Why A Big Tax Loophole For Internet Firms?

By Neal R. Peirce

August 12, 2001

WASHINGTON -- Succumbing to pleas of AOL and its allies that their “infant industry” might be asphyxiated by a welter of confusing local taxes, Congress in 1998 granted Internet service providers a sweeping three-year exemption from state and local taxation.

Yet in January 2000, AOL was able to announce its $165 billion merger with the global media powerhouse Time Warner -- one of the most massive corporate deals ever. “Some infant industry,” snorts state policy analyst Tom Bonnett, author of the recent book, “Competing in the New Economy” (Xlibrus, 2000).

Why, asks Bonnett, doesn’t telephone service, or electricity, or any other utility get the same tax exemption? Are they somehow less vital than Internet service?

Surely not. But the Internet lobby is so powerful, its capacity to subsidize political campaigns so obvious, that no one expects the tax moratorium to die, as now scheduled, October 21. President Bush supports an extension. And each congressional party, says Bonnett, had its own “pandering package” before the last election -- Republicans favoring a tax moratorium to 2006, Democrats to 2003.

The problem is we’ve created a tax loophole likely to morph into a tax blowout as Internet use soars and companies begin claiming that the digitized books, movies and music they deliver by broadband Internet are tax-exempt too.

Moratorium apologists argue Internet providers would be overwhelmed by a plethora of local tax laws. Interesting charge -- but groundless. Firms like Staples, the Gap, Nike and Victoria’s Secret, operating in virtually all states, already have the zip code-sensitive software to apply the correct home sales tax to any buyer in any political subdivision.

What the Internet tax debate accentuates is an even broader issue -- why all mail order, telephone, catalogue or web sales can’t be subjected to normal sales taxes, even for out-of-state sales. (A 1967 Supreme Court decision says states can’t make the seller collect the sales tax unless the seller has a physical presence in the state.)

No tax is perfect, least of all the sales tax, arguably one of the least progressive taxes ever invented. Yet for 65 years, it’s been a centerpiece of states’ tax structures. Applied in 45 states, it generates about a quarter of all state-local revenues, for every purpose from schools to prisons, welfare to roads, parks to universities. Total annual yield: close to $200 billion.

It’s true: states could and should clean up the mess of layered statewide and local sales taxes. But businesses bidding for special exemptions, or ideologues arguing that any new or expanded tax just feeds cockeyed projects of greedy politicos, are actually just pushing taxes burdens onto others.

Bonnett believes we’ll soon see Congress feel the pressure from Main Street retailers and store chains enraged about having to collect sales taxes that the interstate sellers avoid. They’ll be joining hands with governors, county and city officials alarmed about the erosion of their tax base.

Would that coalition be a match for the Internet heavies, the catalogue and on-line sellers? Is there a way to introduce some common sense, deciding on more rational grounds than who’s throwing around the most campaign dollars?

Actually, there’s a deal waiting to be brokered. The idea, pushed by the Federation of Tax Administrators and some progressive state leaders, is to create a virtually automatic system to collect taxes on goods sold across state lines. The special exemption for Internet or interstate sales would go away. But in return, the states would accommodate business by agreeing to radical simplification and uniform operations of their sales taxes.

To get that reform, states themselves may be the obstacle. Getting their accord on touchy issues like taxes is akin to herding cats.

Yet there’s incredible benefit waiting, not just in a deal on interstate sales but finding ways to reduce sales taxes while broadening their reach. The median state sales taxes is now 5 percent (maxing out at 11 percent in some jurisdictions). That’s up from a 3 percent median in the 1960s.

Why’s the rate risen? Because consumer spending has shifted dramatically from goods and toward services -- health care, accounting, personal services. And few states tax services.

“A higher tax rate on a shrinking base is bad medicine,” says Bonnett. “It encourages tax avoidance and mail-order sales over Main Street purchases.”

But if states would broaden their taxes to cover services, they could cut overall rates -- maybe back to 3 percent or so. In the process, they’d strengthen their local merchants against out-of-state sellers. And begin restoring public confidence in the entire system.

Indeed, what an appealing idea: sales taxes across the board, but at a far more reasonable level. And the states, not giant Internet firms or Congress, making critical tax decisions for their constituencies.

The perplexing challenge now is to align the political stars to make it happen.