Internet Taxation in the U.S.A. Controversy revolves around the taxation of Internet sales activity and Internet access. The question generating this controversy is: Should the Internet be a tax-free zone in the United States? On the side supporting at least a moratorium on Internet taxation are the some members of the Federal Government and some business people. Opposing a completely tax-free zone are some of the state governors and local government officials. This paper will present arguments supporting a tax-free zone and the arguments in opposition to a tax-free zone, the current status of the issue, and the steps required to resolve the issue.

To begin the analysis of the situation, definition of some terms is necessary. When a transaction occurs between a seller and a buyer, the seller may be required to collect applicable state and local sales tax from the buyer. The requirement is based on whether or not the seller has a "physical presence," referred to as nexus, in the state where the sale occurred. Examples of nexus would be a retail store or a warehouse in the state. The companies with a number of physical locations are generally referred to as "brick-and-mortar" entities. If the seller does not have nexus in the state, they are not required to collect sales tax. The buyer may be required by the state to pay a use tax to the state. Most mail order sellers and Internet, e-commerce, sellers have nexus in few states and localities. In many case they have only one location.

With the substantial growth in buying over the Internet, an increasing percentage of sales do not require the collection of sales tax by the seller. Due to the large number of buyers and the small dollar value of purchases by a single buyer, collecting use tax presents a significant problem for the states and localities. Most of the discussion has focused on sales tax, but a tax based on access to the Internet is another form of potential taxation. An access tax is charged to people who use the Internet regardless of whether they do transactions over the Internet.

"Furthermore, state laws already exempt most of what is sold over the Internet. State sales taxes generally apply only to tangible goods, whereas virtually all services are exempt, as well as such things commonly purchased over the Internet as airline tickets and stock trades. The Supreme Court ruled in Quill Corp. Vs. North Dakota in 1992 that states could not compel a seller to withhold sales taxes unless the business had a physical presence in that state. Thus some Internet sellers with operations in many states, such as Barnes & Noble, have set up their Internet sales operations as legally separate companies. Since BarnesandNoble.com has no physical presence outside of where its computers and warehouses are located, no sales taxes need be charged on most of its sales." (Bartlett)

A look at the history of Internet tax legislation helps to show which of the groups has had the stronger influence over the past few years. Legislation placing a moratorium on new taxes related to the Internet was under consideration in 1998. At the time President Clinton supported the proposed moratorium. Most members of the Federal Government also supported a moratorium.

"Clinton's support of the Internet Tax Freedom Act currently before Congress puts him at odds with the nation's governors, who want to establish a single sales tax rate for online shopping. To mollify the governors, Clinton called for a bipartisan commission of elected officials, business leaders, consumers and representatives of the Treasury Department to study the issue of taxing the Internet." (King)

The length of the moratorium was the only real subject of debate at the federal level.

"The president did not endorse a specific time limit for the moratorium; a related House bill calls for six years, while a Senate bill calls for an unspecified moratorium." (King)

The legislation, known as the Internet Tax Freedom Act (ITFA), was enacted with a three-year moratorium set to expire on October 21, 2001. This legislation did not prevent state and local governments from collecting any existing taxes. The legislation did prevent the imposition of any new taxes.

The legislation included the establishment of the bipartisan commission, eventually named the Advisory Commission on Electronic Commerce, proposed by President Clinton. The mandate of the commission was to present a recommendation the United States Congress.

"A commission advising Congress on whether and how Internet commerce should be taxed fell into disarray today, with members trading heated accusations and increasingly likely to go back to Congress with no recommendation at all." (Johnston)

"With the business members and anti-tax faction aligned,...

But the law creating the commission, the Internet Tax Freedom Act, requires a two-thirds majority, or 13 votes, for any 'findings and recommendations' to Congress." (Johnston)
Of the 19 members on the commission six represented business and eight represented state and local governments. The expectation would be that the six business members reflect a good cross-section of business interests. However the retail industry did not have a member on the commission. Therefore major retail companies felt that the six business members did not appropriately represent their interests. The retailers perceived that the six were concerned about their own businesses and not the retail business. The business members confused the situation even further by adding recommendations beyond the Internet sales tax issue.

"That open door [continuing commission meetings via telephone] could also result in votes on two tax breaks Mr. Armstrong seeks for AT&T and which, if voted on separately, would win the backing of 16 commissioners and perhaps all 19. They would eliminate the 3% federal excise tax on telephone service -- adopted as an emergency measure to finance the Spanish-American War in 1898, at a time just a handful of people had telephones -- and reduce the overall taxes on phone companies since they are no longer regulated monopolies." (Johnston)

"The commission's members, drawn both from government and private industry, divided into three camps -- the five antitax members, led by Governor Gilmore; the six representatives of businesses, all with major Internet interests; and the eight others, mostly from government at various levels and led by Governor Leavitt, who say that the way an item is sold should have no effect on how it is taxed. The stakes are high. Sales taxes are the largest single source of revenue for state and local governments, approaching half the money they take in. And many officials fear that as sales migrate to the Internet, that revenue will be lost, forcing higher income and property taxes." (Johnston)

Ironically the commission members from government did not necessarily agree among themselves. The expectation would be that the government members would be universally in favor of taxing Internet activity because the state and local governments would be losing tax revenues. In fact, the governor of Virginia who chaired the commission led the anti-tax forces, while the mayor of Dallas supported taxing Internet activity.

The bipartisan committee is an excellent microcosm of the differing opinions on the Internet tax debate. It was not even possible to get two-thirds of 19 people to agree on a recommendation. A variety of studies substantiate the potential for lost sales tax revenue.

"The lack of required Internet sales tax collection will force states to make tough decisions in the future, the study said. Texas, for example, will lose $4.8 billion annually to online sales by 2011, or 'almost 10% of the state's total expected tax collections,' said Donald Bruce, the study's [Center for Business and Economic Research at the University of Tennessee using data from Forrester Research] other co-author. That will force the state to either raise its tax rate by more than a 1.5% or find ways to cut spending, he added." (Regan)

Mike Leavitt, the Republican governor of Utah and chairman of the Governors' Association, brought revised proposals to the Congress in an attempt to reach a compromise.

"The goal, Leavitt said, should be to create a uniform sales-tax system for sellers of all kinds: traditional retail stores, catalogs, Internet outlets and toll-free telephone peddlers." (The Associated Press, qtd. In New York Times)

"In an effort to reach agreement, Leavitt said the governors association is revising its Internet sales-tax proposal in three key ways:

Exempting small Internet sellers from collecting sales taxes until they reach a specified minimum business volume.

Scrapping a proposal for creation of a "trusted third party" to collect and remit sales taxes. Instead, a way would be developed to adapt the current system.

Extension of the moratorium on taxes that single out the Internet, which expires in October 2001."

(The Associated Press, qtd. In New York Times)

The discussion over the past three years has not brought the governors much closer together.

"While neither governor [Engler and Gilmore] opposes an extension of the moratorium, their opinions diverge on what should happen after 2006. Engler [Michigan governor, vice chairman of the National Governors Association] argued that as e-tailing continues to grow in popularity, the 'Internet should not be a way for buyers and sellers…