TO TAX OR NOT TO TAX? THE CASE OF ELECTRONIC COMMERCE

I. INTRODUCTION The sales tax treatment of goods and services purchased via the Internet has attracted attention far beyond that normally afforded to issues of state and local taxation. The discussion is motivated by widely different objectives, with some seeing the issue as how to create the best tax structure, some as a means to reduce the size of government, and others as a way to give preferential tax treatment to a particular industry. A number of the participants in the debate have made claims, apparently based on optimal tax theory, about the appropriateness of taxing transactions through e-commerce. It is somewhat surprising, then, that the question of Internet taxation has not received a thorough and systematic treatment in the context of the diverse body of optimal tax literature. This article seeks to add to the discussion by examining what contributions the optimal tax literature provides for design of sales taxes on electronic commerce. The authors note which arguments are and are not supported by optimal tax theory and the rather unlikely conditions under which an exemption for Internet commerce might be warranted. Following a brief overview of the current sales and use tax system and a summary of the Internet Tax Freedom Act (ITFA), the article addresses the following questions: * Should local and remote purchases of final goods and services be taxed differently on efficiency grounds? * Should local and remote purchases of final goods and services be taxed differently on equity grounds? * How should intermediate transactions be taxed? * How do administrative and compliance costs affect optimal tax considerations? * How does uncertainty affect optimal tax considerations? * Are there nonoptimal tax considerations? II. THE CURRENT SALES AND USE TAX SYSTEM AND THE ITFA The analysis is based on the sales tax as it operates institutionally in the United States and not on the basis of a stylized consumption tax. For example, it is recognized that the existing sales tax is imposed on many intermediate transactions, is levied at rates that vary geographically across the country but are fairly uniform within each location, and exempts significant components of consumption. It is important to note how the current sales and use tax system in the United States treats local and remote purchases differently. In most cases, either the sales tax or the use tax is imposed on items included in the tax base regardless of where the goods are acquired. (1) The sales tax is levied on items purchased in state for use in state, and the use tax is imposed on goods that are stored, used, or consumed in state but purchased out of state. However, use tax collection often relies on voluntary compliance, which increases the opportunity for tax evasion. (2) A major source of evasion arises as firms and consumers fail to report that taxable items purchased out of state are used in state. Not surprisingly, the limited available evidence indicates that use tax compliance is much weaker than sales tax compliance. (3) Under the ITFA of 1998 and its extension through 2003, no new or discriminatory taxes may be levied on Internet sales, and taxes on access to the Internet are prohibited, except for eight states where access taxes have been grandfathered. States are permitted to apply existing sales and use taxes to Internet and other remote sales but may not enact any new taxes that are explicitly targeted at Internet sales. III. SALES TAXES AND CONSUMER PURCHASES A primary theme in the Internet taxation debate is the presumed ideal of tax neutrality. Those opposed to a tax-free Internet have argued that sales of similar--indeed, identical--goods should be taxed in a uniform manner regardless of how they are obtained for final consumption. It may come as some surprise, then, that uniform commodity taxation is not typically optimal in the context of traditional optimal tax theory. …