Subj: Constitutionality: Perspectives of Americans For Tax Reform From: Ron Nehring, 858 794 2338 Americans For Tax Reform (ATR) To: Internet Caucus Advisory Committee Section: Constitutionality A Clear, Constitutional Approach to e-Commerce Taxation Submitted to the Advisory Commission on Electronic Commerce by the e-Freedom Coalition on November 15, 1999. The E-Freedom Coalition recommends that the temporary tax-free zone arrangement created by the Internet Tax Freedom Act (ITFA) be made permanent for both access taxes and sales or use taxes on electronic commerce. Moreover, the Advisory Commission should recommend that any existing state or local taxes that were grandfathered under the ITFA be phased out or repealed outright. The economic arguments against taxing electronic commerce are strong. First, such taxation is inefficient. Imposing multiple, overlapping or discriminatory access or sales taxes on the Internet or electronic commerce in general would be extremely difficult and inefficient in practice. Having 30,000 or even just 50 tax jurisdictions and policies would create a confusing and counter-productive domestic tax regime. Imposing such a tax regime on the Internet or electronic commerce would also have an extremely deleterious effect on the Internet sector just as it is beginning to grow and expand. Industry output and entrepreneurship would likely be greatly curtailed as a result. The negative effects of a new Internet tax regime would reverberate throughout the national economy. Almost every American industry is now engaged in some form of electronic commerce or has initiated Internet-based services. Imposing burdensome taxes on Internet access or sales would discourage further efforts in this regard and likely retard innovation, job creation, and economic growth in general. The creation of such a tax regime or regimes would likely require a significant increase in government tax oversight and enforcement efforts. Tax collection agencies and/or their surrogates at all levels of government would grow larger and more intrusive as efforts to tax electronic commerce proliferated. The resulting expansion in the overall size of government would likely lead to more government meddling in the private sector in general and the high-tech sector in particular. Just as the economic arguments against Internet taxation are strong, so are the legal and constitutional arguments. The Supreme Court has long held that attempts by a state or local government to tax or regulate out-of-state activity or "remote commerce" are unconstitutional. State and local governments can only tax those parties that have a "nexus" or "substantial physical presence" within their jurisdictions. Establishing a tax system that grants state and local governments the right to impose multiple and over-lapping taxes would reverse two centuries worth of sound Supreme Court case law and create a disturbing precedent for the taxation of other forms of interstate commerce. Beyond upsetting legal precedent, taxing electronic commerce represents a direct affront to constitutional first principles and a threat to America's federalist structure of government in general. The Founding Fathers included language in Article 1, Section 8 of the Constitution to allow Congress to "regulate interstate commerce" in an attempt to remedy the problems the colonies experienced when they operated under the Articles of Confederation. Excessive parochialism and perpetual interference with the free flow interstate commerce forced the Founders to abandon the Articles and instead adopt our modern Constitution to alleviate these ills. The federal republic they created allowed for extensive state and local experimentation and autonomy, but also placed firm limits on the ability of state and local governments when interstate commerce was at stake. An important part of America's federalist system of government, therefore, is an understanding and appreciation of the limits of state sovereignty. In order for each state to preserve an autonomous sphere for itself, there must necessarily be limits on its jurisdictional authority. Simply put, a state's jurisdictional authority ends at its own borders. Allowing state or local taxation of the Internet would betray this constitutional first principle by allowing governments to impose their will on consumers and companies outside their jurisdictional boundaries. For these economic and legal reasons, it is vital that the Advisory Commission propose a permanent ban on access taxes or any form of discriminatory sales or use taxes on electronic commerce. Addressing and Debunking the "Fairness" Arguments Despite these arguments, some may still resist the adoption of a permanent ban on Internet access and sales taxes because of certain "fairness" arguments they have heard repeatedly voiced by critics of the Internet Tax Freedom Act. These fairness arguments typically come in two varieties: XXr Fairness Argument #1: It is not fair to exempt remote Internet vendors from access or sales taxes when "bricks and mortar" or "Main Street" businesses within a state are required to collect them. XXr r Fairness Argument #2: It is not fair to deprive state and local governments of the revenues that could be collected by taxing Internet access or electronic sales. These arguments represent legitimate concerns that are being raised by a host of state and local government officials and some businesses. Therefore, it is important that the members of the Advisory Commission address and debunk these fairness arguments to ensure that new tax schemes are not imposed on electronic commerce. The first argument regarding the fairness of exempting remote vendors from access or sales taxes misses an important point: remote vendors do not use or deplete state or local resources which state or local taxes support. In fact, it would be patently unfair to force out-of-state companies to pay taxes for government services or programs they do not use or benefit from. State and local businesses pay or collect such taxes because they can take advantage of the programs or services provided with those funds. Remote vendors engaging in interstate electronic transactions do not benefit in a similar way from these taxes, and shipping companies already pay taxes to cover their use of public goods and services. Moreover, Internet vendors are tangible "bricks and mortar" businesses that will continue to pay routine income taxes where they reside. A permanent Internet tax moratorium would only exclude states and localities from taxing remote vendors of electronic commerce. The second fairness argument regarding the threat a Net tax moratorium poses for future state and local tax revenues is equally flawed. The remarkable and explosive rise of the Internet and electronic commerce is creating a virtually unprecedented level of entrepreneurship and innovation in America. Moreover, this remarkable technological renaissance has been the driving engine behind America's recent strong and sustained economic growth. This has presented policymakers with a paradoxical situation. The rise of this new unregulated and, for the most part, low tax sector, has helped fuel the sustained growth of not only economic activity, but government tax revenues as well. For the first time in decades, Americans now live in an "Age of Surplus," where federal, state, and local governments are taking in record tax revenues. How can this be if critics are correct in their contention that a tax-free Internet represents a serious drain on governmental tax collections? Simple economics explains the apparent paradox. First, the rise of the Internet and the Information Economy has created new jobs and new business opportunities that did not exist previously. In turn, this increased economic activity and output increased individual income and business profits, which, consequently, provided new tax sources and higher revenues overall for all governments. And, again, it is important to reiterate that simply because interstate Internet transactions have been exempted from taxes, that does not mean companies engaging in electronic commerce are completely tax- free. Electronic vendors are still responsible for paying routine corporate income taxes and are treated like any other business within their home states. A permanent moratorium on Net taxes would not upset this balance in any way. Setting a Uniform Jurisdictional Standard for Sales Tax Collection Next, the expansion of economic activity and opportunity through electronic commerce does not require abandoning state and local taxing authority, only better defining it. By placing clear parameters on state and local authority to tax interstate commerce, Congress can reduce the threat of taxation in jurisdictions in which vendors do not have a substantial physical presence. The U.S. Supreme Court has long recognized that the Commerce Clause requires a physical connection between the taxing jurisdiction and the taxpayer. See Complete Auto Transit, Inc. v. Brady, 430 U.S. 274 (1977). A substantial physical presence provides an identifiable standard that ensures a state's power to tax is limited to taxpayers within its borders. Nothing will do more harm to the growth of electronic commerce, and to taxpayers and consumers directly, than expanding state and local taxing authority beyond their borders. The threat of taxation is as much an issue as the obligation of taxation itself. The Supreme Court's decisions in National Bellas Hess, Inc. v. Department of Revenue of Illinois, 386 U.S. 753 (1967), and Quill Corp. v. North Dakota, 504 U.S. 298 (1992), have not been uniformly adhered to or interpreted. States continually litigate new theories in the hope of expanding their jurisdiction beyond their borders, not just for use taxes but other excise and business activity taxes. The cost to taxpayers and consumers in money and time is substantial. All the while, predictable jurisdictional standards are being eroded. This lack of certainty is the biggest threat to business on the Internet. One of the biggest hurdles facing businesses engaged in interstate commerce is simply knowing which tax agencies are involved. For the on-line business, the uncertainty is positively mind-boggling because the technology itself poses new questions in jurisdictional standards. Can an ISP that facilitates the processing of data cause its customers to have tax obligations in the state, county and city of the ISP? Does the mere fact that a customer can order via your web page subject your company to taxation in the state of the consumer? What about the in-state use of a license or copyrighted material? With the exception of PL 86-272, which relates strictly to state income taxes and to sellers of tangible personal property, Congress has left the question of the limits of state taxing authority to the courts. The courts, however, have failed to solve the problem. Each decision is the subject of subsequent dispute and argument over its proper application. New theories are developed and more time and energy spent litigating for certainty and predictability. The definition of "substantial nexus" is most often the subject of dispute. Some decisions suggest that it applies differently depending on the type of tax. While the Supreme Court in Quill reiterated the standard of a "substantial physical presence" articulated in the 1967 decision of National Bellas Hess, 386 U.S. 753, some states argue their standard only applies to the collection obligation under the use tax, and not, for example, to income taxes. See Geoffrey, Inc. v. South Carolina Tax Commission, 437 S.E.2d 13 (S.C. 1993), cert. den., 510 U.S. 992 (1993) (foreign corporation's licensing of its Toys 'R Us trademark in the taxing state and the royalties generated from it established nexus even without a physical presence). The indirect establishment of a substantial presence on the part of the out-of- state person is another fruitful ground of controversy. Over the last decade, the states have attempted to expand the theory of "attributional nexus," which attributes the substantial physical presence of one person to that of another either by way of agency or corporate affiliation. Does advertising by an out- of-state company on a web page that happens to be on a server located in the taxing state suffice? What about a logo on a web page "hot-linked" to an out- of-state vendor? What about the in-state presence of a telecommunications service provider's equipment used by an in-state resident to order from an out- of-state vendor with whom the telecommunications company contracts for services? For example, Texas has asserted that a web site on a Texas server creates nexus for an ISP's out-of-state customer. Even if one assumes that jurisdiction to tax exists, the next layer of uncertainty is what is subject to tax (tax base) and the appropriate rate to apply. Computing the proper tax liability is the most intrusive aspect of taxation and in many cases the most burdensome aspect of taxation. The more tax agencies involved, the more burdensome compliance becomes. Unlike the bricks and mortar business that state and local governments so often argue are being discriminated against, the out-of-state retailer is asked to do that which the in-state retailer is not: determine the place of use for each of its customers. For example, the brick and mortar retailer doesn't ask if I'm taking my purchase and going back to my home which is in a different taxing jurisdiction. They don't care. The sales tax treats the place of purchase as the place of consumption. However, if the same transaction occurred online via the company's web page, different standards would apply. If the store is in my home state, most likely the sales tax would once again apply but the seller would first have to determine the destination of the sale. If the seller was in a different state, the use tax applies and the seller would have to identify the destination of the sale and collect and remit based on the rules and rates for that local jurisdiction assuming the company has nexus (reliance on zip codes is not legally sufficient as many zip codes cross taxing jurisdictions). In the purely digital world, where both the consummation of the agreement and the exchange of the product or service occur on-line, location is not just irrelevant; it can be impossible to determine. The use tax is not a surrogate consumption tax, as some would suggest. It was a device conceived to protect in-state merchants. The physical presence standard properly respects state borders. The basic purpose of taxation is to raise money for government services and programs. Why should a business, having no physical presence in a state, be obligated to contribute to the programs and services in that state? The argument of a "maintenance of a market" for the out-of-state business mistakes the nature of that market. The market exists because of the people, not the government (while such might be true in a centrally planned economy, it is not the case in America). And clearly, out of their own self- interest, the people who live in the jurisdiction properly pay the taxes necessary to support the roads, education and other infrastructure to meet the needs of that market. Subjecting taxpayers to the intricacies of the tax codes of the jurisdiction in which they are physically present is not an insignificant burden, but subjecting taxpayers to all the tax codes in all the jurisdictions of their customers would create an insurmountable burden to all but the largest businesses, or alternatively require the vast expansion of government tax collection agencies and/or their surrogates. Neither suggestion is friendly to taxpayers and consumers.