MIT TECHNOLOGY REVIEW - May/June 1996

The Great Internet Tax Drain
By Nathan Newman

Nathan Newman, a sociologist studying the impact of information technology on regional economies, is codirector of the Center for Community Economic Research at the University of California at Berkeley. His e-mail address is nathan@newman.org.

As commerce migrates onto the Net, the door is slamming shut on the sales-tax collector--potentially shredding the financial stability of states and cities that have pinned their economic future on retail development.


As Orange County goes bankrupt and cities and towns from Los Angeles to New York teeter on the edge of financial chaos, local govern-ments crave some good financial news. This article can't deliver it. This is the story of how the Internet may deal the final body blow to the financial security of local governments. Governments could once count on local economic development to produce local jobs where local employees would spend money in local stores, thereby generating local tax revenue for further development. This virtuous cycle has been fatally undermined by the new technology of cyberspace.One great promise of the Internet is that it will not only supply amusement and information but also serve as a marketplace.

Advocates paint happy pictures of consumers shopping through the ultimate collection of catalogs--giving them access to a nationwide and worldwide marketplace--and ordering and paying for goods from their computers. Often overlooked is the fact that little of this buying and selling will be subject to state and local sales taxes. That's good news for the consumer--but a potential catastrophe for the state and local governments that have come to rely on sales-tax revenues.

States already lose at least $3.3 billion each year because of retail sales that have migrated to mail-order businesses, estimates the U.S. Advisory Commission on Intergovernmental Relations (an agency that brings together representatives of state governments to improve the effect of federal policy on states). That is, roughly $3.3 billion worth of tax revenue would have flowed to state governments if goods had been purchased in stores rather than through mail order. In 1994, California alone lost $483 million, according to the commission, and eight other states lost more than $100 million each.

The Internet's impact has yet to be fully felt. Total retail sales transacted on the Net added up to only about $200 million in 1994, according to CommerceNet, a consortium of businesses exploring use of the Internet--less than one-tenth of 1 percent of what was spent on mail-order shopping. But corporate America is turning to the Internet at a dizzying pace. Companies are establishing sites on the Net at the rate of about 120 per day, according to Anthony Rutkowski, vice-president of the Internet Society, an organization that oversees standards-setting on the Net. The number of World Wide Web pages advertising businesses and products is growing at about 12 percent a month, say industry analysts. Many of these pages make it easy for Net surfers to purchase goods by typing in a credit-card number and mailing address. Businesses offering products online can "provide information 24 hours a day and not have to have people on the phone all the time to service an international market," observes CommerceNet program manager Mark Masotto.

This trend is likely to accelerate as one of the key barriers to Net commerce--lack of security--starts to fall. Fears that hackers could intercept messages and steal passwords or credit-card numbers are becoming more and more unfounded. Last summer, Netscape Communications, which created the most popular program for browsing the World Wide Web, released software and public standards for a "secure digital envelope" that can ensure the privacy of financial data transported over the Internet. Intuit, which makes popular personal finance software, and MasterCard International are among companies announcing support for the new protocol. The floodgates of Internet commerce, it appears, are about to open.

In an ominous collision of trends, this growth coincides with the emergence of sales taxes as a major revenue source for state governments. Beginning in the early 1980s, broad cutbacks in federal funding forced states to pay for more and more services out of their own budgets. With voters typically unwilling to approve higher income taxes, sales taxes often became the only politically feasible way to make up for lost federal revenues. Only Delaware, Montana, New Hampshire, and Oregon now collect no state or local sales taxes; altogether, one-quarter of all tax revenues that states collect stems from sales tax.

In many states, local governments tack on their own sales tax as well. In all, 6,000 counties, cities, and school districts collect sales tax. Ironically, the state most severely hit by the move to catalog and online shopping is California--home to many of the companies and universities that invented the technology that makes the Internet possible. Because of Proposition 13, which limits California's ability to raise money through property taxes, towns and cities are extremely dependent on sales taxes. Cupertino, for example, where Apple Computer has its headquarters, depends on sales taxes for 45 percent of all city revenues, prompting mayor Wally Dean to call the sales-tax dependence "a house of cards for government finances."

Distorted Development

Right now, local governments that rely heavily on sales tax naturally have an incentive to encourage large retailers to move within their borders by granting them large subsidies--typically in the form of property-tax exemptions. But the competition for retail has distorted economic development. The retail establishments that a city or town recruits have tended to succumb to competition from the next wave. First, shopping in urban centers gave way to retail in the suburban towns. Then, those suburban concentrations of stores began to weaken in the face of competition from malls. Now, general purpose department stores in malls are losing out to discount "big box" retailers such as Home Depot and Toys R Us. Cities are vying against one another to attract discount giants that suck in business from a whole region, often devastating the more dispersed retail establishments that local governments, especially in the West, depend on for financing their budgets.

Direct marketing through telephone or the Internet takes this economic cannibalism to a new level. Cities and states are competing with a vengeance to attract order-processing "call centers" to service direct marketing companies. Oklahoma, for example, has worked hard to replace disappearing oil-patch jobs with the data entry, computer programming, and accounting employment that these call centers provide. The state excuses direct marketing companies from having to pay sales tax on 800 numbers, WATS, and private-line service--the essential tools of the mail-order trade--and grants data-processing firms that move to the state a five-year exemption from property taxes. In the end, however, such policies merely reward the flight of local retail to tax-exempt mail order.

Each individual state or municipality is betting that jobs from such call centers will endure and that the gain in long-term jobs will offset the cost of the subsidies. But as the Internet blossoms, even that hope may wither. People will be able to "window shop" the Web the way they do in malls and downtowns--comparing product features and prices, seeing demonstrations, and making purchases. As such online activity becomes more common, the whole job classification of entry-level data clerks at call centers may melt away, leaving only a much smaller set of more specialized, and skilled, troubleshooters. "You'll still need some people to deal with hysterical customers, but that's about it," says Bruce Lowenthal, Tandem Corporation's program manager for electronic commerce over the Internet.

A Constitutional Barrier

There is one obvious response to this problem: allow states to tax mail-order and Internet sales. But the courts have said no. The U.S. Supreme Court, in its 1967 National Bell Hess, Inc. v. Department of Revenue decision, prohibited states from taxing out-of-state sales. The court based its ruling on the Constitution's so-called "commerce clause," which restricts the federal government's power over commerce between states and that prevents states from imposing tariffs on one another. In National Bell Hess, the court ruled that allowing a state to tax a company located in another state would violate the principle that there should be uniformity in the rules of commerce for companies crossing state lines.

The court reaffirmed this principle in its 1992 Quill Corp. v. North Dakota decision, in this case defining "in-state" sales extremely narrowly. The court held that for a state to collect taxes on sales, the vendor must have significant sales operations--such as personnel, inventory, or showrooms--within the state. If no such "nexus" exists between the seller and the state in which the purchase originates, then the transaction must be regarded as interstate commerce and is thus constitutionally out of reach of a state sales tax. Already, direct marketing companies have used toll-free numbers, computers, and faxes to dispense with the need to place operations within a sales-tax-collecting state. As World Wide Web pages begin to eclipse printed catalogs, the physical connection between mail-order retailers and states trying to tax them will recede even farther.

The company at the center of the 1992 decision exemplifies the problem for states. Quill sells more than 9,500 different office products ranging from paper clips to computers; annual sales in excess of $340 million in 1992 make it the nation's third largest mail-order company, trailing only L.L. Bean and Land's End. About half of the more than 200,000 orders that Quill receives monthly come in by telephone. The other half, however, arrive by mail, fax, telex, or computer network. To expand its business, Quill leased computer software that gives customers direct access to Quill's computer for direct orders. The Internet will make these kinds of transactions far easier.

Cutting Losses

In the Quill case, the Supreme Court did leave one option. While no individual state is allowed to unilaterally impose an out-of-state sales tax, the federal government may establish what would amount to a national sales tax--and remit the proceeds to the states in which the purchaser resides. In 1994, Sen. Dale Bumpers (D-Ark.) introduced legislation--the Tax Fairness for Main Street Business Act--that would have established such a tax, but the bill foundered on opposition from the Direct Marketing Association and allied business and consumer groups. These organizations contended that forcing mail-order companies to collect sales taxes would create an unbearable administrative burden; the complexity of tracking tax rates in all the states and local municipalities around the country that charge sales tax would overwhelm most businesses.

Another way that states might tap into the mail-order and online-sales revenue stream would be to levy a fee directly on consumers for the use of any retail channel that bypassed the sales tax. Present court rulings make this constitutional; while states cannot tax companies located in other states, they have full power to tax people located in their own states, regardless of where they buy their goods.

Such a "use tax" would be difficult to collect, however. If compliance were made voluntary, individuals would have to account for their purchases much as they now account for their income in filing their income tax returns--requiring a horrendous amount of bookkeeping that few people would be likely to perform with any degree of accuracy. Alternatively, states could audit individual citizens' purchasing activities by collecting information directly from individual credit-card and checking account records. So far no state has dared to enact such a tax, but legislators may move in this direction if their sales-tax revenues continue to fall. Some states, like California, have in their constitutions strong privacy guarantees that prohibit such actions. But in other places, we may have the specter of Big Brother looking over our shoulders to collect on mail-order purchases.

The Republican majority in Congress is seeking to shift responsibilities from the federal government to state and local levels. They liken the huge federal government to yesterday's mainframe computers--awkward and obsolete. State and local governments, by extension, are analogous to the nimble microchips and personal computers that have achieved supremacy in the information age.

But this metaphor misrepresents the situation. In reality, new information technologies call for more centralized revenue collection, not less. Since so much commerce is national and even international in scope, state taxes should be preferred to local taxes, and federal taxes to state taxes. Otherwise, state and local governments engage in a "race to the bottom" as they cut back on services for their citizens to pay for wasteful tax subsidies. Centralized revenue collection--while admittedly running counter to the political winds favoring "devolution"--also can help erase disparities in services between poor and rich communities, especially in the area of public education. This was the goal that led Michigan's voters in 1994 to approve a new system of school financing that replaced local property taxes with statewide taxes. Likewise, centralization at the national level can help eliminate disparities among states and thus reduce states' incentives to lower taxes as an inducement to business relocation.

Ultimately, states should scale back and even eliminate sales taxes as a revenue source. Continued reliance on a sales tax leaves a government's finances vulnerable to the powerful trend in retail toward mail order and, in the coming decade, Internet-based shopping that crosses state lines. In this environment, a sales tax is the worst economic policy possible for a state, as it gives an economic edge to out-of-state businesses.

Indeed, in the game of mail order, a state's population works against it. Since companies are required to collect sales tax from in-state customers, mail-order companies are drawn to locate in states with small populations. That way, these companies can maximize the number of people that it can market to on a sales-tax-free basis. As retail establishments go online, therefore, they will tend to flee large states such as California.

The best way to make up for the revenue lost by lowered sales taxes would be through a state income tax. One benefit would be progressivity: the average state income tax rate for a family of four is only 0.7 percent of income for the poorest 20 percent of residents and 4.6 percent of the income of the richest 1 percent. (Property taxes are usually little more progressive than sales taxes.) Moreover, income taxes apply no matter how the money is spent, and so are not undermined by increases in online and mail-order shopping. An even better option is to use federal income taxes to substitute for lost revenue at both the local and state level. Although not politically likely right now, this option seems only fair--it was federal cutbacks in aid to states that led states to rely so heavily on sales taxes to begin with.

Fortunately, eliminating state sales taxes would not necessarily require much of any new revenue--if governments would stop squandering money to lure companies to relocate within their borders. Officials all over the country are in a cutthroat scramble to attract high-tech businesses to their locales, hoping to replace tax bases decimated by the decline of manufacturing employment. While some new jobs may appear, state and local governments may see little gain in revenue if trends continue toward untaxable out-of-state and online sales. "Even though it is rational for individual states to compete for specific businesses, the overall economy is worse off for their efforts," wrote Arthur Rolnick and Melvin Burstein last March in The Region, a magazine published by the Federal Reserve Bank of Minneapolis. (Rolnick is senior vice-president and director of research at the Fed in Minneapolis; Burstein is that bank's executive vice-president and general counsel.) At least six states, two cities, and Puerto Rico, they note, have begun to prohibit the use of tax subsidies to recruit retailers.

The federal government has contributed to wasteful relocation subsidies. Its biggest job-subsidies programs--including industrial revenue bonds, the Department of Housing and Urban Development's community development block grants, and most Department of Commerce programs--not only permit but encourage local governments to apply the federal money they receive toward incentives to draw companies from elsewhere. The federal government could end such job piracy quickly if it mandated that any state that engages in interstate job-raiding would lose its federal funding.

The loss of local sales taxes owing to mail-order and online commerce should be treated as an opportunity to look more closely at how technology is changing the burdens we put on local and state governments. We should question whether such burdens make sense in a world where multinational corporations often outpower whole states in total assets and can pit such local governments against each other in competition for jobs and local revenue. While much information-age rhetoric harkens to images of small firms and decentralization, the reality is of soon-to-be trillion-dollar corporations straddling the globe. Even modest-sized enterprises operate more and more on a global basis. Faced with such a disparity in power, local governments can hardly be expected to devise fair and efficient systems of taxation or make informed economic development decisions. The rise of national and global commerce calls for national and even global solutions, regulations, and revenue sources.

We must recognize that while the microchip may be getting smaller, the plane of economic activity encouraged by this technology is national and global. The growing fragility of the basis for state and local sales taxes should make us aware of the need for government to operate more strongly on the national and global level.



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