Subj: Level Playing Field: Perspectives of IPI: Center for Technology Freedom From: Bartlett Cleland Institute for Policy Innovation To: Internet Caucus Advisory Committee [Footnotes were not included in the original - JN] 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, as 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 to erroneously focus narrowly on the static "revenue loss" that supposedly occurs because states are constitutionally prohibited from forcing online companies outside their borders to collect sales and use taxes on remote e-commerce transactions. Ronald Reagan confronted the same kind of static mentality in cutting tax rates in the early 1980s. Focusing exclusively on so-called "lost" sales tax revenues from remote sales when evaluating the Internet's impact on state treasuries is misleading. 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. At least one established major bookseller with retail stores nationwide has attempted to sever nexus by establishing a completely separate online business operation, which not only sells an identical inventory as the bricks-and-mortar stores but also allows e-commerce customers to use local stores for the return and exchange of merchandise purchased over the Internet. When this type of arrangement is inevitably challenged, the courts are likely to pierce any ' ;corporate veil' of efforts by companies selling the same merchandise online and over the counter. To organize e-commerce operations into ' separate' legal entities to break the nexus for sales tax purposes will not stand—they will have to collect the sales and use tax.19 As long ago as 1941, the Supreme Court ruled that Sears could not avoid Iowa taxation on its mail-order service when it had such a substantial physical retail presence in the state.20 Listen to Governor Leavitt'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 and use taxes solves itself. Governor Leavitt constructs two straw men to create the impression of serious problems where none actually exist. In the first case 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 most likely be illegal. Absent other factors, the very existence of the store front and the physical presence of the computer terminals in it should be sufficient to establish 'nexus' obligating the business to collect tax on purchases made from the store's catalog and terminals. 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 and Rep. John Kasich, which would have the federal government preempt states from even collecting sales or use tax on Internet sales within the state. The state-and-local-government lobby misleads the public by taking an isolated instance of a bad idea (the McCain/Kasich bill), which is separate and distinct from the Internet tax moratorium currently in effect, and associate it in the minds of the public with the moratorium as a " campaign" to deprive states and localities of the sovereign right to tax. The irony is doubly rich when one considers the extraordinary extent to which Governor Leavitt's own NGA scheme erodes states' tax sovereignty. 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 world 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, 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. 21 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. A reduction 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. Economist Austan Goolsbee's research illustrates the fallacy of static framework employed by the state-and-local-government lobby. He found 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. This does not include the additional collateral damage done to the Internet.22