The Internet Tax Revolt

Residents of Hennepin County, Minn., can't help but feel a swell of pride whenever they pass the Mall of America, the world's largest indoor retail enterprise and a monument to the entrepreneurial imagination. With more than 500 stores and 2.5 million square feet of space, the mall draws consumers and tourists who provide millions of dollars in sales tax revenue each year to state and local government coffers.

But another mainstay of the economy-Internet-based commerce-has Hennepin County Commissioner Randy Johnson, a self-described free-market Republican, a bit concerned about the future. With online sales of goods and services topping $1.6 billion last year and even conservative estimates putting the market at $1 trillion within five years, Johnson worries openly about how such a shift will affect local tax revenues and his ability to provide critical services such as education, law enforcement and snow removal. Losses could even affect the county's ability to maintain and upgrade its own computer systems.

"We know that we're losing revenue from the sales tax when people order taxable items over the Internet," he said, pointing out that a recent Minnesota panel studying the issue predicted that the state would lose more than $143 million in revenue during 2000. "It's hard to measure exactly how much we're losing within the county, but we know the sellers are not collecting sales tax, and the buyers are not paying the use tax that's required under state law. If things don't change over time, it could be a huge problem for us."

The question, of course, is how to modify a system for collecting taxes that is based on geographic boundaries. Revenue agents must try to put a box around a medium that has no boundaries. And something has to be done because while remote sellers have been around for some time in the form of catalog- and TV-based mail-order houses, the electronic commerce sales market eventually is expected to account for up to 75 percent of all sales.

"There is a lot of anxiety out there about how to maintain the current revenue stream," said Ralph Tabor, associate legislative director for the National Association of Counties. A recent report by the National League of Cities bears out this claim, finding that three-quarters of local officials believe that e-commerce will negatively impact their ability to provide services. "The fears are real and can't be discounted," Tabor said.

The issue is further complicated by a new breed of online commercial player who believes that putting additional taxes and paperwork burdens on an industry that must compete globally could seriously impair its growth. Austan Goolsbee, an assistant professor of economics at University of Chicago's Graduate School of Business, said that an interstate sales tax would have this immediate impact: a 24 percent decrease in the number of buyers and a 30 percent drop in e-commerce sales.

"Revenue losses are currently small, and you cannot assume that all Internet sales are diverted from retail sales," Goolsbee said.

Such statistics often fail to translate in the political arena, where experts from one side of a problem are skeptical of figures generated by the other. Take the number 30,000, for example. Tax freedom advocates say 30,000 is the number of jurisdictions that will be able to tax e-commerce businesses should uncontrolled taxation be allowed. But Hennepin County's Johnson said that when he presses tax freedom advocates for a source for the figure, they can't cite one.

On the other hand, state and local authorities who claim e-commerce is shrinking the tax base are off base, tax freedom advocates say. Mark Nebergall, a spokesman for the Internet Tax Fairness Coalition, which includes companies such as America Online and Microsoft Corp., described such opinions as rooted in a "Chicken Little" complex. "All these governments are going around yelling, 'The sky is falling, the sky is falling; we're not going to be able to educate our kids or protect our citizens or put out fires,' " Nebergall said.

"But every day, I hear news reports about how local governments are experiencing budget surpluses, and you can't tell me that doesn't have something to do with electronic commerce and the spinoff economic growth it has generated," he said. He also cited a recent report by the consulting firm Ernst & Young that found that the total sales and use taxes not collected in 1998 from Internet sales was less than $170 million, or one-tenth of 1 percent of total local sales and use tax revenues.

Yet for a state such as Washington, which has no personal income tax and takes nearly half of its revenue from sales taxes, a dramatic decrease in its tax base would spell disaster. "Sixty percent of our general budget goes to education," said Washington Gov. Gary Locke (D). "It would be ironic if electronic commerce erodes the science and math education that the visionary leaders of tomorrow need to keep this industry going."

A Balancing Act

Into this fray has stepped the newly minted Advisory Commission on Electronic Commerce-a panel of federal, state and local officials, business leaders and nonprofit association executives created last year as part of the Internet Tax Freedom Act, which placed a moratorium on collecting new sales taxes over the Internet for three years.

This heterogeneous group, with its members' competing interests, has been given 18 months to come up with a fair, equitable and simple tax plan. It then has to persuade Congress to make it happen.

Dallas Mayor Ron Kirk, a commission member, immediately laid down the gauntlet when the commission met for the first time in Williamsburg, Va., in late June. "We in the cities don't want to be an impediment to the growth of this important industry, but we also do not want to remove a major source of revenue that provides our citizens with basic everyday services," he said. "It is neither cynical nor emotional to raise the issue of what effect the buying and selling of goods over the Internet is going to have on one of our strongest sources of revenue."

Well, no one claimed that the task would be easy. But just about everyone agreed that their work was critical, with the future course of commerce-electronic and traditional-at stake. So important, in fact, that when the commission finally met face to face, members of the panel refused to discuss any quick-fix proposals for how to tax an electronic sale that might take place on a server in London or in the Caribbean or how to collect taxes on purchases without invading the privacy of individual consumers.

"Only after hearing the input of all affected parties can our proposals possibly be legitimate," said the commission chairman, Virginia Gov. James Gilmore (R). "This is vital for us developing a consensus. And only with a consensus will we be successful and will Congress value our recommendations."

A number of potential solutions have been tossed out for public consumption. And while many of them seem unlikely or impractical, a middle ground is discernible. Moreover, observers from both sides of the aisle believe that information technology will be vital to solving the problem.

The Endgame

At present, 45 states collect revenue through sales and use taxes. And many states, including California, already are collecting taxes on Internet-based sales-but only when the buyer is a resident of the state and the seller has a significant presence in the state too.

This is the so-called catalog model of taxation, brought about by Quill v. North Dakota, a U.S. Supreme Court decision which stated that companies do not have to act as tax collectors for a state unless they have a substantial physical presence-or a "nexus"-in the state. If a company doesn't meet the nexus requirement, the Supreme Court would have to change its opinion-a painstakingly slow and unlikely course of action-or Congress would have to make a revision under the Interstate Commerce Clause in order to tax the company's e-commerce sales.

Observers say the latter is likely to be one of the recommendations that the commission will offer when it sends its report to Capitol Hill in April 2000.

At least one potential solution doesn't require federal legislation: the "No Net Tax" plan that many business leaders have bandied about. The idea is that e-commerce is a such a powerful economic engine that any short-term tax revenue drop would be offset by greater economic growth and the creation of more small businesses, more jobs, higher incomes, greater income tax collection and, ultimately, a larger tax base.

Of course, state and local governments call this view pure fantasy. "It would set Internet vendors up as an elite class of vendors and put Main Street vendors at a 6, 7 [or] 8 percent competitive disadvantage right up front," Tabor said. "If we did that, we'd have to exempt all businesses from collecting sales tax. And then where would we be?"

Those who desire a free-for-all solution would have Congress remove all interstate barriers to taxation so that potential taxing jurisdictions could be given a fair shot at all interstate transactions at their own set rates and on their own terms. Business leaders complain that such a plan would put Internet vendors-especially small businesses-at a horrible disadvantage. "Main Street vendors have to collect for just one jurisdiction, but now they want to knock the remote seller over to the other side, which is to know the rates and compliance requirements of 30,000 jurisdictions," Nebergall said. "So now who's at a major disadvantage?"

The key, say most players, is to come up with a moderate plan that takes the tax structure and simplifies it to the point that remote sellers can comply with interstate tax requirements while fulfilling the bottom lines of state and local governments.

Robert Locke, finance director for Mountain View, Calif., believes Congress should set up a tax structure that not only allows for the collection of interstate taxes but sets a maximum tax rate and identifies items, such as groceries and prescription medication, that would be considered tax exempt. States could then subscribe to the plan (or choose from a couple of plans) and then legislate the new changes.

"If the administration or obligation to collect sales taxes is raised to the state level with common rules throughout a state, then you're suddenly down to just 50 rules that a business has to follow," Locke said, noting that Mountain View, a city that is home to technology titans Netscape Communications Corp., Hewlett-Packard Co. and Sun Microsystems Inc., has seen a 10 percent decline in sales tax revenues over the past year. "Each state would then be responsible for allocating those funds to the local level."

Hennepin County's Johnson notes that if there were a uniform tax system, a simple software program that includes a base state tax rate plus local options could be used by businesses to easily calculate and administer sales tax. "The software is probably already available," he said.

Another IT solution would target the privacy implications of collecting sales tax via a medium that is capable of storing the names and purchases of every citizen in the country. A server-and-software system would collect the money and forward it to the proper tax authority. "It's an electronic middleman that basically knows that a transaction occurs but it doesn't know who did it and how it was done," said Don Upson, secretary of technology and chief information officer for Virginia. "It's an interesting prospect."

Such solutions deal with only a few of "thousands of related issues," Upson said, including how to handle product sales to American consumers that take place on American company-owned servers based in foreign countries and how to tax the sale of digital goods and intellectual property such as software and computer-

generated music. Mountain View's Locke suggests that the server location be taken out of the equation by basing the point of sale on where the company's headquarters are located, and Hennepin County's Johnson pointed out that software and computer-generated music transactions may prove to be undetectable and therefore untaxable.

Whatever the solution, Internet vendors seem resigned to accepting some form of interstate tax as long as it's simple, fair, nondiscriminatory and equitable. "Tax advantages are not what's going to allow the Internet to grow," said John Sigdmore, vice chairman and chief operating officer of MCI WorldCom and a member of the e-commerce commission. "We don't believe it's feasible or fair to tax one form of commerce differently than another. But whether or not we want to collect sales tax for 30,000 different taxing jurisdictions is another matter altogether."

Localities are likely to accept a simple, uniform state-based option. "I think cities and counties are very open-minded about what they're willing to work out and how the system might be streamlined," said Delna Jones, county commissioner of Washington County, Ore., and a commission member despite the fact that her state levies no sales tax. "But the bottom line is they will not allow for the removal or reduction of what is a critical contribution to the operation of local government."

A Profitable Future?

The one point that all parties seem to agree on enthusiastically is that the time is now to do something about whether and how to allow interstate taxation of interstate commerce. "The challenge and opportunity are that we might be able to produce something that works to everyone's satisfaction," Upson said. "The danger is, if we don't, then the [Internet Tax Freedom] Act expires, and you're right back to where you were: Everybody trying to impose their own will on this medium. And good luck."

Without a clear-cut solution that everybody can abide by, Johnson also foresees disaster. "Over time, our revenues will drop, and if they drop dramatically, we don't have a lot of other options short of increasing our property taxes at the local level, which might send our Main Street businesses elsewhere, and our income taxes at the state level. Or we'd have to dramatically cut back services. And that's not feasible, because we cut the fat out a long time ago."

Most observers and players believe that it won't come to that because most business owners recognize that they, along with their employees, benefit from public services. Finding the middle ground is made easier by the fact that some of the most creative minds in government and industry are working on this before Internet-based commerce becomes the dominant commercial model.

"The tax issue is not big enough at this point to drive state and local governments to ruin, but it's big enough that we can see it and, luckily, it's small enough right now that we can solve it," said commission member and Utah Gov. Mike Leavitt (R). "And I feel strongly that we will find a solution."

- Heather Hayes is a free-lance writer based in Stuarts Draft, Va.

*****

A Time to Share

For state and local officials, sitting idly by while a panel of 19 people debate an issue that could have a radical impact on the future of local revenues is not easy. So Virginia Gov. James Gilmore (R), chairman of the Advisory Commission on Electronic Commerce, has invited everyone who wants a platform for their opinions or ideas to contact the commission. "We will listen to every voice," he stated at the inaugural meeting of the commission in Williamsburg, Va., in June.

It's not just revenue agents and elected officials that have a role to play in the process. Chief information officers, especially, can bring their technology vision to the table. "I think that CIOs should really step in and help educate elected officials to the enormity of the change that is likely to take place very rapidly," said Randy Johnson, a Hennepin County, Minn., commissioner. "Most CIOs understand the potential of electronic commerce and can figure its economic effects pretty quickly. But many elected officials don't, and CIOs need to step up to the plate and help them realize what's happening now and what might happen in the future."

Don Upson, Virginia's secretary of technology and CIO, agreed, noting that CIOs should bring their unique perspective to the commission. "This is an open and fair process," he said. "We want to hear from people. The time to present your ideas is now. You can't do anything for three years anyway, so now is the time to work together. Everyone has a strong incentive in seeing that this exercise is successful."

- Heather Hayes

*****

Possible Solutions

The Advisory Commission on Electronic Commerce has purposefully shied away from boxing itself into any one solution to the Internet tax problem, but several ideas used alone or in combination are being tossed about, including:

* An across-the-board sales tax exemption for all Internet-based transactions-the "No Net Tax."

* Moving to a uniform system of sales taxes at the state level that use a software program coded with state tax rates and local tax options as well as the types of products considered taxable in that state.

* An electronic server-and-software-based middleman that collects uniform taxes on each transaction from businesses and routes it to the proper taxing authority.

* A federal sales tax.

* The point of sale based on the headquarters location of a company rather than the server location.

* The "free-for-all" solution: Simply keep the status quo and let states and localities determine which transactions they want to tax.