 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 participants

in the network. Too few people use the Internet when

those external benefits are not reflected in the price of

access to it. Providing a subsidy would thus increase use

of the Internet and benefit society.

Network externalities, however, exist mainly in the early

stages 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 remote

purchases is an indirect and unevenly targeted means of

encouraging more people to use the Internet (and in states

that have no sales tax, no incentive at all). Thus, such an

approach may not increase overall efficiency, whereas a

more direct incentive for Internet use or access might.

Some opponents of remote-seller use tax collection agree

that nonneutral, or uneven, taxation of commodities can

lead 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 some

people believe, governments have an inherent tendency

to be too large. If taxes are costly to collect, that cost can

help constrain government spending. Reducing the costs

of 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 the

social 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 well

as with a variety of tax and spending controls that have

been 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 of

them buys the good over the Internet. Proponents further

maintain that because Internet access—as well as the use

of credit cards and other instruments typically used to

shop 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 ix

Both arguments 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. Consumers who buy the

same goods through different channels choose to do so

and in other ways are not identical; comparing them to

assess 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 in

support of those benefits and services. But the “tax” in

question is a levy on consumers that is merely collected

by firms, and any impact on those businesses appears as

compliance costs, a burden that could be lightened by

compensation. 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 states

choose 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. 

Economic Issues in Taxing

Internet and Mail-Order Sales

States and local governments that levy taxes on

retail sales have long faced the issue of the cost of

collecting that revenue when their residents purchase items

by mail or telephone from retailers that are located out

of 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-commerce

share 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 collect

sales 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 on

purchases made by their residents. As a result, all of the

states that levy sales taxes have adopted a companion

“use” tax, to be collected from residents, that applies to

goods 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 the

administrative 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

taxes. Relatively little revenue is collected, however.2

Consequently, the underlying economic issue is not

whether sales over the Internet (or by mail or telephone)

are to be subject to tax—they already are. The issue is

rather the cost of collecting such taxes.

Under the Constitution, the Congress could reduce the

administrative costs of collecting sales and use taxes by

giving states and local governments the authority to

require 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 basis

of 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 (see

the discussion below) and rates imposed by the 45 states

and thousands of local jurisdictions that levy sales and

use 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

1. The lower estimate appears in Peter A. Johnson, A Current

Calculation of Uncollected Sales Tax Arising from Internet Growth (New

York: 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). 

2. Enforcement of the use tax is practical only for consumer goods

(such as automobiles and boats) that must be registered in a state

and 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 administrative

and 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 established

the Advisory Commission on Electronic Commerce to

develop recommendations about taxation related to the

Internet, including recommendations on expanding the

duty of retailers to collect taxes on remote sales. But the

commission was unable to reach a consensus and issued

no official recommendations.

Thus, the Congress still faces the question of whether to

act on this issue and, if so, what action to take. This

Congressional Budget Office paper examines in more

detail 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 the

debate 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 and

on 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).

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 their

own 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 retail

sales with sellers acting as collection agents; however, the

base of the tax in most jurisdictions is neither comprehensive 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 of

tangible goods, such as food and medicine, to lighten the

burden 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

The general sales tax finances a substantial portion of

states’ 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 the

revenue in the five no-sales-tax states—Alaska, Delaware,

Montana, New Hampshire, and Oregon. Thirty-five

states also allow local governments to levy sales taxes.

(However, in many cases, the states administer those

local taxes.)

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 and

that 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 have

sought ways to maintain their revenue base in the face of

3. The “optimal tax” framework for commodity taxes with an explicit

trade-off between excess burden and administrative and compliance

costs 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 to

Tax? The Case of Electronic Commerce,” Contemporary Economic

Policy, vol. 21, no. 1 (2003), pp. 25-40.

4. Raymond L. Ring Jr., in his article “Consumers’ Share and

Producers’ Share of the General Sales Tax” (National Tax Journal,

vol. 52, no. 1, 1999, pp. 79-90), estimated that 41 percent of the

sales 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 for

nontaxable services. Information also is not available to determine

whether the share of the tax base that is made up of purchases by

businesses, governments, and nonprofit organizations has changed

over the past decade.
ECONOMIC ISSUES IN TAXING INTERNET AND MAIL-ORDER SALES 3

a growing volume of out-of-jurisdiction purchases. In

that pursuit, they tested their authority to require remote

sellers to collect the use tax applicable in the customer’s

state. But the Supreme Court invalidated those statutes

as unconstitutional constraints on interstate commerce

in cases in which the remote sellers had an insufficient

connection 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 firm

lacked the requisite physical presence in Illinois—or

“nexus” with the state—either to justify the burden that

the statute imposed on interstate commerce or to overcome the statute’s “offense” to due process.6

The Court used the firm’s costs for complying with

such 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.”

In a more recent case, the Court signaled its view of

where 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 to

out-of-state customers.7

 The Quill Corporation, a Delaware-based remote seller, was connected to customers in

North Dakota only by common carrier or the mail. The

Court found that Quill’s “minimum contacts” with the

state satisfied the requirements of due process but that

the firm nevertheless lacked what the judges now termed

a “substantial nexus” with the state as required under the

commerce 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 the

underlying 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 the

Constitution] to resolve.”

The Growth of E-Commerce

Determining the rate of growth of e-commerce over

more than a few years is difficult. The federal government first published complete data on total e-commerce

for 1999. The value of Internet sales grew by more than

half over the next two years, rising from $660 billion in

1999 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 both

business-to-business and business-to-consumer transactions.)

5. National Bellas Hess, Incorporated, v. Department of Revenue for the

State of Illinois, 386 U.S. 753 (1967). 

6. In due process jurisprudence, the relevant inquiry is framed as

whether a defendant has had minimum contacts with the

jurisdiction “such that the maintenance of the suit does not offend

traditional notions of fair play and substantial justice.” See

International Shoe Co. v. Washington, 326 U.S. 310 (1945), quoting

Milliken v. Meyer, 311 U.S. 457 (1940).

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.
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

State Tax

Rate, 2003

(Percent)

Top Combined State

and Local Tax Rate,

2003 (Percent)

Total State Tax

Revenue, 2002

(Millions of

 dollars)

State General Sales Tax Revenue, 2002

In Millions

of Dollars

As a Percentage of

Total State Taxes

Alabamaa 4 11 6,879 1,747 25.4

Alaskaa 0 7 1,090 0 0

Arizonaa 5.6 8.6 8,477 4,289 50.6

Arkansasa 5.125 9.875 5,034 1,918 38.1

Californiaa 6 8.5 77,755 23,793 30.6

Coloradoa 2.9 7.9 6,923 1,904 27.5

Connecticut 6 6 9,033 3,044 33.7

Delaware 0 0 2,174 0 0

Floridaa 6 7.5 24,816 14,418 58.1

Georgiaa 4 7 13,772 4,834 35.1

Hawaii 4 4 3,421 1,611 47.1

Idahoa 5 8 2,271 795 35.0

Illinoisa 6.25 9.25 22,460 6,424 28.6

Indiana 6 6 9,995 3,798 38.0

Iowaa 5 7 5,006 1,747 34.9

Kansasa 5.3 8.3 4,808 1,798 37.4

Kentucky 6 6 7,975 2,313 29.0

Louisianaa 4 9.5 7,346 2,329 31.7

Maine 5 5 2,627 835 31.8

Maryland 5 5 10,821 2,694 24.9

Massachusetts 5 5 14,820 3,690 24.9

Michigan 6 6 21,864 7,784 35.6

Minnesotaa 6.5 7.5 12,936 3,739 28.9

Mississippia 7 7.25 4,729 2,341 49.5

Missouria 4.225 8.35 8,679 2,855 32.9

Montana 0 0 1,443 0 0

Nebraskaa 5.5 7 2,993 1,069 35.7

Nevada 6.5 7.25 3,945 2,071 52.5

New Hampshire 0 0 1,884 0 0

(Continued)

Retail sales statistics give some indication of the growth

of 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 those

sales cannot be identified for 1992, but data for 1999 to

2001 show the share almost doubling, from 16.6 percent

to 31.3 percent.

The Magnitude of Uncollected State and

Local 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 5

Table 1.

Continued

State Tax

Rate, 2003

(Percent)

Top Combined State

and Local Tax Rate,

2003 (Percent)

Total State Tax

Revenue, 2002

(Millions of

 dollars)

State General Sales Tax Revenue, 2002

In Millions

of Dollars

As a Percentage of

Total State Taxes

New Jersey 6 6 18,329 5,994 32.7

New Mexicoa 5 7.25 3,628 1,339 36.9

New Yorka 4 8.5 43,262 8,609 19.9

North Carolinaa 4.5 7.5 15,535 3,216 20.7

North Dakotaa 5 7.5 1,117 335 30.0

Ohioa 5 7 19,617 6,395 32.6

Oklahomaa 4.5 9.85 6,053 1,531 25.3

Oregon 0 0 5,139 0 0

Pennsylvaniaa 6 7 22,136 7,327 33.1

Rhode Island 7 7 2,128 732 34.4

South Carolinaa 5 7 5,749 2,334 40.6

South Dakotaa 4 6 977 524 53.6

Tennesseea 7 9.75 7,798 4,679 60.0

Texasa 6.25 8.25 28,662 14,560 50.8

Utaha 4.75 7 3,925 1,499 38.2

Vermonta 5 6 1,534 215 14.0

Virginiaa 3.5 4.5 12,781 2,799 21.9

Washingtona 6.5 8.9 12,629 7,906 62.6

West Virginia 6 6 3,552 963 27.1

Wisconsina 5 6 11,814 3,698 31.3

Wyominga 4 6 1,094 445 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 of

collecting tax revenue from all remote sales rather than

the increase in such uncollected revenue caused by ecommerce. Any policy requiring remote sellers to collect

and remit use taxes levied on e-commerce would probably be applied to mail-order and telephone sales as well

(assuming that all types of remote sellers would bear

similar compliance costs).

The General Accounting Office in 2000 projected upper

and lower bounds for uncollected revenue from remote

sales for 2003.10 Its upper-bound estimate was $20.4 billion, or 7.9 percent of projected state and local general

sales tax revenue of $256.4 billion, and its lower-bound

estimate was $2.5 billion. Those projections are probably

too high because they predated the recent recession (total

9. Advisory Commission on Intergovernmental Relations, Taxation

of 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.

10. General Accounting Office, Sales Taxes: Electronic Commerce

Growth Presents Challenges; Revenue Losses Are Uncertain, GAO/

GGD/OCE-00-165 (June 2000).
6 ECONOMIC ISSUES IN TAXING INTERNET AND MAIL-ORDER SALES

Table 2.

Sales Tax Revenue for Selected Local Governments

with Populations of 200,000 or More, 2000

Local Government

Sales Tax Revenue

(Thousands of dollars)

Total Tax Revenue

(Thousands of dollars)

Sales Tax as a Percentage

of Total Tax

Albuquerque, N.M. 96,367 200,847 48.0

Anaheim, Calif. 57,343 159,718 35.9

Bakersfield, Calif. 37,582 69,764 53.9

Chicago, Ill. 181,834 1,910,382 9.5

Denver, Colo. (City and county) 361,349 649,534 55.6

Houston, Tex. 313,864 1,072,223 29.3

Kansas City, Mo. 141,243 512,680 27.5

Los Angeles, Calif. 442,148 2,300,418 19.2

Montgomery, Ala. 58,778 110,280 53.3

New Orleans, La. 133,490 359,037 37.2

New York, N.Y. 3,525,610 22,547,398 15.6

Norfolk, Va. 24,321 273,002 8.9

Oklahoma City, Okla. 204,073 272,439 74.9

Philadelphia, Pa. 104,328 1,918,632 5.4

Phoenix, Ariz. 278,731 618,214 45.1

San Diego, Calif. 372,785 855,886 43.6

San Francisco, Calif. (City and county) 270,274 1,511,562 17.9

St. Paul, Minn. 11,049 129,068 8.6

Tampa, Fla. 11,402 158,761 7.2

Tulsa, Okla. 202,108 246,359 82.0

Washington, D.C. 640,212 3,215,766 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 remote

sales. Factors that must be estimated include the rate of

growth of e-commerce; the proportion of e-commerce

that 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 those

factors in estimating total sales over the Internet.

More-recent estimates of uncollected tax revenue from

all remote sales are not available. But two forecasts of

such revenue from the e-commerce share of remote sales

for 2006 and 2011 assign different values to each of the

factors 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’ and

local 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 from

Internet Growth. 
ECONOMIC ISSUES IN TAXING INTERNET AND MAIL-ORDER SALES 7

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 the

Congress can give states the authority to require remote

sellers to collect use taxes. In fact, that policy role is the

federal 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 call

on principles related to economic efficiency, fairness, and

states’ 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 on

remote 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 the

Internet) and require remote sellers to collect taxes on

Internet sales. Policymakers eventually enacted the

Internet Tax Freedom Act (ITFA), which allowed existing taxes on Internet access to remain in effect but imposed a three-year moratorium on new federal, state,

and local access levies. In addition, it allowed existing

taxes on sales over the Internet to remain in effect and

permitted governments to impose new taxes on such

sales as long as they applied equally to sales made by

other 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 to

issue 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 taxation

and the loss from incurring administrative and compliance costs for collection. The desirability of remote collection depends on the magnitudes of those two kinds

of costs.

13. See Advisory Commission on Electronic Commerce, Report to

Congress (April 2000).
8 ECONOMIC 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 that

to raise a given amount of tax revenue, those distortions, or excess burden, can be minimized by taxing all

commodities 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 as

part 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 it

over 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 purchase

books over the Internet for $100 inclusive of the shipping cost, pay no sales tax, and fail to comply with the

use 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) purchased 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 cost

of the same books (including profit) available for sale

from the local bookseller is $97; the portion of the

books’ cost that is sales tax ($5) is a transfer from the

consumer to the government and uses no resources.

Thus, the tax differential that results from the consumer’s noncompliance with the use tax causes this

consumer to make a choice that increases the production cost of books by $3. That money represents a loss

of 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 than

in 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 and

charges a jurisdiction B customer $100 (with no sales

tax) 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 is

purchased 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

14. Were individuals’ preferences known, tax rates could be set to vary

among commodities according to how closely each good’s use was

tied 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 have

settled instead for establishing uniform tax rates across commodities

as a way to minimize excess burden. For a discussion of the history

of that policy process, see Joel Slemrod, “Optimal Taxation and

Optimal Tax Systems,” Journal of Economic Perspectives, vol. 4,

no. 1 (1990), pp. 157-178. 

15. James M. Poterba, “Retail Price Reactions to Changes in State and

Local 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 9

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 to

goods.17 Other research shows that reduced economic

well-being can result when consumers alter their

choices of what to buy because of differential taxes on

commodities.18

In sum, avoiding a situation in which residents of a

given state face differential taxation on the same good

tends to minimize distortions. Not collecting use taxes

on e-commerce amplifies the differential taxation that

is already occurring through mail-order, telephone, and

cross-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 with

those laws. Administrative costs can be thought of as

the expenses incurred by the tax authorities, the state

and 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 it

to the state or to the local government. Of course, some

compliance costs may be passed on to the consumer in

the form of higher prices for retailers’ goods.19 (As discussed later, consumers would also bear compliance

costs 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 is

collected 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 nonetheless

appear to design their tax structures to account for

them. For example, some services are excluded from the

existing sales tax base because they are thought to entail

higher-than-usual administrative costs per dollar of

revenue collected.20

High administrative costs help explain why states and

local governments seldom enforce use taxes for most

business-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 size

of that percentage suggests that the cost of achieving

compliance by other means—for example, by pursuing

individual Connecticut taxpayers—is high.

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: Basil

Blackwell, 1985), pp. 109-129, Table 6.7.

19. When general sales taxes differ across products or locations, which

is 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 the

tax.

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. 15-

32. See Joel Slemrod, “Optimal Taxation and Optimal Tax

Systems,” for a more general discussion of how the consideration

of administrative costs can change policymakers’ judgments about

the optimal tax system. 
10 ECONOMIC ISSUES IN TAXING INTERNET AND MAIL-ORDER SALES

One 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’ compliance

costs. Those costs would probably be higher for remote

sales than for local sales. Vendors making remote sales

would be dealing with the varied tax bases, rates, and

audit 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 to

which the sales tax applies and at most two rates (one

state and one local).21

Thus, the size of vendors’ compliance costs relative to

the 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 for

measuring those costs. A recent analysis for the state of

Washington found that compliance costs ranged from

0.97 percent of the state’s sales tax revenue collected by

large 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.

Cline 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 in

which a firm did business increased and the size of the

firm 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 compliance

costs from collecting use taxes will constitute a substantially greater burden for vendors’ remote sales than the

costs 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 policy

that is focused on reducing the social costs of taxation

must 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.

21. The available data indicate that more than 7,500 jurisdictions levy

a sales tax. However, as of 1994, state and local tax bases were

virtually identical within each of the 29 states that administer the

tax for local governments. Even in the states that allow local

administration, local governments tend to follow the broad outlines

of 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 of

Collecting 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, “Tax

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 that

would tend to offset the gains in economic efficiency

from reducing distortion costs. However, states and

local 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 to

voluntarily 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, the

adoption of computer technology, and compensation

can reduce costs and thereby increase the likelihood of

Congressional 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 the

states imposing a sales tax. Both thresholds were

achieved by August 2003; at that point, 20 states had

enacted legislation that aligned their sales tax systems

with the provisions of the agreement.26 Most of those

changes are to take effect by July 1, 2004.

The states adopting the SSUTA will now review each

state’s law to ensure that it complies with the agreement. Once the 10-state and 20-percent-population

thresholds have been verified, the agreement will go

into effect, and a governing board with one vote per

state will be established. That board, which will include

participation by businesses, will respond to questions

and resolve disputes, judge states’ compliance with the

agreement, 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 and

rates and imposing uniform sourcing rules (for identifying the purchaser’s residence). It would require the

use of computer technology to simplify the process by

which sales and use taxes are computed, remitted, and

audited. And it would require states to compensate remote sellers for many of the remaining compliance

costs.

Although states’ compensation of retailers’ costs for

collecting 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 to

collecting taxes that would result from improvements

in technology and simplification, compensation would

shift those costs from retailers and consumers to the

state’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 in

tax 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

25. 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 the

agreement, which may cause them to be judged as not being in

conformance with it. Texas and Washington would continue to

have vendors remit sales tax on local purchases to the jurisdiction

of the origin of the sale rather than to the jurisdiction of the

residence 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.
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, and

would simplify the procedures by which purchasers

could obtain tax exemptions. It would also shift the

responsibility for validating those exemptions from the

seller to the state. Furthermore, the agreement would

impose uniform sourcing rules that relied first on the

destination 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 the

purchaser’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 address

from which tangible property was shipped or, in the

case of a digital good, the location at which it was first

available for transmission. (Box 1 discusses origin-based

versus destination-based sales taxes and the social costs

of taxation.) Devising a reliable and simple system for

sourcing 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’ costs

of coping with the complexity of numerous tax bases,

rates, and auditing procedures. Those programs could

determine, in real time (during the transaction), the

sales tax status of a product on the basis of the state and

local tax law in the purchaser’s jurisdiction. Information on the amount of the tax and the jurisdiction to

which 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. (The

states 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, and

other necessary factors.) Remote sellers could also deal

with their sales and use taxes on their own, using a

CAS. Alternatively, sellers with sales in at least five

states 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 compliance

costs 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 period

of 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 compensated

vendors at least to some degree for their compliance costs. How

that compensation compares with actual compliance costs in most

states is not known; however, the state of Washington estimated

that a large firm is compensated for 65 percent of its compliance

costs 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 a

study 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 the

destination of the purchased item; if the purchaser

resides in the state, the tax is incurred. By contrast, in

an “origin-based” system, the tax is levied at the source

or origin of the item being sold; if the seller is in the

state, 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 remote

sales 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 is

that retailers deal only with the sales tax system in the

jurisdiction 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 compliance

of individuals; under an origin-based framework, all

1. 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; and

Wade 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 in

conformance with a destination-based tax.

the use taxes paid under a destination-based system

would be collected as sales taxes by vendors whose

businesses would all lie within the taxing jurisdiction.

The effect on states’ and local governments’ revenue of

moving to an origin-based system would vary by

jurisdiction. 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 who

marketed 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 of

revenue 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 in

places 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 size

of the public sector. How retailers reacted to the

differences in taxes and how states and local governments responded to retailers’ decisions about where to

locate their businesses would help determine an originbased system’s impact in each state.

An industry monitoring group, the Council on State

Taxation (COST), has praised the SSUTA as a move in

the right direction.28 However, COST suggests that the

agreement lacks enforcement provisions, is vague about

how closely compensation would be tied to actual compliance costs, and is missing a federal monitoring mechanism that should be incorporated before the authority to

require remote sellers to collect and remit use taxes is

provided by the Congress.

Other Economic Issues in the

Remote Collection Debate

Both opponents and proponents of remote collection cite

additional economic considerations beyond distortion

28. Council on State Taxation, Report Card on the Streamlined Sales

Tax Implementing States’ Agreement (Washington, D.C.: Council

on State Taxation, October 11, 2002).
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 the

good 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 a

manageable problem. The good must be shipped to a

location, which is a reasonable approximation of where

it will be used, and the opportunities for businesses and

consumers 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 have

the purchase shipped to the lower-tax jurisdiction

(using a post office box, for example, or the address of

a 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 not

collect 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 less

easily tracked than businesses’ purchases) could conceivably have the digital product “shipped” to a computer in any location and pay for the product with a

credit 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 a

shipping address and the customer’s financial information were not adequate to to determine the customer’s

residence for a transaction. Of course, the digital nature

of 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 to

generate 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.

costs and administrative and compliance costs in their

arguments—in particular, network externalities, the size

of government, horizontal and vertical equity, unfair

taxation of remote sellers, and states’ fiscal autonomy. In

general, however, reflection suggests that those issues are

less 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 the

notion that the Internet is characterized by “externalities”

that cause too few people to become part of the network

and 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

current use of the Internet. More than 136 million of the

241 million people in the United States above the age of

eight (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 price

established 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, more

accurately, 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 amount

equal to the external benefit that society receives from the

transaction will increase output to a level that more

nearly 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 the

Internet, 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 to

communicate with its other members. If the network’s

services are provided competitively, the price that a new

member pays accurately reflects the value of those benefits. But the other members of the network each receive

a 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 more

members 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 incentive

that 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-commerce 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 to

purchase the network’s services. Those initial participants tend to be “high-demand individuals” who not

only value the services highly but whose intense interest

in 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 with

successively less demand for network services and possessing less technological expertise are induced to join.

Those new entrants generate ever-smaller benefits for

other 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 on

participating in the network by those who have yet to

join. Those always-potential entrants would have provided relatively few benefits to other participants—and

they 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 when

more 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 reduc- 30. The discussion here concentrates on direct network externalities;

also relevant but not discussed are indirect network externalities

and learning network externalities. The reasoning behind the

discussion of direct network externalities is basically identical to

that 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.

31. The time path is discussed in Nicholas Economides, “The

Economics 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 new

entrants remained significant, the object of an incentive

would be to stimulate the growth of the network, not

of e-commerce per se.33

Opponents of remote collection proffer another argument to support their position: that it is not the size of

the 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 that

allows its production costs to decline enough to make it

competitive. Yet the industry’s sales exceeded $1 trillion

in 2001 (including both business-to-business and

business-to-consumer sales), and more and more socalled bricks-and-mortar firms are expanding their use

of e-commerce to complement their traditional mode

of selling. The e-commerce model thus hardly seems

endangered. Furthermore, a standard problem with

subsidizing an infant industry is knowing when to

eliminate the subsidy. Unless a clearly articulated case

can be made for the future benefits that will be offered

by a mature industry, the passage of time becomes an

argument 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.)

The Size of the Public Sector

The basic principles of efficiency and neutral taxation

that 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 government 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 production

of too many or too few goods and services and, as a

consequence, 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 reallocated

from the private to the public sector would generate

public consumption whose value was less than the value

of the private consumption that it replaced. That outcome would mean a loss of economic well-being for

society, even if it were possible to collect taxes without

imposing efficiency costs.

Some opponents of requiring remote sellers to collect

use 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.

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, through

the administrative costs associated with collecting taxes

32. In fact, the Internet in its infancy did receive an incentive. But the

subsidy 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 start

a network.

33. Users of the Internet receive an incentive if they use a telephone

line 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.

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 and

literature 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, “Tax

Policy 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; and

James M. Poterba, “Public Finance and Public Choice,” pp. 391-

396.
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 fact

that 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 some

efficiency costs in order to create incentives to reduce

other efficiency costs. Which inefficiency effect was

larger would depend on how state and local officials

responded to increased revenue from a use tax, as well

as on whether an inherent bias toward a larger-thanoptimal public sector really exists in the first place.

In sum, both opponents and proponents of remote

sales 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.

A second way in which mandated collection of use

taxes is relevant to the issue of the public sector’s size is

that 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

higher taxes than their neighbors do—a penalty that

takes the form of lost tax base and less tax revenue as

retailers 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 and

use taxes meant pushing states to impose the same

rates, it would undoubtedly reduce the potential scope

of 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 base

definitions.37

To summarize, remote collection could influence the

size 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 through

the political process. Competition could also proceed

on the basis of other taxes, such as those on income and

property, 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 in35. See Aaron Lukas, Tax Bytes: A Primer on the Taxation of Electronic

Commerce (Washington, D.C.: Cato Institute, December 17,

1999), pp. 10-11.

36. The effect of fiscal centralization (and tax competition) on the size

of state and local governments has been a subject of considerable

empirical interest. A series of articles on the topic appeared in the

American Economic Review: see Wallace E. Oates, “Searching for

Leviathan: An Empirical Study,” vol. 75, no. 4 (1985), pp. 748-

757; 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, “Searching

for Leviathan: A Reply and Some Further Reflections,” all in

vol. 79, no. 3 (1989), pp. 560-583. 

37. Cline and Neubig, Masters of Complexity and Bearers of Great

Burden, pp. 9-10. The authors illustrate that complexity with

flowcharts of the tax status of nine types of groceries and

11 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

International Considerations

Remote sales include not only purchases from merchants in other states but also purchases from sellers in

other countries. A concern raised by opponents of remote collection is that if remote sellers are required to

collect 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 have

called on policymakers to ensure that any alteration in

collection 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 that

are 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 such

great 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 the

issue is the states’ inability to influence the cost of collecting use taxes from abroad. Those costs depend on

treaties, which are negotiated by the federal government.

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 remote

sellers 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 remote

seller established within the EU collects and remits the

VAT under an origin-based system, thus treating the

seller as a U.S. state treats a local seller. U.S. remote

sellers who have established a company within the EU

are entitled to be treated as an EU company; those who

have not done so must collect the VAT on the basis of a

customer’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 remote

seller can register separately with each EU country and

comply 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 over

whether to grant states that authority. Opponents argue

that it is unfair to require merchants to pay taxes to

states from which they receive no benefits. Proponents

contend that to exempt out-of-jurisdiction sales from

use taxes favors people who are economically better off

and who are more likely to have Internet access, and

treats otherwise equivalent consumers differently on the

basis of the means by which they purchase identical

goods.

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.

38. 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 and

finds 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.
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 more

heavily 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 the

same 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, two

consumers who purchase the same items, one on-line

and one from bricks-and-mortar establishments, are

treated differently. Yet the proper measurement of horizontal equity is problematic. By definition, if both consumers have equal access to the Internet, they are

choosing to not purchase the same “bundle” of goods

and services. Presumably, each consumer has reasons

for 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 be

taxed, 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 from

higher-income ones. A progressive tax takes more

taxes—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 collect

use 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, compared

with 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, for

those 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 the

Internet is becoming more evenly distributed over

time.39

Some observers believe that the issue of vertical equity

in remote sales taxation goes beyond the ownership and

use of computers and the Internet. Purchases over the

Internet (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 not

taxing 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 fashion

other 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 distributed

in 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. (A

coefficient 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 reliable

approach 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 access

to 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 the

form of public services in exchange for collecting the

tax. 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 with

the benefit principle of taxation.

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 on

each airline ticket. Second, governments usually assess

the tax on those identifiable beneficiaries as a function

of 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 concern of opponents to remote-seller tax collection is not relevant to the tax itself but rather to the lack

of 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 the

social costs of taxation to retailers who may be unable

in turn to shift their compliance costs to consumers in

the form of higher prices. Some observers might be less

concerned 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. 

Fiscal Autonomy of States and Local Governments

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 of

states and local governments will be diminished by the

changes in the tax system that may be required to obtain that authority.

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 impede

interstate commerce, which generally means that taxes

must not discriminate according to a taxpayer’s state of

residence 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.

State and local governments have chosen to structure

their general sales and use taxes to conform to a variety

of policy objectives and voter preferences. Some governments make a considerable effort to exclude items

from the tax base to distribute the burden of sales and

use 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 of

business-to-business sales in the base. Some include a

variety of services. And some governments compensate

sellers for at least a portion of the costs they incur as

collection agents.

The issue before the Congress is whether to grant state

and local governments the authority to require remote

sellers to collect use taxes. As discussed earlier, that authority might impose substantial compliance costs on

remote 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

41. “When a business . . . remits sales taxes to the state in which it is

located, there is a plausible linkage among the taxes paid, the

services provided, and legislative representation . . . [t]he remote

seller does not benefit from most of the services that distant state

or those local governments provide” (Lukas, Tax Bytes, p. 13).
ECONOMIC ISSUES IN TAXING INTERNET AND MAIL-ORDER SALES 21

both)—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 (to

reduce compliance costs) in exchange for the authority

effectively to collect taxes on remote sales.42 Much of

that 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.

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 the

Internet Tax Freedom Act), which calls for states to

exempt from sales taxation the intrastate sale of digital

products (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 for

state 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 the

changes states make to obtain those benefits satisfy their

concerns about compliance costs.

42. See Adam Thierer, The Governors’ Misguided Plan to Tax the

Internet and Create a New National Sales Tax, Heritage Foundation

Backgrounder (Washington, D.C.: Heritage Foundation, January 3,

2000), p. 12.


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