Why Cyberspace Should Be Tax Free

Sunday, July 30, 2000

A federal commission is badly split over whether to allow states to tax interstate commerce conducted on the Internet. The supporters of a moratorium on taxation, including former presidential candidates Senator John McCain and Steve Forbes and, to some extent, Vice President Al Gore, believe that web sales should not be taxed in order to encourage the growth of this revolutionary new medium for commerce. This argument is weak, but there is a much stronger case for excluding Internet commerce that relies on political-economy considerations.

Let’s begin with the 150 American tax economists, conservatives as well as liberals, who are supporting a petition against continuing the moratorium on taxation of cybershoppers. They argue that the growth of e-commerce should be driven by its convenience and competitive advantage, not by special subsidies. To make collections easier, they want taxes to be based on where consumers live, not on the location of e-commerce producers.

The argument for taxing web sales relies on the concept of economic efficiency. When Internet commerce is exempt from sales taxes, some consumers buy over the web simply because it it cheaper, not because it is more efficient or convenient. They use the Internet only because tax advantages artificially lower the cost of Internet purchases compared with traditional retailers. This is why the petition favors the same sales tax rate on Internet and brick-and-mortar retailers.

False Assumptions

University of Chicago economist Austan Goolsbee shows that the rapid growth in e-commerce is in good part due to the tax factor. He finds that Internet sales have grown more rapidly in states and localities that have higher sales taxes on retail shopping.

My economist colleagues are correct in their analyses of the efficiency effects of exempting e-commerce from taxes. But their perspective is too narrow and they do not go far enough. Their recommendations are crucially dependent on the assumptions, never made explicit, that both other taxes and government spending are independent of whether the Internet is taxed. Yet one does not have to be a cynic about governments to recognize that these assumptions are false. For their analysis of the effects of Internet taxes on revenues and spending is static and ignores the dynamic changes these taxes have on the behavior of individuals, businesses, and politicians at the state and local level.

If Internet sales are permitted to be taxed at a lower rate than brick-and-mortar retailers, these retailers are likely to put strong pressure on politicians to greatly lower, perhaps even eliminate, taxes on their sales as well. If they are politically successful, tax rates on conventional and web sales would become more equal but at much lower levels than at present. By contrast, the tax economists’ petition advocates equal treatment at the present high tax rates imposed on conventional merchandisers.

Smaller Government

A more relevant analysis would also incorporate the commonsense belief that public spending rises when governments can tax more readily. If the Internet continues to receive special exemption from all sales taxes, it should slow the increase in overall tax revenues and also slow government spending. Once this effect is recognized, the case for taxing Internet sales would not be persuasive, especially to persons who are concerned about the size of governments.

Clearly, the link between taxes and public spending is not unique to Internet taxation. A colleague, Casey Mulligan, and I have shown that public spending in most democracies does in fact grow faster when governments have easier access to more efficient taxes, such as sales, value-added, and Social Security taxes. According to our analysis, it is not surprising that both the Republican-dominated Congress and President Clinton have proposed sizable increases in federal government spending in response to the almost $2 trillion surplus in the federal budget anticipated during the coming decade. This is why I continue to maintain a prediction in an earlier essay that most of the surplus will be spent on government programs such as medical care and Social Security rather than remitted to individuals and businesses through tax reductions.

If the Internet continues to receive special exemption from all sales taxes, it should slow the increase in overall tax revenues and also slow government spending.

Of course, not everyone will like these implications of web tax exception. But surely these effects on overall tax policy and the size of government must be included in any complete evaluation of whether e-commerce should continue to be exempt from sales and other taxes.