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Taxation and the Cyber-Frontier:
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A Framework for Economic Growth

By

Jack Kemp
Co-Director
Empower America

Submitted to the
ADVISORY COMMISSION on ELECTRONIC COMMERCE

December 14, 1999


"There occurs at breathtaking moments in history an exhilarating burst of energy and motivation, of hope and zest and imagination, and a severing of the bonds that normally hold in check the full release of human possibilities. A door is opened, and the caged eagle soars."
John Gardner, author

Reading these words, one cannot help but imagine that we are now living at one such moment in history. On the eve of the 21st Century, the burst of energy is palpable. Increased communication and wider interaction among the people of the world, expanded commerce — all of these greatly increase our potential for discovery and growth. Young people are fascinated with computers and gadgets and machines. And the rest of us, who may be merely young at heart, marvel at the daily news of the latest discoveries and inventions and contemplate the changes on the horizon. It does seem as if a door is being opened. But this is not just any door. This is the door into a new era, and through it the Internet is taking flight over the threshold.

In late 1999, there are more than 100 million American adults using the Internet, up from 65 million in mid-1998 and 84 million at the end of 1998. According to a University of Texas study, Internet-economy revenues are expected to reach $1.2 trillion by 2002, rivaling health care as the nation's largest industrial sector. Between 1970 and 1997, Detroit's share of America's industrial production has ranged between 4 and 6 percent, and now hovers at just below 6. Silicon Valley's share of our nation's industrial output, however, has followed a steady upward path from just over 1 percent in 1970 to 8 percent in 1998, having overtaken Detroit for good in 1995. Between 25 and 33 percent of America's economic growth in the 1990s has been due to the information-technology sector.

These statistics register a seismic shift to be sure, one that we should welcome and encourage. A free and dynamic economy fueled by technological progress and free trade has proven over the centuries to be mankind's best strategy for protecting and expanding liberty, opportunity, wealth, and indeed peace to the greatest number of our fellow humans. With an unmatched capacity for ubiquitous and instantaneous communications, the Internet may now become our best hope for spreading the ideas of capitalism and seeding the world with democracy and the rule of law. Therefore, the Internet—cyberspace generally—must be viewed as much more than just another means or "form of doing business." Information technology and the Internet comprise the framework and the backbone of the new-era, computer-based economy. They create an entirely new economic infrastructure that expands and enhances the marketplace -- of ideas as well as goods -- for the whole world.

The effects of this new economic infrastructure extend far beyond mere commerce. The Internet is an agent of revolutionary change in the way people worldwide communicate and interact with each other, socially, politically and culturally as well as economically. A free and unfettered Internet will hasten the day when Democratic Capitalism comes to people who today are struggling against privation, dictatorship and oppression. Consequently, Empower America believes that any policies—state, local, federal or international—that inhibit or retard the development and operation of the Internet should be held to a heavy burden of proof before being adopted.

By establishing the Advisory Commission on Electronic Commerce (ACEC), the United States Congress has acknowledged the fact that the Internet presents many new public policy challenges. Recognizing these challenges, the Congress has charged the Commission with studying federal, state, local, and international taxation and tariff treatment of the Internet and transactions executed on it. Additionally, the Commission is tasked specifically to examine model state legislation, such as that put forth recently by the National Governors Association (NGA), that would affect the way states and localities tax Internet transactions.

Empower America believes that it is important for the Commission to maintain a broad focus as it conducts its work. The seismic shift currently underway in the economy calls us not only to evaluate the immediate good and harm that could come from new taxes aimed specifically at the Internet or extensions of taxes that are currently levied on activities occurring on the Internet, but also to reevaluate our whole set of existing economic policies that impact the Internet directly and indirectly, with the federal tax code at the very top of the list. Congress cannot make serious and far-ranging decisions regarding Internet taxation and regulation in a vacuum. It would make little sense, for example, to lock in new nation-wide policies to tax the Internet until we are prepared to replace the seven-million-word abomination called the Internal Revenue Code.

Therefore, Empower America believes that in order to provide Congress the most useful policy guidance, the Commission's studies and the recommendations that flow from them should extend beyond narrow questions of tax administration and revenue generation. The Commission should focus broadly on how policies that govern the economic infrastructure being erected in cyberspace ultimately affect overall entrepreneurial activity, investment behavior and economic performance in general.


Lessons from the National Commission on
Economic Growth and Tax Reform

The framework developed in 1996 by the National Commission on Economic Growth and Tax Reform (TRC), which was chaired by Empower America co-director Jack Kemp, can be useful in considering whether to tax the Internet and if so how. The TRC found that the current federal tax code is plagued by three principal defects: It is economically destructive, impossibly complex and overly intrusive. The Commission also found the Internal Revenue Code to be outrageously expensive and manifestly unfair and recommended that it be repealed in its entirety and replaced with a new simplified tax system for the 21st Century; one with a single low rate that taxes income only once with a generous personal exemption.

With few exceptions, little has changed legislatively in the four years since the TRC submitted its report to the Congress. Incremental changes to the federal tax code were enacted in 1997 — some for the better, some for the worse — but except for the creation of the Roth IRA and a cut in the capital gains tax rate in 1997 (and minor expansions of both in 1998), the federal tax code remains as anti-growth, anti-saving, anti-investment, anti-family and anti-entrepreneur as it was in 1996.

On the positive side of events during the past few years, these relatively minor reductions in the rates at which the returns on saving and investment are taxed have interacted beneficially with a dramatic rate of technological innovation. This virtuous cycle of investment and innovation permitted the economy to overcome much of the drag exerted on it by the anti-growth tax environment in which it operates.

Enactment of the Roth IRA (plus its minor expansion in 1998) and the 1997 cut in the capital gains tax rate (also expanded slightly in 1998) coincided closely in time with the technological lift-off of the Internet. Consequently, the recent tax rate cuts, though relatively minor in nature, had beneficial effects that were magnified well beyond what otherwise might have been expected of them. The combined effect of technological take-off and an improved investment environment launched the new-era, computer-based economy, the outlines of which we are only now beginning to glimpse. [After the introduction of graphic interfaces and the rollout of the Netscape Navigator in 1994, the Internet began to be integrated seriously into the nation's economic infrastructure. By 1996, productivity enhancements brought about by the Internet began to show up as significant increases in the statistical measures of productivity growth. After 1996, the Internet combined with the 1997/98 tax changes to boost the economy into overdrive.]

The federal tax system does not exist in splendid isolation. It interacts with the panoply of taxes levied by state and local governments, and it is the combined tax system that ultimately has a profound effect on economic performance. When the combined effects of all levels of taxation are considered, the major defects identified by the TRC are magnified. Therefore, the framework, principles and criteria developed by the TRC to evaluate methods of taxation at the national level are also valuable in evaluating proposed alterations in state and local tax laws, especially if those proposed changes have a demonstrable effect on interstate commerce or require an active role for the federal government in their enactment and/or their implementation.

In contemplating the construction of a new federal tax system, the TRC began from the proposition that we must devise a tax code that reflects America's highest values (the right to life, liberty, property and the opportunity to succeed) and unleashes her greatest potential. The Commission recognized that surely such a fair and simple tax code must generate sufficient revenue for government to carry out its legitimate tasks, but in doing so the tax system must not restrict the innovative and entrepreneurial capacities of Americans upon which rising living standards and our general prosperity so greatly depend. Not only is this general advice valid for writing a new federal tax code from scratch, but it also applies with equal merit to any incremental changes to state, local or federal tax laws that may be contemplated short of a complete overhaul.

Likewise, the six points of principle and the six specific points of policy that the TRC determined should govern major tax overhaul (See "The Tax Test," Unleashing America's Potential: A Pro-Growth, Pro-Family Tax System for the 21st Century, The National Commission Economic Growth and Tax Reform, January, Washington, DC, 1996) offer useful guidance in contemplating incremental changes in tax policy at any level of government. However, a unique problem arises when attempting to apply the TRC's 12 criteria to incremental tax changes aimed at correcting one or another specific problems: An incremental change in tax policy may bring the overall system into closer conformity with one criterion only to drive it further out of conformity with one or more of the other criteria.

It is, therefore, vitally important for lawmakers to recognize that with a tax system as complex and flawed as the current one, it may be impossible to fix one problem incrementally without creating another set of (perhaps even worse) problems in the process. And, since the current tax system taxes the return on saving and investment so many times and at such high rates, this warning applies especially in cases where the "improvement" contemplated entails a tax rate increase on one or more sectors or economic activities. The current tax system is such a jumble of conflicting, contradictory and tangled provisions, interacting in unexpected and harmful ways both within each single tax system and among the various governmental levels of taxation, that attempting to fix any one specific set of problems incrementally can be like attempting to level a table by sawing off one leg at a time: a counterproductive exercise leaving one with a table that is equally or even more unstable and smaller to boot.

Put simply, the questions of whether to tax the Internet, and if so how and by whom, can only really be decided in the context of comprehensive tax reform.

Unfortunately, the focus on reducing tax rates and eliminating other tax impediments to economic growth, not to mention interest in a complete overhaul of the tax system, seem to have given way to a preoccupation with retiring public debt, increasing public spending and levying new taxes on the Internet eagle that has been laying the golden eggs. Under the guise of "fairness" and a need for additional government revenues, some sectors of the business community and many state and local officials have embarked on a campaign to regulate the Internet, to levy fees on Internet usage and/or collect new taxes on Internet sales.

The Current Tax Climate in Cyberspace

President Ronald Reagan identified the predisposition in Congress to be, "if it moves, tax it." President Reagan's dictum still holds, it seems, not only in Washington but also in state and foreign capitals, even if it moves at the speed of light. No sooner was the Internet a reality than efforts were underway to tax it—in the Congress, in state capitals and even at the United Nations. This time, however, two Members of Congress themselves moved at lightening speed to forestall this knee-jerk reaction. Sen. Ron Wyden (D-OR) and Rep. Christopher Cox (R-CA) introduced and Congress enacted The Internet Tax Freedom Act, which contained a moratorium on new Internet taxation. The purpose of the legislation, in the words of Sen. Wyden, "is to try to figure out a rational Internet tax policy. This may mean no taxes at all, or it may mean tax equality for all transactions, no matter the technology."

The moratorium did not bestow any new privileges or advantages on cyberspace businesses, it merely put a stop to the unseemly rush to lard new taxes on top of those already affecting this new universe: i.e., bandwidth taxes, byte taxes, access fees, multiple and discriminatory taxes on the Internet itself and novel new definitions of "nexus" to permit states to force Internet companies to collect sales and use taxes on remote Internet sales even when those firms have no real presence within a state. The moratorium allows for the imposition and collection of state and local sales and use taxes on electronic business, at a rate no greater and no less and under circumstances no different than those currently imposed on phone- and mail order companies. Because the authors of the legislation recognized that the Internet is inherently susceptible to multiple and discriminatory taxation in a way that commerce conducted in more traditional ways is not, the moratorium likewise seeks to prevent the Internet from being singled out and taxed discriminatorily in new and creative ways.

Applying the Principles of the TRC

Advocates of taxing the Internet begin from the premise that most state and local sales and use taxes currently go uncollected from remote sales over the Internet. This fact rankles state and local officials who argue they're not getting all the revenue due them. It also irritates merchants who sell merchandise face to face out of a storefront and must collect the sales and use tax from the consumer and feel they are put at a competitive disadvantage vis-à-vis online merchants.

But this situation is not new. For more than 30 years now, state and local officials and representatives of the retail-sales industry have also rankled at the fact that most sales and use taxes levied on remote mail-order and phone sales are not collected due the well established constitutional prohibition against states extending their tax reach beyond their own borders to force firms with no presence in a state to collect its taxes for it. The advent of the Internet does not alter these constitutional considerations but it has provided the state-and-local-government lobby a fresh opportunity to reopen this old issue, even though it has been a matter of settled law for many years now. In effect, the state-and-local-government lobby has found a new pretext for taking away from companies engaged in remote sales—all remote sales, not just over the Internet—the legal and Constitutional protections against tax overreach by state and local governments.

The Principle of Fairness and Tax Neutrality

The advocates of extending the states' taxing authority beyond their borders observe that the current restrictions confer a competitive price advantage on firms that sell their products through e-commerce relative to retail businesses that sell directly to customers face-to-face out of a storefront and must collect the tax. In the framework of the TRC, this situation might be argued to violate the principle of neutrality, which holds that a tax system should not pick winners or play favorites but allow people freely to make decisions based on their own needs and dreams. "Taxes cannot help but raise the cost of everything they fall on. But at least they should fall on things neutrally without penalizing one form of economic behavior and promoting another." (TRC, p. 20.) Quoting Senator Robert Bennett of Utah, the TRC pointed out that, "Neutrality means that the tax code should not be used to punish the bad guys and reward the good guys." (TRC, p. 20.)

In the eyes of retail merchants who feel the economic pinch of a competitive disadvantage and among state and local officials who feel deprived of tax revenue, a situation that allows Internet sales to avoid the sales and use tax is viewed as "administratively inefficient" and "unfair" because it does not treat all merchants "neutrally." "How" a product or service is sold, they contend, is not relevant to whether or not the transaction should be taxed. Thus, they argue, government should take the steps necessary to "level the playing field" between retail and "e-tail" forms of doing business. In the case of sales and use taxes, doing so would require the Congress to overturn more than thirty years of judicial case law, perhaps even amending the Constitution and probably getting itself involved in assisting state and local governments collect the tax, if not actually collecting the tax on their behalf.

The non-neutrality decried by the advocates of expanding states' taxing authority beyond their own borders, however, is not the kind of intentional bias the TRC had in mind when inveighing against non-neutral tax code provisions. The disparity in tax treatment at issue here is a direct consequence of the constitutional design of American federalism and the checks and balances intricately woven into its fabric. While the American system of federalism invests states with an extensive and independent power to tax, it simultaneously limits that power by restricting the states' taxing authority to reach no further than its own geographic boundaries. While that limitation may doubtlessly prove frustrating to state and local public officials in their endeavors to raise tax revenue, especially when technological innovations such as the Internet suddenly alter the economic landscape in which they are accustomed to operating, frustration is not a legitimate justification for altering the constitutional order.

No "tax bias" favoring remote sales merchants can be found in any provision of the federal tax code nor in any other federal statute, and there is no "tax bias" resulting from a conscious policy decision by Congress to benefit remote Internet sales at the expense of traditional store-front, face-to-face sales. Moreover, what the state-and-local-government/retail sales lobbies characterize as "unfair non-neutrality" is not a phenomenon that easily can be remedied by any legislative body without imposing undeserved injury on innocent businesses and individuals and without causing significant collateral damage to the overall economy. In other words, the tax disparity that has arisen between "e-tail" and storefront retail sales arises naturally as a consequence of technological innovation in a marketplace that operates in a legal framework of federalism. The only way to eliminate the disparate tax treatment would be for governments to take extraordinarily coercive and intrusive actions to collect a tax that is in practical terms uncollectable at a reasonable cost to individuals and society at large.

Second, the tax disparity complained of by the advocates of Internet taxation is neither new nor uniquely related to the Internet. It goes back more than 30 years to the rise in remote mail-order sales, which also escape most sales and use taxes, not as a result of electronic wizardry, but by virtue of the fact that the Constitution bars states and localities from forcing a person or firm not present in the state to collect their taxes for them. The fact that most sales and use tax revenue levied on remote mail order sales is never collected reflects the cold reality that while states and their subdivisions may possess the authority to levy a sales or use tax on any consumer within their boundaries, it does not necessarily follow that they possess the practical constitutional means by which to collect it.

There is, of course, always a trade-off between ease of collection of a tax and individuals' rights and freedoms. The case of remote Internet sales offers a glimpse of what will become a vexing problem for government in the Cyber Age, and the vexation will increasingly apply to other forms of taxation as well.

All of life is unfair from some vantage point. By its very nature, scientific innovation, such as the Internet, confers an advantage on those businesses and individuals situated to take advantage of it and, conversely, puts all other competitors at a disadvantage. Such is the "creative destruction" at play in the operation of free markets. While the resentment of those disadvantaged in this process is understandable, it is essential that the political process not be abused by interested parties to enlist federal intervention on their behalf in a way that would interrupt the natural and socially beneficial operation of the market. In fact, the real violation of the TRC's neutrality principle would be for the federal government to intervene on behalf of technologically disadvantaged merchants to stifle the salutatory effects of creative destruction wrought by the Internet by inflicting a tax penalty on their competitors.

Empower America urges the Commission to recommend to Congress a principle that as technology imposes new obstacles to government taxation, government must place the rights and freedom of the individual above its bureaucratic convenience and fiscal interest in collecting tax revenue. Moreover, government should reject arguments by one sector of society that the "unfairness" or "administrative inefficiency" created as a byproduct of technological advance is in any way a justification for "leveling the playing field" or achieving administrative efficiency at the expense of individuals and firms in the technologically advantaged sector.

Does The Internet Get A Tax-Free Ride?

The Internet tax moratorium has helped foster a myth that the Internet is getting special treatment and a tax-free ride, which, ostensibly, harms more traditional "bricks-and-mortar" businesses and depletes state and local coffers. Despite what the public might be led to believe, companies that do business on the Internet carry their own weight. There are no additional legal and constitutional protections extended to them that traditional "bricks-and-mortar" businesses don't already enjoy. Companies that conduct business via the Internet pay corporate income taxes, local property taxes, taxes on telecommunications carriers, non-discriminatory business license taxes. They collect non-discriminatory sales taxes and pay other taxes and fees to the state and local governments where they reside and place demands on public services. They pay the appropriate payroll taxes on their employees, and they are subject to the same state, local and federal regulations that affect other businesses.

The empirical evidence is quite clear that far from a being a drain on government coffers, cyberspace has been an overall boon to the economy and to state, local and federal treasuries. By 1996, the Internet was producing dramatic gains in productivity and was helping to pull the economy out of the slow-growth rut it had been mired in since the early 1990's recession and the 1993 tax increase. Thanks to the productivity enhancements emanating from the Internet, the economy was by that time expanding again by more than three percent a year. The deficit was in a free fall. Then, in 1997, for the first time in almost a decade, Congress reduced tax rates by cutting the capital gains tax rate and creating Roth IRAs, which eliminated one entire layer of taxation on retirement saving. Investment boomed and economic growth jumped to more than 4 percent a year for two consecutive years and remains close to, if not more than, 4 percent for a third straight year.

By 1998, the soaring economy had put the federal budget in surplus by $69 billion, and the Congressional Budget Office was projecting large federal budget surpluses as far as the eye could see. (This year, FY 1999, the federal accounts closed $123 billion in surplus.) In 1996, with productivity surging, inflation non-existent and real incomes and profits on the rise, "real-bracket-creep" pushed federal revenues up as a share of gross domestic product (GDP) to 19 percent for the first time since 1981 when inflation-generated bracket creep was fueling the progressive income tax to confiscate an increasing share of national output each year. As Internet-boosted productivity growth continues, revenues will amount to 21 percent or more of GDP this year, an all time high. See Chart 1.
Chart 1 shows that the same pattern holds true at the state level as well. Total state revenues from all sources—including taxes on businesses, individual income, sales, and property, and other excise taxes and fees—have been rising consistently throughout the first few years of the Internet era. Revenue growth from 1996 though 1998 averaged 5.6 percent a year. Combined state and local revenues as a share of GDP hit an all time high of 11 percent in 1995 and remain near that high point today at more than 10.7 percent.

Moreover, state sales tax collections in particular have risen consistently since the advent of the Internet. In 1994, the year Netscape made the Internet browser famous, states collected $123 billion in sales taxes. By 1995 when the fist real e-commerce transactions had been registered, states collected $132.2 billion in sales taxes. As Internet use and e-commerce proliferated, sales tax revenues did not shrink but continued to rise. States collected $139.4 billion in 1996, $147.1 billion in 1997, and $155.3 billion in 1998. A recent CATO Institute study showed that state sales tax revenues grew at nearly twice the rate of inflation between 1992 and 1998.

One cannot simply rely on sales tax figures, however, when evaluating the Internet's impact on state treasuries and on the economy as a whole. Other non-sales tax revenue streams must be considered as well.

State revenues from all sources -- including taxes on businesses, individual income, sales, and property, and other excise taxes and fees -- have been rising consistently throughout the first few years of the Internet era. The chart below shows that total state revenues have increased an average of 5.8 percent from 1993 through 1998. What is remarkable is that the percentage increases have remained so strong. Revenue growth from 1995 though 1998 also averaged 5.8 percent. In 1993, many states were still recovering from the recession of 1990-91, and a 6.5 percent increase in 1993 could be at least partially attributable to lackluster revenues in the previous years. Revenue growth of 6.6 percent in 1998, however, compounds at least 5 consecutive years of strong increases.

Year

This revenue growth, moreover, is far outpacing the rate of inflation even as many states cut tax rates and eliminate other taxes and fees altogether. The Internet Economy is responsible for between 25 and 33 percent of America's economic growth over the last five years. The Internet encourages entrepreneurship and new business starts. It increases worker productivity. And the downward pressure it exerts on prices assists the Federal Reserve in its efforts to keep inflation low. It seems reasonable to say that more than any other factor in the mid- to late-1990s, it is the Internet (a largely unencumbered Internet, remember) that has been responsible for a vibrant U.S. economy, strong state economies, and robust state revenue growth.

On Strawmen, Non-Problems And Real Problems That Solve Themselves

Utah Governor Michael Leavitt, speaking on behalf of the National Governors Association (NGA) at the National Press Club on November 16, 1999, acknowledged that uncollected sales and use taxes from Internet sales pose no fiscal problem currently. The Governors' concern is that as e-commerce expands, uncollected taxes will also increase and pose a revenue problem for state and local governments. This concern is misplaced. It arises from a static view of the relationship between a growing economy and government revenues. This static framework leads the state-and-local lobby erroneously to focus narrowly on the static "revenue loss" that supposedly occurs because states' are constitutionally prohibited from forcing Internet companies outside their borders to collect sales and use taxes on remote e-commerce transactions. It is the same kind of static mentality that Ronald Reagan confronted in cutting tax rates in the early 1980s.

It is misleading to focus statically on so-called "lost" sales tax revenues from remote sales when evaluating the Internet's impact on state treasuries. First, there is no evidence that the Internet has given rise to a zero-sum game between e-commerce and local-merchant purchases, and there is every reason to anticipate a positive-sum relationship. For example, the advent of the VCR did not mean that people stopped going to the cinema to view movies. People still value, and are willing to pay a fair amount to enjoy, the "theater experience." The overall movie industry today has never been stronger.

There is every reason to believe that if policy makers do not undermine economic growth with ill-conceived policies, the retail-sales industry will continue to evolve, adapt and thrive in this changing environment.

Governor Leavitt himself, ironically, offered a profound insight that undermines the pessimism espoused by his own organization. "In the Century ahead, 'e-tailing' will not simply replace brick-and-mortar retailing. The two will converge in a new world of 'clicks and mortar.'" How right he is when he predicts that, "The successful retailer of the future will have a retail presence, a catalogue presence and an Internet presence." Where he goes astray, however, is in failing to see the implications of his own insight. He says, "convergence [between e-tailing and brick-and-mortar retailing] demands a level playing field as its first principle." But, convergence doesn't demand a level playing field a priori, and by implication with government policy to do the leveling. The convergence itself will create the level playing field without government having to lift a finger. The very retail-presence/storefront-locations that Governor Leavitt foresees will create nexus and solve the problem about which the NGA and her sister "public interest groups" are currently wringing their hands. (Empower America believes that the Court will pierce the veil of efforts by companies selling the same merchandise online and over the counter to organize their ecommerce operations into artificial separate legal entities to break the nexus for sales tax purposes and hold them to collect the sales and use tax.)


Listen to the Governor's own prediction: "Amazon.com recently established six distribution centers throughout the country. This gives Amazon nexus to those seven states—the physical connection that triggers the obligation under the laws of those states and their municipalities [sic -- what he really means is "under the Commerce Clause rulings of the Supreme Court] to collect sales tax. It means even Amazon.com will be subject to an Industrial Age sales tax system." If, as the Governor predicts, "savvy consumers expect to be able to integrate the Web with in-store shopping," which is quite likely, the problem of uncollected sales taxes solves itself. QED.

Empower America does take serious exception with Governor Leavitt's construction of two straw men to create the impression of serious problems where none actually exist. The first case is where he describes a single brick-and-mortar store with a cash register, a catalog mail order terminal and an Internet terminal allowing customers using both the catalog and Internet forms of ordering to avoid the sales or use tax while the customer one aisle over paying at the cash register must pony up the tax. "Would this be fair?" he asks, not bothering to mention that not only would it not be fair it would be illegal. The very existence of the store front and the physical presence of the computer terminals in it would be sufficient to establish a nexus obligating the business to collect the sales tax on purchases made from the store.

The second over-stated problem relates to what Governor Leavitt describes as a "campaign to prohibit state and local governments from creating tax systems in their own communities." The only effort that approaches this description consists of a single bill introduced by Senator John McCain (hardly a campaign) that would have the federal government completely preempt states from even collecting the sales or use tax on Internet sales within the state. Empower America happens to agree that this is a very bad idea and opposes it. However, it is duplicitous for the state-and-local-government lobby to take an isolated instance of a bad idea (Senator McCain's bill) and associate it in the minds of the public with the very good idea of a moratorium on new Internet taxes and on new state authority to force companies to collect sales and use taxes on remote Internet sales even when those companies do not have a real presence in the state.

Once all the strawmen, non-problems and real problems that will correct themselves are swept aside, a dynamic view of the Internet economy reveals a much more optimistic outlook for state revenues in the upcoming cyber-century than the state-and-local lobby would have us believe. Ernst & Young has produced an estimate of sales and use taxes not collected in 1998 as a result of the increase in remote sales from the Internet: $170 million. That is only one-tenth of one percent of total state and local sales and use tax collections. Anyway, eighty percent of transactions conducted online are business-to-business sales, which are either non-taxable or paid directly by in-state business purchasers, and most of the business-to-consumer transactions are non-taxable securities and information services, or airline tickets for which applicable taxes are in fact collected.

Furthermore, states are not as dependent on sales tax revenues as their lobbyists would have the Commission believe. While salivating over all the sales tax revenue "lost" to remote sales, state and local officials tend to overlook the fact that more aggressive efforts to coerce and/or entice companies to collect these taxes will set in motion reactions by consumers and online firms that will thwart the collection efforts.

Sixty percent of state revenue and 75 percent of state and local revenue combined comes from non-sales taxes, such as income and property taxes. A static estimate used by NGA puts the revenue "loss" from uncollected sales taxes at $10 billion in 2003. A more realistic study out of the University of Chicago, which takes consumers' behavioral responses into account, estimates that the volume of sales over the Internet would decline 30 percent if sales taxes were collected on all remote Internet sales as consumers purchased less (anywhere from one-third to three-fourths less according to the empirical research). This study places the revenue "loss" from uncollected sales and use taxes at $2.6 billion in 2002.

The reduction in overall GDP from more aggressive efforts to collect sales and use taxes on remote Internet sales would result from more than just reduced retail sales. It would come about as the entire information technology industry contracted in reaction to the gloomier outlook for e-commerce. Right now, e-commerce is the tip of the Internet economy iceberg: only about 35 percent of all revenues in the Internet economy came from e-commerce in 1999. The remaining 65 percent came from the infrastructure, applications and intermediary companies that build and maintain the hard and soft framework and backbone of cyberspace. In the first quarter of 1999, the Internet infrastructure, application and intermediary companies generated $80 billion in revenue compared to $37.5 billion in e-commerce.

To appreciate the fallacy of the static framework employed by the state-and-local-government lobby, consider the findings of Prof. Goolsbee of the University of Chicago that if more aggressive efforts to collect these taxes on remote Internet sales reduced economic growth by no more than one-third of one percentage point, the dynamic revenue lost from other sources would offset any additional sales tax revenue likely to be collected, and the considerable collateral damage done to the Internet would be on top of that.

Empower America does not believe the state-and-local-government makes a persuasive case that the current tax treatment of remote Internet sales will pose a significant threat to the ability of states and local governments to raise sufficient revenues to carry out their legitimate governmental functions.

The International Perspective

Right now, the U.S. Trade Representative is trying to convince the international community to support a tariff-free Internet. An opportunity to adopt a permanent moratorium on Internet tariffs was lost in Seattle earlier this month when the WTO ministerial talks collapsed. While it is true that a temporary international moratorium on Internet tariffs remains in place "until further notice," the cloud of uncertainty over the issue can only be heightened by growing doubts after Seattle that the WTO can enforce its own accords. For example, what happens if country A decides to impose a tariff on the sales of goods via e-commerce? Can it effectively be stopped? When the system of rules comes into serious question, rules are apt to be broken.

The international moratorium on Internet tariffs is an important initiative and could be central to the development of a truly open worldwide marketplace. We oppose tariffs because they represent a wedge between producers and consumers and lead to unproductive behavior and inefficient markets. Remember, however, that tariffs are taxes, and taxes are tariffs. Today, domestic sales taxes are levied primarily on those living in a certain state. But as we have seen with remote catalog sales, and as we will increasingly see with sales over the Internet, sales taxes more and more resemble what we have traditionally called tariffs. tar-iff \'tar-&f\ n A duty…imposed by a government on imported or exported goods. The Merriam Webster Dictionary, Home and Office Edition, 1995. We should ask ourselves a few provocative questions:

1. Could you imagine if the U.S. government imposed a sales tax on overseas importers of American goods? That is, would we ever think about taxing foreign businesses and consumers when they buy our goods and thus discouraging U.S. exports? No. Why, then, would we consider a new national mandate on inter-state sales tax payments?

2. How can we discourage other nations from imposing tariffs and trade-barriers in cyberspace even as we, here at home, are erecting and strengthening cyber-walls between the companies and consumers in the various United States? Doesn't the formal establishment of a tariff regime among the states make our push for free trade among the nations hypocritical?

In addition, we must take seriously the potential of an Offshore Effect. For years we've understood and seen the effects of rapid capital mobility. Now, we must face the reality of rapid business mobility. We are not referring to the huge corporation deciding to build a monstrous factory in a third-world backwater sometime next year. No, we refer to the working mom who operates her own Internet site moving her server overseas in about as much time as it takes to sign up with a new Internet service provider. When asked about this subject at a November 3, 1999, forum sponsored by the National Chamber Foundation, Todd Mogren of CoastalTool.com remarked, "We could move our entire e-commerce operation in about 4 hours."

Some are worried that small Caribbean or South Pacific island-nations will set up Internet havens featuring low taxes and friendly regulations and steal away e-commerce businesses from leading industrial nations. We say, Why don't we ensure that the United States remains the Internet haven of the world?

The Governors' Proposal

Brief Analysis of the "Pro-Internet Tax" Position

It may be helpful to demonstrate the point about considering Internet taxation in the context of comprehensive tax reform if we take a hard look at the details and implications of one plan that would create a new national sales tax regime. The highest profile "pro-tax" plan is the one proposed by the National Governors' Association (NGA).

The NGA has proposed a two-step process on the way to a "uniform" national sales tax regime beginning with the Internet. The first step would be to create a "zero burden", "voluntary" "pilot program" under which retailers would cooperate with states and Trusted Third Parties (TTPs) to "collect sales and use taxes that may be owed by purchasers." The second step would be to "adopt a completely unified system [for levying and collecting sales and use taxes] over the next 6-8 year time period," based on the pilot program and under which all states and all U.S. businesses and consumers would operate. According the plan's main sponsor, the plan is based on the American system of federalism and states' rights. Empower America disagrees. The plan is the very antithesis of American Federalism.

Initially, the NGA scheme may look innocuous enough because the first step is really an outgrowth of a current common practice by which individual states cooperate with other states on a case-by-case, state-to-state basis. The tip off that something new is afoot, however, is the fact that the NGA proposal would presumably create some sort of interstate entity with legal authority to administer the program and license the TTPs. Businesses and states could participate in the trial program voluntarily, employing new software and bureaucratic structures to collect sales taxes on remote transactions.

The seeds of the structure, setting up the institutions and technology to administer the system, are sown in the first step. The meat of the NGA proposal, however, can be seen in the second step where the goal "is for all state and local governments to adopt the same classification systems, definitions, and audits" and for the system to "eventually be extended to all merchants and all types of transactions, regardless of whether they occur in a store, through a catalog, or via the Internet." (Emphasis added.) The first thing that can be said is that this national system of interstate taxation, which starts out as a voluntary pilot program, doesn't look so voluntary by the time we reach implementation of the second phase. For later in the NGA proposal we see that "[f]inancial incentives and penalties would be adopted to ensure that all states participate in the uniform system." Penalties are clearly incompatible with a "voluntary" system. The NGA also contends that "[s]tates that do not adopt the approachwill be denied the ability to collect taxes on remote sales until they adopt the uniform system." Does this mean that some new interstate entity could revoke or nullify those certain state-to-state remote sales agreements currently in place if one party to the agreement does not want to join the new state tax confederation?

This quite involuntary system would "include uniform sourcing rules and limitations on the extent and frequency of state and local tax law changes. Specifically, states would not be able to unilaterally make changes in the product classification, exemption definitions, or sourcing rules." Instead, a "consensus board" would make such decisions, and states would "be obligated to follow" these rules that the consensus board could only change once per year. (Emphasis added.) The NGA says states could continue to change tax rates but that they could only do so "within the uniform system." It is unclear exactly who or what would (or could) stop states from making such basic decisions. Of course, there are the NGA's "[f]inancial incentives and penalties", but we fail to see how an interstate entity could constitutionally impose such a regime.

Indeed, there appears to be a colorable argument to be made against such an interstate compact or agreement based on at least two Supreme Court cases, Virginia v. Tennessee (1893) and U.S. Steel Corp. v. Multistate Tax Compact (1978). A brief history of the Compacts and Agreements Clause is helpful:

Except for the single limitation that the consent of Congress must be obtained, the original inherent sovereign rights of the States to make compacts with each other was not surrendered under the Constitution.2038 ''The Compact,'' as the Supreme Court has put it, ''adapts to our Union of sovereign States the age-old treaty-making power of independent sovereign nations.''2039 In American history, the compact technique can be traced back to the numerous controversies that arose over the ill-defined boundaries of the original colonies. These disputes were usually resolved by negotiation, with the resulting agreement subject to approval by the Crown.2040 When the political ties with Britain were broken, the Articles of Confederation provided for appeal to Congress in all disputes between two or more States over boundaries or ''any cause whatever''2041 and required the approval of Congress for any ''treaty confederation or alliance'' to which a State should be a party.2042

The Framers of the Constitution went further. By the first clause of this section they laid down an unqualified prohibition against ''any treaty, alliance or confederation,'' and by the third clause they required the consent of Congress for ''any agreement or compact.'' The significance of this distinction was pointed out by Chief Justice Taney in Holmes v. Jennison.2043 ''As these words ('agreement or compact') could not have been idly or superfluously used by the framers of the Constitution, they cannot be construed to mean the same thing with the word treaty. They evidently mean something more, and were designed to make the prohibition more comprehensive. . . . The word 'agreement,' does not necessarily import and direct any express stipulation; nor is it necessary that it should be in writing.

''If there is a verbal understanding, to which both parties have assented, and upon which both are acting, it is an 'agreement.' And the use of all of these terms, 'treaty,' 'agreement,' 'compact,' show that it was the intention of the framers of the Constitution to use the broadest and most comprehensive terms; and that they anxiously desired to cut off all connection or communication between a State and a foreign power; and we shall fail to execute that evident intention, unless we give to the word 'agreement' its most extended signification; and so apply it as to prohibit every agreement, written or verbal, formal or informal, positive or implied, by the mutual understanding of the parties.''2044 But in Virginia v. Tennessee,2045 decided more than a half century later, the Court shifted position, holding that the unqualified prohibition of compacts and agreements between States without the consent of Congress did not apply to agreements concerning such minor matters as adjustments of boundaries, which have no tendency to increase the political powers of the contracting States or to encroach upon the just supremacy of the United States. Adhering to this later understanding of the clause, the Court found no enhancement of state power quoad the Federal Government through entry into the Multistate Tax Compact and thus sustained the agreement among participating States without congressional consent.2046 (See footnote (FindLaw.com, http://caselaw.findlaw.com/data/constitution/article01/58.html#F2045 )
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While current interpretation does not impose an outright ban on congressionally unapproved compacts and agreements, but instead permits "agreements between States…concerning such minor matters as adjustments of boundaries," the Court appears to reaffirm a constitutional requirement of congressional approval in at least two situations. In the most liberal interpretation of the Compact Clause's requirement of congressional approval (Multistate Tax Compact) the Court upheld the constitutionality of Multistate Tax Compact, even though it did not receive congressional approval, because it did not fail the tests laid down in Virginia v. Tennessee: The Compact did not "tend to increase the political powers of the contracting states or to encroach upon the just supremacy of the United States." The Court seems content to apply these two tests on a case-by-case basis and require the consent of Congress for any compact or agreement between states that fails it. In the opinion of Empower America, a strong argument can be made that the NGA Internet tax proposal violates both of these tests, and because it does not seek approval from Congress, may very well be unconstitutional.

In Multistate Tax Compact, the Court went out of its way to specify reasons why it believed the Multistate Tax Compact passed the two Virginia v. Tennessee tests and was exempt from the Compact Clause. The Court observed that under the Compact, "Individual states retain complete control over all legislative and administrative action affecting tax rates, the composition of the tax base, and the means and methods of determining tax liability and collecting any taxes due." The NGA proposal certainly fails these tests. By definition, the NGA scheme is designed specifically both to limit each individual state's ability to set tax rates and to determine the composition of the tax base and at the same time to allow the states collectively to overcome constitutional limitations on each state's individual taxing authority.

Attempting to rebut the argument that the NGA scheme fails the Multistate Tax Compact application of the Virginia v. Tennessee tests, state and local officials may be tempted to argue that by ceding each state's individual taxing authority to a supra-state authority and by drastically curtailing each state's control over the make up of their own tax system, the Governors' scheme actually results in a serious diminution of each state's political power, not an enhancement of it, and that consequently the scheme would satisfy the Court's requirement of not "increasing the political powers of the contracting states." However, this argument, to the extent that it shields the NGA plan from a clause three (Compact Clause) challenge under Article I, Section 10, may actually expose the plan to a far more serious challenge under clause one (Confederation Clause) of that same Section.

By conceding that the NGA plan transfers legal taxing authority from individual states to a new supra-state authority, and in the process expands the states' political authority collectively beyond what any one of them individually might achieve in its absence, any such argument would appear to elevate the plan above a simple "compact" or "agreement" among states to something much more treaty-like or confederation-like in nature. Another hint that more than a simple compact or agreement is in play here is evidenced in the enforcement mechanism employed. The Multistate Tax Compact was clearly no more than a contractual agreement and contained no intrinsic power to punish failure to comply with it. Enforcement, as with any other contract, was left to the courts. The NGA plan, however, vests considerable powers of enforcement in the supra-state authority in the form of financial and political penalties that it may levy.

The creation of a new collective legal authority that (1) expands the collective tax reach of the participating states beyond what they are limited to individually under the Constitution, (2) requires the participating states to harmonize their tax policies, and (3) subjects participating states to financial and political penalties if they fail to comply with the new legal authority's edicts, may well be viewed by the Court as the creation of a confederation of states or a tax treaty among the states in clear violation of clause one of Article I, Section 10 (the Confederation Clause). Alternatively, this exercise in state-level multilateralism, the ceding of state sovereignty to a supra-state bureaucratic board, may be viewed by the Court as analogous to an alliance among the states colluding to circumvent constitutional limitations on their separate individual powers, which also would be prohibited under clause one of Article I, Section 10.

Additionally, if the NGA compact can succeed in unifying policy among the 50 states on such a fundamental and far-reaching policy decision as instituting a uniform national sales tax, the question arises of whether the governors' scheme encroaches on federal supremacy given the substantial case law (Multistate Tax Compact, Quill, etc.) and the long-accepted practices of federalism governing interstate tax issues in general and remote sales in particular.

Empower America believes that it is up to the Congress, not a confederation or alliance of the states, to decide whether we need a uniform national sales tax. Therefore, Empower America urges the Commission to recommend that Congress refrain from upsetting the well established constitutional law with respect to remote sales and further that Congress exercise its powers under the Constitution to prevent the states from colluding, such as is proposed in the NGA plan, to circumvent this body of settled jurisprudence.

Beyond the legal issue, the question arises that even if the NGA plan were found to be constitutional and practicable, would it be advisable given our experience with international multilateral institutions? Historically, such bureaucratic multilateral commissions, entities, or regimes have almost without exception run into numerous problems, unforeseen by many at the time they were created, but easily predictable by now.

Look at the experiences of the European Commission. Several years ago Ireland embarked on a program to turn around its economy. They drastically cut corporate tax rates and offered incentives to foreign high-tech investors. Quickly, the Irish economy took off and in just a few years, the country became an oasis of software innovation and semiconductor manufacturing in a continent stuck in the technological and economic sand. Capital flowed to Ireland -- capital that may have previously been invested on the European mainland -- and Irish tax revenues rose as a result of economic growth. Unable -- or more likely, unwilling -- to lower their own tax rates for fear they might need to reform their bloated social welfare programs, the nations of Europe appealed to and then bullied Ireland in an attempt to get the tiny island nation to raise its tax rates and "harmonize" them with the rest of stagnating Europe. Ireland said no, cut its rates further, and continues to enjoy its newfound prosperity as the "Celtic-tiger."

[According the to the Wall Street Journal: "Attracting investment with low tax rates, the [European] Commission maintains, is the equivalent of state aid to industry and therefore verboten. The Commission demanded that Ireland play 'fair' by eliminating the 10% rate and charging all companies an across-the-board rate of 32%. In its response, Ireland , we are happy to say, pulled off a neat hat trick that manages both to meet the Commission's demands and enhance Ireland 's status as a low-tax country. In negotiations last week, Ireland agreed to eliminate the 10% rate. At the same time, it foiled the demands for 'fairness' by announcing plans to lower the tax rate for every company to 12.5%. This is one-third the average corporate tax rate in Europe. Irish citizens and the companies that employ them have every reason to cheer the result."]

It is quite probable that European nations will have to follow suit sooner or later to attract investment, jobs, and very frankly government revenue. This virtuous cycle of competition among governmental entities has worked well in our states, where leaders realized that to keep and attract business and jobs, they would have to enact more favorable tax and regulatory policies than the neighboring states. American lawmakers should be wary of those who complain of "destructive tax competition" and should once and for all abandon the zero-sum austerity model that punishes success and instead adopt a pro-growth opportunity model. If America hopes to retain its lead in the fluid and volatile world of technology, we have no other choice.

The NGA's proposal would "be implemented through a combination of uniform legislation and multistate agreements among participating states." It is not too far a stretch to compare what the NGA has in mind to the world's numerous multilateral organizations like the United Nations (UN) and the European Commission (EC). Because of its potential power over the economic policies of member states, though, the entity the NGA has in mind perhaps has more in common with the International Monetary Fund (IMF). Congress must surely examine the interstate commerce implications of any such proposal.

Over the last 30 years, no multilateral organization has had a greater impact on international economics, and none certainly has been as destructive to freedom and prosperity, as the IMF. From Yugoslavia to Thailand, from Indonesia to Pakistan, and from Brazil to Russia the IMF's multilateral bureaucrats have reeked havoc in the name of harmonization, modernization, and sustaining revenue flows to government coffers.

Through a system of "incentives and penalties", the IMF has forced upon numerous developing nations a potent economic poison -- tax increases and currency devaluation -- that has both usurped power from the policy-making bodies of these nations and also impoverished their people and government treasuries by stifling growth and debasing the value of assets.

None of these organizations has the goal of economic destruction, but the record makes it clear that these multilateral institutions, by their very nature, are driven by the incentives not of competition but collaboration, not by the democratic forces of sovereign citizens but the bloated forces of institutional back offices, and not by the market but command and control. There is good cause for skepticism when we learn of proposals to create new multilateral entities with "consensus boards" and the rest to in effect harmonize state tax policy in the name of administrative efficiency.

The leading proponent of the NGA proposal, Utah Governor Michael O. Leavitt, says states' rights and our nation's longstanding philosophy of federalism are paramount in this debate. And he has criticized "anti-Internet tax" plans because he says they use federal power to take away state authority: "Asking Congress to roll over the most important of state roles is a clear invitation for an all-powerful federal government. I would ask particularly my fellow Republicans: Are we not the party of devolution? Are we not the party that believes government closest to the people governs best?"

We agree that sustaining federalism and retaining -- or, more appropriately, reestablishing -- a clear line between the federal and state governments is crucial. But the NGA proposal does not appear to conform to its proponents' stated admiration for states' rights. As we demonstrate above, the NGA proposal turns over some of the most important state powers -- the power to formulate tax policy among them -- to an ill-defined board or commission empanelled with representatives of unknown origin. In addition, although the NGA says it does not need and asks for no assistance from Congress to implement its plan, it is difficult to see how a national interstate organization could force reluctant states to participate or reprimand states after the fact without some sort of coercion from Congress. We would oppose such coercion, but nevertheless, the NGA proposal seems to violate the principles of federalism upon which it is supposedly based. The 10th Amendment states, "The powers not delegated to the United States by the Constitution, nor prohibited by it to the States, are reserved to the States respectively, or to the people." Federalism is all about the sovereignty of the state and limitations of supra-state power.

It is important to mention that there is also at least one "anti-Internet tax" proposal that we believe violates the principles of federalism as well. A plan that denies a state the right to tax sales that take place within the state, whether over the Internet, the telephone, through the mail or over the counter, seems to deny a state its fundamental power to tax within its jurisdiction. We believe such plans are well intentioned in their enthusiasm for the possibilities of free enterprise over the Internet, but protecting the Internet from the greedy hand of government can be accomplished without doing damage to our basic tenets of states' sovereignty -- a possibility under such sweeping "no sales taxes on the Internet, period" proposals.

Governors and state legislators should guard their respective state's prerogatives very carefully. Washington has already co-opted many of the states' original powers and, many would say, violated the 10th Amendment. Citizens, it seems, may not be as thrilled with grand cooperation at the expense of local control as some might think. Imagine how alarmed taxpayers may be to find that a new "consensus board" will have control over the taxes they pay.

Of course, we have neglected to mention potentially the most important result of the NGA proposal. If it were enacted, the NGA proposal would enshrine a complicated web of 20th century tax schemes on one of the most important sources of economic growth and cultural renewal in the 21st century. The plan would take billions of dollars out of the private economy, reducing the power of workers to invest and of businesses to grow, and it would contaminate with tariffs this new worldwide network that has great potential to be the first truly global free trade zone.

It is quite possible that such a system would not be complimentary to a new federal system of taxation envisioned under comprehensive tax reform. From the publicly available details it appears that the NGA system would create a sub-national, supra-state, extra-constitutional (and possibly unconstitutional) governance body that is inconsistent with the principles of federalism and state sovereignty. And it is certain that such a system would have negative effects on consumers, businesses, entrepreneurs, and on the prospects for economic growth at the state and national levels. It is even possible that such a system, because of its inherent regulatory and tax burdens and destructive economic effects, could have an adverse impact on state and municipal revenue levels.

History of Taxation at the Federal Level

Finally, when contemplating new tax structures, it is useful as in so many disciplines to consider the lessons of history. Look at what happened to the income tax and Social Security tax regimes since their respective inceptions. When Washington began collecting Social Security payroll taxes in 1937, the total tax was 3 percent on the first $3,000 in wages for a maximum of $90. Even though explanatory government flyers at the time assured workers that this "is the most you will ever have to pay", the payroll tax, adjusted for inflation, has since risen about 1,000 percent. In 2,000, every American worker will pay 12.4 cents of every dollar earned up to $78,000. Just recently, Empower America held a citizens' forum on Social Security in Los Angeles and heard from a young couple with two children who earn about $40,000 per year. Each year they pay $5,300 in payroll taxes.

It took a Constitutional amendment to do it, but the first individual income tax was passed in 1913. Only two out of 100 American households paid the tax, and the top marginal rate was seven percent. "In fact," as Amity Shlaes points out in The Greedy Hand, "there was a floor debate at the time on whether to put a 10 percent cap in the Constitutional amendment. The answer was no -- largely because people thought the idea that the tax might ever rise that high too absurd to address." The Wilson administration, however, quickly pushed the top rate to 67 percent and started taxing corporate income. Then during World War II, income taxes were expanded to tens of millions of middle-class workers who were never supposed to be affected by the "wealth levy." Today, there are five statutory tax rates, ranging from 15 to 39.6 percent with phase outs of personal exemptions and itemized deductions that raise the effective top marginal tax rate to 43 percent for a married couple with two children.

Conclusion

Experience with the depressing evolution of the income tax and the Social Security payroll tax reinforce each of our other arguments with regard to sound pro-growth economics, federalism, and the current legal framework.

We have not addressed direct taxes on the Internet in great detail, but we want to reiterate our opposition to bandwidth taxes, bit taxes, access fees, and multiple or discriminatory taxes on the Internet itself. This amounts to support for an extension of the applicable provisions of the Internet Tax Freedom Act. We applaud continued efforts to discourage, and if possible prohibit, such taxes in the international sphere as well.

When we consider all the opportunities and unknown upsides of the Internet economy, the likely prospect that real tax reform is just around the corner, and the fact that the leading "pro-Internet tax" alternative is deeply flawed, it is apparent to us that setting out today to achieve a unified, national interstate sales tax system is highly premature. It is our forceful belief that no interstate Internet sales tax regime be considered, and certainly not be implemented, until we as a nation take action on the issue central to any discussion of taxation in the 21st century: comprehensive tax reform.