A heated debate is once again under way inCongress over the tax treatment of electronic com-merce and the Internet Tax Freedom Act of 1997.The ITFA imposed a moratorium on state andlocal taxes on Internet access and banned “multi-ple or discriminatory” taxes on electronic com-merce. That moratorium was intended to last onlythree years but was extended by Congress in 2001for another two years. It will lapse on November 1,2003.

The ITFA has been a remarkably misunderstoodor misinterpreted statute and has very little to dowith what really lies at the heart of this debate—theeffort by state and local governments to collect salesand use taxes on remote vendors in interstate com-merce (mail order, catalog, and e-commerce compa-nies). Contrary to press reports and statementsmade by some members of Congress, the ITFAmoratorium does not directly affect the ability ofstates and localities to impose sales and use taxes onpurchases made over the Internet.

What state and local officials are really at warwith is not the ITFA but 30 years of SupremeCourt jurisprudence that has not come down intheir favor. Their ultimate goal is to overturnthose precedents, which held that states could

require only firms with a physical presence—or“nexus”—in their jurisdictions to collect taxes ontheir behalf. State and local tax officials haveworked to eliminate or water down these restric-tions on their tax reach but thus far have notbeen able to get around them or convinceCongress to authorize the imposition of collec-tion obligations on interstate vendors.

Although extending the existing ITFA mora-torium and continuing to uphold the SupremeCourt’s nexus jurisprudence makes good sense,Congress must also take an affirmative standagainst efforts by state and local governments tocreate a collusive multistate tax compact to taxinterstate sales. Other options exist that stateand local governments can pursue before look-ing to impose unconstitutional tax burdens oninterstate commerce. Of course, getting runawaystate spending under control would go a longway toward solving many of their supposedproblems. Merely extending sales tax collectionresponsibilities to electronic commerce—whichconstitutes less than 2 percent of all retail activi-ty in the United States—will not solve the fiscalcrisis that state and local governments have cre-ated through their profligate spending habits.

The Internet Tax SolutionTax Competition, Not Tax Collusion

by Adam D. Thierer and Veronique de Rugy

_____________________________________________________________________________________________________

Adam D. Thierer is director of telecommunications studies and Veronique de Rugy is a policy analyst at the CatoInstitute.

Executive Summary

No. 494 October 23, 2003

Introduction

Many policymakers, journalists, and oth-ers view the debate over Internet taxation infairly narrow terms. They believe the debate isreally about whether or not federal, state, orlocal legislators should “tax the Net.”Consequently, the war of words has focusedon competing bumper-sticker slogans suchas “Don’t Tax the Net” and “Level the TaxPlaying Field.”

Framing the debate in this manner grosslyunderestimates the complexity and impor-tance of the issue. For instance, the don’t-tax-the-net side chooses to ignore the fact that theInternet is not really a “tax-free zone.”Although states cannot force remote vendorsof interstate commerce to collect and remitsales taxes, states have a corresponding “usetax” that requires consumers in their jurisdic-tion to remit the tax owed on out-of-state pur-chases. However, those levies are difficult toenforce. In other words, the absence of use taxcollection is what makes the Internet (e.g.,mail order and catalog sales) appear to be taxfree. Anti-tax activists ought to ask themselveswhether this is really the best way to achievelower tax rates and smaller government. It ispossible that states simply offset tax losses onremote sales by raising taxes on other classesof goods or vendors. Finally, there are legiti-mate tax fairness issues at stake. All otherthings being equal, similar goods and servicesshould be taxed in similar ways.

The arguments offered by those peoplewho would like to extend the sales tax toInternet purchases seldom prove valid. Inparticular, the level-playing-field argument—the notion that interstate vendors have a sig-nificant tax advantage over Main Street ven-dors—does not hold water. Indeed, to theextent that there is a genuine level-playing-field problem with regard to the sales tax, it isoften one of the states’ own making, becausethe current system is riddled with exemp-tions and special rules.

Attempts to blame the rise of the Internetfor a decline in the sales tax base or state and

local revenues are completely without merit.Internet business represents a minusculeportion of aggregate retail activity in theUnited States and can hardly be fingered asthe culprit for recent state and local govern-ment budget shortfalls. In fact, according tothe U.S. Department of Commerce, e-com-merce activity accounted for just 1.3 percentof all aggregate retail sales in 2002.1

Regardless, as policymakers debate thiscontentious issue, three themes or principlesshould guide the discussion.

Federalism: A Two-Sided CoinAlthough state and local governments

must lead reform efforts, Congress has animportant role to play. Although the sales taxis a state and local system, efforts to imposecollection responsibilities on out-of-statevendors automatically warrants some degreeof federal oversight by Congress. Because thedebate is infused with endless talk of protect-ing federalism and states’ rights, it is impor-tant to understand what is meant by thoseterms. Many state and local officials and taxadministrators seem to believe that states’rights means that state and local govern-ments should be free to impose any type oftax or regulatory regime on commercialactivities, even if interstate activities areinvolved. Such an argument shows a misun-derstanding of the federal system that theFounding Fathers set forth in the U.S.Constitution.

Federalism is a two-sided coin: one side isstates’ rights and the other is interstate com-merce. The vast majority of tasks undertakenby the federal government since the NewDeal have been an unjustifiable usurpationof the powers that the Constitution grantedto the states or the citizenry. But theConstitution was also an explicit rejection ofthe Articles of Confederation: the disadvan-tages of untrammeled states’ rights weretrade disputes, protectionism, and interfer-ence with the flow of interstate commerce.Consequently, the Founders granted Con-gress the authority to take steps to regulatecommerce among the states—that is, to keep

2

Federalism is atwo-sided coin:

one side is states’rights and the

other is interstatecommerce.

open the channels of interstate commerce toensure that free trade would win out overstate protectionism.

Applying the Founders’ vision to high-tech markets they could not have foreseen istricky but not impossible. In the debate overthe taxation of e-commerce it means thatCongress will need to oversee state-ledreform efforts to ensure that states do notimpose unconstitutional tax collection bur-dens on remote vendors in interstate com-merce. In addition to extending the currentITFA moratorium on “multiple and discrim-inatory” taxes as well as Internet access taxes,Congress will consider whether to put itsstamp of approval on a multistate tax com-pact or collection agreement called theStreamlined Sales Tax Project.

The SSTP is presented as an effort to sim-plify and harmonize sales tax administrationamong the states in order to get around con-stitutional hurdles to taxing remote vendors.Although simplification is a laudable goal,tax harmonization can also have a downside.In particular, even though advocates of theSSTP talk only about harmonizing tax-basedefinitions and collection systems, the nextlogical step may be the harmonization of taxrates. Indeed, many retailers may demandthat Congress force the states to adopt onerate per state to achieve the ultimate form ofsales tax simplification.

Congress should reject such proposalsand be wary of collusive tax compacts thatwould in the long run grant the states open-ended tax authority over the channels ofinterstate commerce, not only because of thepotential constitutional issues they raise, butbecause tax competition between and amongthe states might be negatively affected.Preserving or enhancing tax competitionshould be a guiding theme in this debate.

“Fairness” and “Neutrality” Aren’tNeutral Terms

Although fairness and neutrality animateefforts to extend sales tax collection obliga-tions to Internet vendors, the current salestax system is hardly perfectly fair or neutral,

and efforts to extend it to the Internet wouldraise different fairness and neutrality issues.Although state and local officials are rushingto devise a mechanism to tax interstate sales,and e-commerce in particular, they have paidmuch less attention to the fact that constantpolitical meddling and special-interest favor-itism have turned the sales tax base intoSwiss cheese. Countless special rules, exemp-tions, and loopholes have been devised forfavored industries or products.

Of course, for those people who desirefewer taxes in general, the fact that manygoods and services are exempt offers a cer-tain kind of tax relief. But the downside ofsuch exemptions is that politicians mightuse them as an excuse to raise the rates onother activities or certain groups of taxpay-ers. In fact, as states engaged in a spendingfrenzy in the 1990s, many legislators in-creased sales tax rates. Moreover, the averagestate sales tax rate has increased from 1.2percent in 1950 to almost 5 percent today.The combined state, city, and county rate isnow closer to 6 percent. Despite steady taxrate increases, however, spending has oftenoutpaced revenues and led to claims of bud-get shortfalls.

Is the Internet somehow to blame for thecurrent situation? Will taxing e-commercemake up for the perceived tax shortfallsmany governments fear? Unlikely on bothcounts. Even if state and local officials suc-ceeded in devising a sales tax collectionscheme to capture the minuscule portion ofretail economic activity generated by the elec-tronic commerce sector, it would likely be aPyrrhic victory, especially if states keptincreasing spending.

Extending current sales tax collectionschemes to the Internet in the name of fair-ness seems particularly hypocritical giventhe many games politicians have playedwith the current sales tax system. Moreover,it would hardly be fair to demand thatinterstate vendors collect and remit salestaxes in jurisdictions where they have nophysical presence and consume no govern-ment services.

3

Preserving orenhancing taxcompetitionshould be a guid-ing theme in thisdebate.

More Than One Way to Skin This Cat The leading solution favored by the states—

a multistate compact on “simplified” and har-monized sales and use tax collection—is notthe only solution available. State and local law-makers have several options. They can main-tain the status quo. They can reduce theirreliance on sales and use taxes or perhaps eveneliminate them entirely. Or they can search foran alternative method of taxing consumption.But those options are not very likely to gainmuch political support given the popularity ofthe sales tax with state and local legislators.

That means policymakers will ultimatelybe forced to choose between two systems ofsales tax reform. The first option, which hasstrong support from state and local politi-cians, is a “destination-based” sales taxregime organized by a multistate compact,which would give states the power to imposetax collection duties on vendors outside theirjurisdictions after tax rates and product defi-nitions had been sufficiently “simplified” toget around Supreme Court or congressionalprotections of interstate commerce. That isthe SSTP model.

The second option, which has receivedmuch less attention, is an “origin-based” taxregime, under which states would exercisetheir right to tax equally all sales inside theirborders, regardless of the buyer’s residence orthe ultimate location of consumption. Underthat model, all sales would be “sourced” tothe principal place of business for the sellerand taxed accordingly. In fact, in manyinstances we already find ourselves in an ori-gin-based tax regime. For example, someonewho lives in Washington, D.C., but buys agood across the Potomac River in Virginia istaxed at the origin of sale in Virginia regard-less of whether he brings the good back intothe District. Each day in America, millions ofcross-border transactions take place that aretaxed only at the origin of the sale; no ques-tions are asked about where the good will beconsumed. So why not extend the same prin-ciple to cross-border transactions involvingInternet, mail order, or other interstate sales?Although such an origin-based, or “seller-

state,” sourcing methodology has a growingnumber of proponents, it remains controver-sial and unpopular within political circlessince many policymakers fear a “race to thebottom” in terms of intense tax competition.

In the end, the debate over Internet taxa-tion comes down to a question of which over-arching tax philosophy will prevail in thefuture: tax competition or tax collusion?States can choose to remain truly indepen-dent governmental entities that respect eachother’s sovereignty by avoiding extraterritori-al tax schemes and abiding by the protectionsfor interstate commerce that were establishedin the Constitution and upheld in laterSupreme Court cases. Alternatively, the statescould choose to enter into a collusive multi-state compact for interstate sales and use taxcollection, such as the SSTP, which wouldrequire that they surrender a large degree oftheir sovereignty (and the sovereignty of theirsubordinate local government units in partic-ular) in an effort to extract a small amount ofrevenue from interstate commercial activities.

The states would be wise to reject the latterposition and the cumbersome and potential-ly unconstitutional regime that it entails.Instead, they should embrace tax competitionand search for solutions that are consistentwith it, such as an origin-based tax system.Congress must continue to monitor thesedevelopments and stand firm against anyeffort by the states to supercede its authorityover the channels of interstate commerce. Ofcourse, in the end, maintaining the currentSupreme Court nexus jurisprudence is a per-fectly acceptable solution, especially in lightof some of the other alternatives being con-sidered.

The Complexities of SalesTax Administration

Although there is little agreement abouthow to address the issue of Internet taxation,the antagonists in this contentious debateappear to agree on at least one point: the cur-rent system of state and local sales taxation in

4

In the end, thedebate over

Internet taxationcomes down to a

question of whichoverarching taxphilosophy will

prevail in thefuture: tax

competition ortax collusion?

the United States is threatened by the realitiesof the modern, service-based, Information Ageeconomy. For example, during the heated1999–2000 debates of the Advisory Commis-sion on Electronic Commerce, or Internet TaxCommission as it was commonly known,Republican governors James Gilmore ofVirginia and Mike Leavitt of Utah were fre-quently at odds on whether and how to tax e-commerce. Nonetheless, they agreed that thecurrent sales tax system would have to bereformed in light of the changing nature of theeconomy. As Governor Gilmore, who alsoserved as chairman of the ACEC, noted:

The Internet changes everything. More tothe point, the Internet changes every-thing including government. Old rules donot work well in this new borderlesseconomy. Sometimes they do not workat all. Regardless, change is everywhere,and government has to change as well.2

Likewise, Governor Leavitt, who generallysupports the application of some type of taxregime to the Internet, agreed with GovernorGilmore, arguing: “The existing system ofsales tax will not work in the 21st century. Itis unthinkably complex and incompatiblewith the direction of commerce in the world.So we [must] modernize it.”3

These statements raise three questionsthat policymakers have yet to fully confront:

• What is it about the current state andlocal sales tax system in the UnitedStates that is so troubling that it wouldforce intellectual combatants such asGovernors Gilmore and Leavitt to joint-ly denounce it?

• If Gilmore and Leavitt are correct intheir belief that the current system ofsales and use taxation in America is atodds with modern economic realities,how can it be altered to ensure that itdoes not unjustly burden buyers or sell-ers?

• If the sales tax cannot be fixed, what, ifanything, will replace it?

To answer those questions, a bit of histor-ical background is necessary.

The Sales Tax, Theory and RealityThe sales tax dates back to the Great

Depression, when politicians thought thatdeclining revenues, from property taxes inparticular, necessitated temporary alterna-tive sources of revenues.4 The sales tax is oneof many “temporary” taxes that never wentaway, however. Today, all but five states havea sales tax.5 Most states rely on a sales tax forthe bulk of their general fund revenues, andgeneral sales tax receipts make up roughlyone-third of overall state revenues.6

Most economists agree that an efficienttax should have the following properties:

• Simplicity. The tax should be easy tounderstand and inexpensive to adminis-ter.

• Neutrality. The tax should not diverteconomic resources from more produc-tive to less productive uses or createbiases in favor of particular taxpayers,activities, or industries.

• Equity. The tax should not impose bur-dens on taxpayers without offeringthem corresponding gains or propor-tional benefits in return.

• Transparency. The tax should not beimposed in ways that obscure its bur-den; that is, it should not be a hiddentax.

• Low Rates. Lower tax rates reduce gener-al collection and administration burdensfor taxpayers and minimize distortionsin the base since higher rates create pres-sures for carve-outs.

In theory, sales taxes have many of thoseproperties. The sales tax is a tax on all indi-vidual consumption. Consumption taxes canbe fair and efficient if the system treats alltaxpayers equally and does not have a dis-criminatory structure. The sales tax couldachieve this goal and was probably evenmeant to do so. In addition, unlike incometaxes, sales taxes do not create a destructive

5

As argued byGovernor Leavitt“The existing system of salestax will not work in the 21stcentury. It isunthinkablycomplex andincompatiblewith the directionof commerce inthe world.”

bias against savings and investment thatreduces capital formation. So, a sales taxcould be viewed as a relatively fair and eco-nomically efficient way of raising revenue.

Thanks to special-interest rent seekersand politicians, however, the theoreticallysimple sales tax regime has become very com-plex and sometimes quite burdensome.Vendors, for instance, have to keep up with awide variety of unique product definitions,product and service exemptions, and salestax holidays, as well as the many intricacies oflocal sales tax systems. Things are even morecomplicated for vendors operating in morethan one state (i.e., remote vendors in inter-state commerce). If those vendors must col-lect and remit the sales or use taxes for stateand local governments, the complexities canbecome overwhelming and impose an expen-sive compliance burden on retailers. That canpresent a substantial challenge and econom-ic burden, given that 46 states and approxi-mately 7,500 local governments impose dif-ferent sales tax rates and product definitions,according to Robert J. Cline and Thomas S.Neubig of Ernst & Young.7

The concern is also that remote vendorsmight be forced to collect and remit sales anduse taxes to jurisdictions in which they haveno physical presence and therefore receive nocorresponding benefits for their tax collec-tion efforts. Of course, the flip side is that ifremote vendors do not collect any taxes,Main Street vendors will claim they are beingunfairly burdened because they do have tocollect taxes on comparable products.

To summarize, in the debate over the tax-ation of remote sales and e-commerce, manystate and local officials have chosen to focusprimarily on one of the principles associatedwith an optimal tax system (neutrality) andargue that the central focus of ongoing salestax reform talks should be rectifying the sup-posed preferential treatment of remote sell-ers relative to Main Street businesses.

Main Street vendors and tax officialsargue that the current sales tax regime dis-torts economic activity, causing a shift insales and resources from conventional store

sales to e-commerce and mail order compa-nies by taxing the former and not the latter.8

The argument that the sales tax regimeshould not artificially favor some goods andsome channels over others possesses someforce. “It is a standard principle of both legalsystems and economics that similarly situat-ed goods and services should be treated alikeor discriminatory rules or price distortionswill occur,” argues Karl Frieden, author ofCybertaxation: The Taxation of E-Commerce.9

However, adding an extra layer of tax in thename of neutrality does not seem like a goodidea either.

Further Economic and Legal PrinciplesIt seems reasonable to ask whether perfect

tax neutrality—to the extent it is even possi-ble—should be achieved at any and all costs.What should happen when other importantgoals or values come in conflict with tax neu-trality? In particular, in the case of e-com-merce and remote sales, should constitution-al principles such as the right to due processand the free flow of interstate commerce beset aside in an attempt to achieve perfect taxparity? And what about the principle of taxcompetition between and among the states?

At least with regard to due process andinterstate commerce concerns, SupremeCourt decisions have made it clear that suchprinciples are worthy of consideration andmay need to trump efforts to create perfecttax parity. For example, in three importantcases—National Bellas Hess, Inc. v. Department ofRevenue of State of Illinois (1967),10 CompleteAuto Transit, Inc. v. Brady (1977),11 and QuillCorporation v. North Dakota (1992)12—theCourt said that various equity and efficiencyconcerns need to be taken into considerationwhen state and local governments attempt toimpose collection burdens on remote sellersof interstate goods.

The Court’s 1967 decision in Bellas Hessbuilt on the foundation of its earlier 1954decision in Miller Bros. Co. v. State of Maryland,13

which held that the state of Maryland couldnot constitutionally impose a use tax obliga-tion on a Delaware seller who had no physical

6

Thanks to special-interest

rent seekers andpoliticians, the

theoretically simple sales tax

regime hasbecome very complex and

sometimes quiteburdensome.

retail outlets or sales persons in Maryland.Although the Court had upheld the power ofstates to impose tax collection liabilities onout-of-state sellers in some earlier cases,14 ineach of those cases the Court had found thatthe presence of local agents or retail stores inthe taxing state was sufficient for the state todemand the businesses to collect taxes since,“in those situations the out-of-state seller wasplainly accorded the protection and servicesof the taxing State.”15

In Bellas Hess the Court noted that it had“never held that a State may impose the duty ofuse tax collection and payment upon a sellerwhose only connection with customers in theState is by common carrier or the United Statesmail.”16 And reiterating what it had said in theearlier case of State of Wisconsin v. J.C. Penney Co.(1941),17 the Court declared, “The simple butcontrolling question is whether the state hasgiven anything for which it can ask return.”18

In other words, state and local businessescollect sales (and other) taxes for a given juris-diction because they can expect to takeadvantage of the government programs orpublic services made possible by those funds,such as roads, schools, parks, police, and fireprotection. Remote vendors engaging ininterstate transactions, however, typically donot benefit from the programs or servicesthose taxes fund. Therefore, on Due ProcessClause grounds, the Court found that toimpose such collection obligations would betantamount to taxation without representa-tion, or taxation without any correspondingbenefit. Similarly, on Commerce Clausegrounds the Court found that if a companydid not have certain “minimal contacts” witha particular taxing jurisdiction, it would beunfair to impose collection burdens on out-of-state vendors.19 The threshold of physicalpresence or minimal contacts necessary totrigger tax collection duties is known as “tax-able nexus,” and it is the central animatingprinciple—and most widely debated con-cept—in the debate over the taxation ofremote commerce.

The Bellas Hess nexus framework wasrefined in the Court’s 1977 Complete Auto

Transit decision, which established a formalfour-part test to determine whether a statesales tax would be considered constitutional.Although the Complete Auto Transit case dealtspecifically with income tax apportionmentamong the states, it clearly has some rele-vance to the debate over the imposition oftransaction taxes such as the use tax. Underthe four-part test, for a sales tax to pass con-stitutional muster it must

• Be applied to an activity with a substan-tial nexus within the taxing state.

• Be fairly apportioned.• Not discriminate against interstate com-

merce.• Be fairly related to the services provided

by the state.

The logic behind the Court’s frameworkin Complete Auto Transit flowed directly fromthe Commerce Clause even though Congresshas not passed any specific statute governingthis particular controversy. As the Courtnoted in Bellas Hess, “The very purpose of theCommerce Clause was to ensure a nationaleconomy free from . . . unjustifiable localentanglements.” This is an example of theCourt applying what is know as “dormantCommerce Clause” analysis to a controversyon which Congress has failed to act or pro-vide guidance.20

However, with regard to sales and use taxnexus, no decision has been more important,or created more controversy, than the Court’s1992 decision in Quill Corp. v. North Dakota.The Quill ruling is particularly importantbecause it was the Court’s last major state-ment on nexus matters related to the salesand use tax obligations that states canimpose on remote vendors. Therefore, it stillgoverns taxation of mail order and catalogsales and, by extension, electronic commerce.

In Quill, the Court ruled that the CommerceClause prevented North Dakota from com-pelling the Quill Corporation, an out-of-statemail order company, to collect and pay usetaxes on products sold to customers located inNorth Dakota because the company had no

7

The Quill rulingwas the Court’slast major state-ment on nexusmatters related tothe sales and usetax obligationsthat states canimpose onremote vendors.

outlets, sales people, or property in the state.This reinforced the earlier nexus precedentsfound in Bellas Hess and Complete Auto Transit. Itis important to note, however, that althoughthe Court reaffirmed the physical presencenexus test in Quill, it did so exclusively onCommerce Clause grounds and largely dis-posed of Due Process nexus protections forremote vendors. The Court argued that “dueprocess jurisprudence has evolved substantiallysince Bellas Hess,” to the point that the Courtwould now abandon “formalistic tests focusedon a defendant’s presence within a State infavor of a more flexible inquiry into whether adefendant’s contacts with the forum made itreasonable” for the state to demand collectionof sales and use taxes.21

The Court stressed that because the QuillCorporation had “purposefully directed” itsretail activities at North Dakota residents, “themagnitude of those contacts are more thansufficient for due process purposes, and the taxis related to the benefits Quill receives fromaccess to the State.”22 Some scholars argue thatthe facts in Quill are not entirely analogous toInternet sales, however, and it remains an openquestion whether the Court would overturnstate-based efforts to tax remote Internet com-merce on Due Process Clause grounds. 23 Itcould be the case that more traditional dueprocess analysis, such as the logic employed inthe J.C. Penney and the Bellas Hess cases, wouldprevail if Internet vendors pushed a constitu-tional challenge on these grounds. But resolv-ing that question through the courts would bea long and costly process.

As the law currently stands, therefore, DueProcess Clause protections have been largelyeliminated, but Commerce Clause–relatednexus standards still protect interstate ven-dors from state and local tax collectionschemes. Understanding that their hands aretied by the Constitution, the courts (in theQuill decision in particular) and state andlocal legislators and tax collectors haveworked for many years to evade the nexusrestrictions while simultaneously pushingCongress and the courts to abandon thoseprotections for interstate vendors. Thus far,

Congress and the courts have refused tooblige, although legislation was introducedin Congress following the Quill decision thatwould have overturned the remainingCommerce Clause restraints on taxation ofremote vendors.24 Although the legislationwas the subject of intense debate (and did notpass), one fact that is undisputed is the roleof Congress in resolving this matter so longas Commerce Clause considerations are onthe table. As the Court noted in Bellas Hess,“Under the Constitution, this is a domainwhere Congress alone has the power of regu-lation and control.”25 And in Quill, the Courtconcluded, “the underlying issue is not onlyone that Congress may be better qualified toresolve, but also one that Congress has theultimate power to resolve. . . . Congress is nowfree to decide whether, when, and to whatextent the States may burden interstate mail-order concerns with a duty to collect usetaxes.”26 As discussed below, it remains to beseen whether Congress will act at all toresolve these nexus controversies or whetherit will continue to rely on the courts to han-dle nexus disputes under existing but dor-mant Commerce Clause precedents.

Tax Competition as a Guiding PrincipleOne of the many benefits of a federalist sys-

tem of government is that it encourages juris-dictions to compete for the allegiance of the cit-izenry. As the pioneering work of CharlesTiebout and many other economists and polit-ical scientists has illustrated,27 tax competitionprovides governments with powerful incentivesto keep their tax rates low, improve governmentefficiency, and attract businesses and individu-als. Some governments offer citizens or busi-nesses a veritable capitalist paradise, free of sig-nificant tax or regulatory burdens, while othersoffer a more activist government that appeals toa different part of the populace. This encour-ages citizens and companies to “vote with theirfeet” and find jurisdictions that suit their tastes.

Of course, whether a reduction in tax ratesis a desirable outcome depends on one’s per-spective. Those who want lower tax rates andtax reform favor competition between coun-

8

One of the manybenefits of a

federalist systemof government is

that it encouragesjurisdictions tocompete for theallegiance of the

citizenry.

tries and between state and local govern-ments. We should not overlook the fact thatsales tax competition may give state govern-ments an added incentive to rationalize andsimplify their tax systems. In particular, if taxrates fall because of cross-border competi-tion, it is likely that loopholes will disappearand the tax base will be simplified.

Regardless, cross-border tax competitionoften raises neutrality and fairness questionswhen the impact on the national market-place is considered. For example, is it “fair”that Massachusetts consumers drive intoNew Hampshire each weekend to take advan-tage of sales tax–free shopping opportunitiesand then return home to consume thosegoods? One way to view this phenomenon isthat Massachusetts is being unfairly deprivedof tax revenues because of such cross-bordershopping. At the same time, similar activitiesoccur frequently in many jurisdictions andcan be viewed as an important check on thetaxing power of any single government enti-ty. If Massachusetts officials attempt toimpose too great a burden on their citizens orcompanies, those entities may shop else-where or relocate. That is a healthy part of afederalist system of government. Without a“release valve,” or some sort of escape mecha-nism, federalism would be an empty vessel.“So long as states and localities are allowed toset sales tax rates and define what is taxable,there will be cross-border competition forconsumers. It will be no different in cyber-space,” notes Doug Lathrop, director of theTax and Fiscal Policy Task Force for theALEC.28

Even though cross-border commercialactivity will sometimes raise tax neutralityconcerns, a good case can be made that theprinciple of tax competition should receiveequal consideration in discussions about thefuture of sales tax policy in America. Thereare good reasons to challenge the assertionthat tax parity or neutrality should beachieved by any means necessary. That isespecially true given the increasing complexi-ty and compliance burdens associated withthe sales tax.

Sales Tax Complications

The current sales tax system is complicatedby (1) endless political meddling with the salestax code to create special rules and exemptionsfor a variety of goods and industries; (2) a gen-eral exemption for the service sector; and (3)the rise of interstate commerce, or “remotesales” activity (e-commerce, mail order, catalogsales), which poses unique tax collection prob-lems for state and local governments.

The Exemptions GamePoliticians have long used the tax code as

a method of favoring special interests oradvancing various sociopolitical objectives.With the sales tax, state and local officialshave created a substantial number of exemp-tions or special rules for politically favoredcauses, products, or entire industries.

Take agriculture, for example. Farmersproduce crops that are sold in the same way ascountless other commodities in the market-place. Yet numerous agricultural inputs,products, machinery, and final outputs areexempted from sales taxes in most jurisdic-tions.29 Other significant goods-based exemp-tions seen in most jurisdictions include foodand groceries, clothing and textiles, and phar-maceuticals (especially prescription drugs).The rationale for such exemptions is ratherstraightforward: such products are “special”or “too important” to be included within thesales tax base because they are considerednecessities for many individuals. In addition,sales tax “holidays” (for example back-to-school week or Christmas shopping season)30

are increasingly frequent and popular inmany taxing jurisdictions.

Regardless of the sociopolitical rationalesbehind such exemptions, some critics arguethat those exemptions and holidays put pres-sure on legislators to raise rates on otherproducts or producers to make up for “short-falls.” More important for the purposes ofthis paper, efforts to carve out special exemp-tions for entire industries or classes of goodshave created complicated and sometimes

9

Sales tax competition may give state governments anadded incentiveto rationalize andsimplify their taxsystems.

quite bizarre product classification regula-tions. Exemptions for food are notoriouslyambiguous and confusing. As a recent USAToday column asked, “Is a Twix bar candy ora cookie? Is dandruff shampoo a beauty aidor medical supply?”31 If granola bars are“candy” they would likely be taxed in manystates, but if they are “food” they would not.Marshmallows present a similar challenge:taxable candy or tax-exempt food additive?And should “fruit juice” be taxed as a “softdrink” or exempted like the fruits fromwhich it comes? What if it’s not 100 percentpure fruit juice? The tax treatment of somegoods, such as shoes, varies widely. Somestates exempt shoes as clothing, while othershave created unique tax treatments for ath-letic shoes or boots.

Definitional disputes have added evengreater complexity to the sales tax system in theUnited States, especially for interstate vendors,who often have to contend with dozens, if nothundreds, of conflicting product classificationschemes. Again, because state and local gov-ernments rely on business vendors to calculateand collect the sales tax at the time of sale,compliance costs are a serious matter for busi-nesses. Vendors must accurately determine theproper tax treatment of individual goods orrun the risk of repercussions—namely expen-sive and time-consuming audits—from stateand local tax administrators. In theory the salestax is considered a pass-through expense to theconsumer and is not supposed to impose sig-nificant burdens on vendors in terms of collec-tion and compliance costs, but clearly it canpose costly burdens. Large vendors may havelittle difficulty making such determinationsand calculations, but smaller businesses orremote vendors with less support staff mayencounter difficulties in handling tax compli-ance burdens. And with the threat of auditsalways lurking overhead, companies must takegreat pains to try to understand and complywith this increasingly complex system.

The Rise of the Service Sector When the sales tax was first being formu-

lated during the 1930s, tracing and taxing the

sale of commodities was a far more rudimen-tary undertaking because the industrial econ-omy of the time was primarily goods based. Inother words, most commodities were tangiblegoods, typically sold over the counter at aretail commercial establishment. Moreover, asdiscussed in more detail below, interstate com-merce was a much smaller proportion of eco-nomic activity than it is today. That made salestax collection a fairly routine matter.

But as the United States began a gradualshift to a service-based economy in subse-quent decades, questions arose about howand whether to incorporate service-sectoractivity into the sales tax. The increasinglyservice-oriented economy challenged the tra-ditional state and local sales tax systembecause it had historically concerned itselfwith collecting taxes on tangible goods, notintangible services. Taxing the sale of lawbooks at a local bookstore was easy enough,but how should the legal services be taxed?Likewise, a sales tax can easily be imposed onthe sale of building materials, but what aboutarchitectural, contractor, or construction ser-vices? The sales tax was not designed to cap-ture these activities and thus, they were defacto exempted.

Although some people decry this generalservice sector exemption—arguing that it is“unfair” to other taxpayers or has raised thetax burden on others—that argument goesboth ways. The exemption has been a boonfor companies and taxpayers who have beenrelieved of the burden of paying additionaltaxes. Taxing services would probably proveimpossible in practice anyway. Given thefluid, intangible nature of service-sector activ-ity, imposing taxes on such activities would befar more complicated than taxing goods. Inparticular, taxing digital services that canmove across the planet at the click of a buttonwould entail enforcement efforts that couldprove burdensome and intrusive. Finally,practically speaking, taxing services is consid-ered by many people to be political suicide.Limited efforts have been made by somestates to expand the coverage of their salestaxes to include services, but those efforts

10

The increasinglyservice-oriented

economy challenged the

traditional stateand local sales tax

system.

have been met with staunch political opposi-tion and have largely failed.32 Taxing serviceshas never really been a tenable option.

Remote Sales, Interstate Activity, and E-Commerce

The rise of national markets and “remotesellers” (mail order, catalog, and e-commercevendors) has posed a different sort of prob-lem for the sales tax system. Even thoughremote sales typically involve the sale ofgoods, which have always been subjected tothe sales tax, interstate sales create a variety ofjurisdictional tax collection problems. Thatis because the sales tax is a state and localtax—not a national tax—which relies on col-lection by vendors “at the counter” within aparticular taxing jurisdiction.

To understand how problems arise wheninterstate vendors and commerce enter thepicture, it is important to recall how the salestax is administered. Again, because the salestax system in the United States was intendedto be commodity based, it is typically imposedon consumers as they make purchases ofgoods over the counter at a commercial estab-lishment. Consequently, state and local gov-ernments rely on business vendors to collectthe sales tax at the time of sale. Theoretically,the sales tax is considered a pass-throughexpense to the consumer and is not supposedto impose significant burdens on vendors interms of collection and compliance costs.

When the sales tax is collected at thecounter, it is assumed that the tax will serveas a rough proxy for where the actual con-sumption of that good will take place. Forexample, a book purchased in Newark, NewJersey, will be taxed under the sales tax rateand definitions of the city of Newark and thestate of New Jersey on the assumption thatconsumers will “consume” that book inthose jurisdictions. More specifically, itassumes that the individuals who purchasethat book live within the confines of thosetaxing jurisdictions and that a tax at thecounter will be paid predominately by thoseindividuals who will benefit from the publicservices provided with those revenues.

Of course, neither of those assumptions isnecessarily true. Buyers who live in NewJersey may plan to take the book to New YorkCity and “consume” it there. Alternatively,some book buyers may be from adjoiningstates, such as New York or Pennsylvania,and take the book back to their home statesto “consume” it. At the moment of sale, how-ever, no questions are asked of the consumerabout where the ultimate consumption willtake place. While this tax sourcing distinc-tion seems like an esoteric and perhaps evenirrelevant matter, it is not.

Tax administrators refer to the current sys-tem as a “destination-based” sourcing meth-odology, but that is a misnomer; it is really an“origin-based” sourcing rule, at least for in-state sales. “In fact, it can be strongly arguedthat the state sales taxes in most states alreadybegin with a point-of-origin sales tax, thendefault to the destination state in the case ofinterstate sales,” note sales tax experts AndrewWagner and Wade Anderson.33 In otherwords, sales taxes are imposed at the origin ofsale, not the final point of destination or con-sumption. Although this will usually produceresults that tax collectors desire, since mostgoods will be purchased and consumed in thesame taxing jurisdiction, there will be manyexceptions to the rule. And, given the increas-ing mobility of both commercial goods andconsumers themselves, the assumptionunderlying the destination-based sourcingmethodology breaks down under closerinspection, especially when the rise of inter-state sales is factored into the equation.

Hoover Institution senior fellow CharlesMcLure Jr., a proponent of the destination-based sourcing methodology, nonethelesspoints out: “Sales taxes function best whenlocal merchants sell primarily tangible productsto local customers, as was once the case.However, the italicized words in the previoussentence no longer describe the way theworld actually functions. As a result, it isinherently difficult to implement a destina-tion-based sales tax.”34

So although this origin–destination dis-tinction is largely irrelevant for intrastate

11

Tax administra-tors refer to thecurrent system asa “destination-based” sourcingmethodology, buthat is a misnomer.

sales, it is vitally important when interstateactivity is brought into the picture. Becausestate and local tax collectors have traditional-ly relied on commercial vendors to calculateand collect the sales tax on purchases at thepoint of sale, there have always been logisticalquestions and legal concerns about applyingthe same collection duties to out-of-statevendors. The decision to apply a destination-based sourcing methodology to interstateactivity necessitates the adoption of a use taxas a means of collecting taxes on retail salesactivities that originate out of state. Use taxesare owed by customers to their home states(and local jurisdictions) on purchases fromout-of-state companies that do not havenexus in that state or locality.35 Every time anindividual purchases taxable tangible goods,whether in person, over the phone, or on theInternet, the purchase is subject to a use taxin the state where the merchandise is used.

In theory, that means that the customer inVirginia who buys a book from Amazon.comis obligated to file use tax forms and remit ause tax based on the prevailing Virginia stateand local rate. Compliance with this require-ment by individual consumers is extremelylow for business-to-customer (B2C) transac-tions. Much e-commerce is business-to-busi-ness (B2B), wherein compliance is muchhigher. The low compliance rate for B2Ctransactions is often due to ignorance on thepart of taxpayers and should not be consid-ered explicit tax evasion. Also, for practicaland political reasons, governments find itvery inconvenient and unpopular to collectand enforce use taxes on individual citizens,except for those items that are easily trace-able, such as automobiles or boats that mustbe registered in the state of use. At the end ofthe day, therefore, the purchase of a bookfrom a bookstore in Virginia is subject to thestate sales tax, while the same purchase fromAmazon—though technically subject to anequivalent use tax—is effectively “tax free”because of the unenforceability of the use tax.

The unenforceability of the use tax explainswhy state and local governments have gone togreat lengths to evade legal nexus protections

and demand direct collection of the sales tax byout-of-state vendors. But, given the practicalproblems associated with collecting the use taxand the nexus constraints placed on state andlocal officials by the courts, it is worth askingwhy those officials persist in their quest toretain and extend a destination-based method-ology for sourcing remote sales activities. Whynot adopt a pure origin-based standard insteadand avoid enforcement and legal hassles alto-gether? In other words, allow the taxation ofinterstate vendors only at the origin of a trans-action where they have their primary place ofbusiness.

The answer, not surprisingly, has more todo with politics than sound economics. “Thetrue premise behind a use tax in the destina-tion state actually has very little to do withconsumption. Rather, the purpose is to pro-tect in-state vendors,” argue Wagner andAnderson.36 Indeed, in 1964, Congress con-vened a Special Subcommittee on StateTaxation of Interstate Commerce that subse-quently became known as the WillisCommission after its chairman, Rep. EdwinE. Willis (D-La.). Volume 3, Part 3 of the mas-sive Willis Commission report noted:

As a practical matter . . . outshipmentsand inshipments present very differentproblems. So long as there were Stateswhich did not impose a sales tax orwhich imposed it at a lower rate, theStates had no interest in taxing out-shipments. To do so would produceprotests by their own businessmen thatthey were being placed at a competitivedisadvantage to other businessmenlocated in sales-tax free States or Stateswith lower rates. Accordingly, the Stateshave made very little attempt to taxsales of goods shipped to the buyer inanother State.37

So the application of a destination-basedsourcing rule to interstate transactions wasdone not to satisfy any particular economicobjective, but to avoid the uncomfortablebusiness of imposing taxes on a state’s own

12

The decision to apply a

destination-basedsourcing

methodology tointerstate activity

necessitates theadoption of

a use tax.

exports. Better to attempt to impose a tax onanother state’s imports and avoid burdeningdomestic vendors with tax collection dutiesfor the goods they send out of state. Eventoday that largely remains the rationale for adestination-based sourcing methodology forremote sales taxation—even though a switchto a pure origin-based methodology wouldimmediately level the proverbial tax playingfield by demanding that all sellers (remoteinterstate vendors and Main Street business-es alike) collect sales taxes only at the point ofsale. The origin-based alternative to destina-tion-based tax collection schemes is dis-cussed in greater detail later in this paper.

The decision to stick with a destination-based sourcing methodology has necessitat-ed a “by any means necessary” crusade bystate and local tax administrators to devise asystem to get around current nexus con-straints in order to collect the use tax owedon interstate transactions. In recent years,state and local tax administrators haveworked to devise a multistate solution to theproblem of use tax enforcement that will getaround the nexus protections required by thecourts. The key to this effort—called theSSTP—is the simplification and harmoniza-tion of sales tax rates and definitions.

But this system, which will be critiquedmore thoroughly below, is still plagued by thesame fundamental problem the current systemfaces—an adamant refusal to abandon the des-tination-based sourcing rule for interstatetransactions. So long as tax officials seek totrace and tax sales based on the final destina-tion or place of consumption, they will alwayshave to deal with legal and logistical difficulties.

Many scholars have pointed out that theadvent of widespread e-commerce poses addi-tional problems for a destination-basedmethodology and the use tax because theInternet makes geography largely irrelevant.“Traditional concepts of tax jurisdiction, suchas residency, source, and permanent establish-ment, cannot be relied on,”38 note sales taxexperts Terry Ryan and Eric Miethke. “In thepurely digital world, where both the consum-mation of the agreement and the exchange of

the product or service occurs on-line, locationis not just irrelevant; it can be impossible todetermine,” argues Dean Andal, former chair-man of the California Board of Equalization.39

Bearing such considerations in mind, Friedenappropriately concludes: “It is clear that cre-ation of sourcing rules for a digital economywill be an arduous and frustrating task. Noone set of rules is likely to prove ideal, andtherefore, a considerable amount of experi-mentation can be expected.”40

As an aside, it should be noted that if thesales tax were a uniform national tax on con-sumption, many of these problems woulddisappear; there would be a single rate andsingle definition or classification for eachcommodity. And every interstate vendorwould be required to collect and remit thattax because they resided within the confinesof the United States. In legal terms, everyAmerican corporation has “nexus” or physi-cal presence within the confines of theUnited States, so they could all be taxed bythe federal government regardless of wherethey where headquartered in the country.41

But the United States does not have anational sales tax system at present.42 Instead,the sales tax is exclusively a state and local taxsystem. Jurisdictional tax sourcing controver-sies were bound to arise as interstate commer-cial activities proliferated. Very little federalguidance exists regarding how to resolve suchdisputes. To make matters more complicated,state and local taxing jurisdictions often haveoverlapping boundaries and contradictory taxrules and rates. In the case of the sales tax, eachstate and local government jurisdiction hasformulated its own unique sales tax system.This greatly complicates the sales tax treat-ment of interstate commerce and makes itvery expensive for remote vendors of interstatecommerce to administer the system.43

According to Cline and Neubig, “highcompliance costs result directly from com-plexities built into each component of thesales tax system: definitions of what is taxable,multiplicity of tax rates, numerous exemp-tions for specific buyers or uses, overlappingjurisdictions, filing requirements and audit

13

Many scholarshave pointed outthat the advent owidespread e-commerceposes additionalproblems for adestination-basedmethodology andthe use tax.

procedures.”44 They estimate that “for firmsselling nationally with collection responsibili-ties in all 46 states, the compliance costs rangefrom 14 percent of sales tax collected for largeretailers, to 48 percent for medium retailers,and 87 percent for small retailers.”45

This remarkable complexity and the costsassociated with it explain why the SupremeCourt ruled in the Quill decision that it wouldunduly burden interstate commerce if remotevendors were required to collect sales and usetaxes for jurisdictions where they have nophysical presence. And it also explains whysome state and local officials have attemptedto create a multi-state compact such as theSSTP to get around Quill’s restrictions andbegin taxing interstate activity.

Myths about the InternetTax Freedom Act

Before summarizing the spectrum of salestax reform options available to state and locallegislators, it is important to clarify some com-monly held misperceptions in the debate overInternet taxation, in particular about the ITFAand the role of Congress in this process. Manypolicymakers, members of the media, and thegeneral public continue to harbor the illusionthat an extension of the existing ITFA mora-torium will (1) keep the Internet “tax free,” (2)increase the disparate treatment of Internetsales and retail states, further eroding the taxbase of states and local governments, and (3)allow Congress to impose an unwarranted fed-eral solution on state and local governments.In reality, the ITFA has not and will not do anyof these things.

The Moratorium Has Nothing to Dowith the Internet “Tax Free Zone”

The ITFA imposed a moratorium on stateand local Internet access taxes and banned“multiple” and “discriminatory” taxes on elec-tronic commerce. The moratorium lasted onlythree years but was extended by Congress in2001 for another two years and will lapse onceagain on November 1, 2003. Contrary to press

reports and even press releases and speechesissued by members of Congress, the moratori-um does not directly affect the ability of statesand localities to impose sales taxes on pur-chases made over the Internet.

As mentioned earlier, state taxing activi-ties are constrained by the Quill decision,which prevents states from collecting salestaxes from vendors who lack a physical pres-ence, or nexus, in that state. The ITFA merelyimposed a moratorium on state and localtaxes on Internet access and banned “multi-ple or discriminatory” taxes on e-commerce.Even if the moratorium were never renewed,state and local tax collectors could not cur-rently tax interstate purchases made over theInternet. Claiming that the ITFA created a“tax-free zone” is only correct with regard toInternet access, which is specifically protect-ed from parochial tax efforts.

The Net Does Not Pose a Serious Threatto Retail Stores or State and LocalGovernments

Those who support broadening the abilityof states to collect sales taxes on remote retail-ers suggest that the inability of state govern-ments to collect taxes on e-commerce saleshas deprived states of billions of dollars inneeded revenue and that essential govern-ment services will be imperiled.46 But thisargument doesn’t hold water. The U.S.Department of Commerce has been collect-ing quarterly data on e-commerce retail salessince late 1999.47 Since that time, e-commerceactivity has grown from roughly $5.5 billionin the fourth quarter of 1999 to $14.3 billionas of the fourth quarter of 2002. But as Figure1 illustrates, despite steady growth, e-com-merce activity continues to be a minusculecomponent of overall consumer spending,accounting for just 1.3 percent of aggregateretail sales in 2002. For the three-year periodduring which the Department of Commercehas been collecting data, e-commerce hasaveraged just 1.1 percent of total retail sales.Figure 2 documents e-commerce sales as apercentage of retail activity for each quarter ofthe past three years.

14

The moratoriumdoes not directlyaffect the ability

of states andlocalities to

impose sales taxeson purchases

made over theInternet.

Given these data, it is hard to make a cred-ible case that the Internet has caused a fiscalcrisis in the states. Indeed, to the extent thereis a state and local budgetary “crisis” today, ithas much more to do with the massivespending spree by states in recent years.

In fact, just a few years ago, many stateand local officials were bragging about theirstrong fiscal situation. “Money is just pour-ing in over the transom,” noted California

governor Gray Davis in March 2000.48

Similarly, in February 2001 a NationalConference of State Legislatures press releasequoted NCSL president Jim Costa, a statesenator from California, boasting that “moststate budgets in recent years have purred likethe engine of a luxury car.”49 That sameNCSL press release noted that 33 states saidrevenue growth was on or above target inearly 2001 and that 31 states reported that

15

E-commerce is a minusculecomponent ofconsumer spending,accounting forjust 1.3 percent of aggregateretail sales in2002.

$3.6 Trillion Aggregate Retail

Sales

E-Commerce Sales Only 1.3% of Total Retail

Figure 1E-Commerce Sales Only a Sliver of Aggregate Retail Activity (Year 2002 Totals)

Source: U.S. Department of Commerce, www.census.gov/mrts/www/current.html.

0.007 0.008 0.008 0.009

0.012 0.011 0.01 0.0110.013 0.013 0.012 0.013

0.016

00.0020.0040.0060.0080.01

0.0120.0140.0160.0180.02

1999-4

2000-1

2000-2

2000-3

2000-4

2001-1

2001-2

2001-3

2001-4

2002-1

2002-2

2002-3

2002-4

Source: U.S. Department of Commerce, www.census.gov/mrts/www/current.html.

Figure 2E-Commerce as Percentage of Total Retail Sales (1999–2002, by quarter)

budget cuts would not be necessary to bal-ance FY 2001 budgets.

Various reports and surveys backed upthese claims with hard data. Office ofManagement and Budget surveys note thatstate and local government tax receipts grewby more than 30 percent between 1994 and1999, controlling for inflation and thegrowth in population.50 Similarly, a recentCato Institute survey of the fiscal situation inthe states revealed that between fiscal years1990 and 2001, state tax revenue grew 86 per-cent—more than the 55 percent of inflationplus population growth.51 Likewise, inDecember 1998, Michael Flynn of the ALECpublished a report on surplus revenue in thestates, which noted that states are “in theirbest financial health in over a decade” with$74 billion in windfall surplus tax revenuesover the past four years.52 Finally, a Nelson A.Rockefeller Institute of Government reportshowed that as recently as fiscal year 2000,state tax revenues grew by 8.7 percent.Adjusted for inflation, this increase repre-sented the second largest in the last decade.53

Today’s headlines tell a very differentstory. “States in Fiscal Crisis,” notes theWashington Post;54 “For Struggling States, AllSolutions Point to Washington,” says theNew York Times;55 and “States Want FederalBailout, But Financial Help Unlikely,” readsan Investors’ Business Daily headline.56 Theseheadlines reflect the sobering reality manystates are facing today: the good times aregone as revenues have dried up and budgetsurpluses have disappeared.

Exactly what happened in the past fewyears that led to this reversal of fiscal for-tunes for the states? Is the Internet somehowto blame for these budget shortfalls? Giventhe data presented above regarding the verylimited slice held by e-commerce in the muchlarger economic retailing pie, that’s unlikely.

The real cause of the states’ fiscal policywoes emanates from their insatiable appetitefor spending. Despite the record surpluses ofthe 1990s, most states continued to spend farmore than they take in. According to theNational Association of State Budget

Officers, state general fund spending grew atan average rate of 5.7 percent from FY90 toFY01 while inflation averaged just 2.8 per-cent over that same period.57 The pace accel-erated in the late 90s with growth of 7.0 per-cent in FY99, 6.6 percent in FY2000, and 8.0percent in FY01.58 Glenn Hubbard, formerchairman of the Bush administration’sCouncil of Economic Advisers, recently toldInvestors’ Business Daily, “I don’t mean tosound harsh, but the states that are in theworst trouble did, frankly, increase spendingsubstantially during periods in which mosteconomists would have said the (revenue)gains were transitory.”59

Instead of facing up to their spendinghabits, state and local officials have attempt-ed to pin the blame on a variety of other fac-tors: the limited tax cuts that some states putin place in the 90s; the lack of increased aidfrom the federal government; and, of course,the Internet.

But although profligate spending is clearlythe real cause of the states’ current fiscal poli-cy woes, many officials still claim that e-com-merce is a significant drag on revenue genera-tion and that taxing the Internet will helpmake up at least some of the current budgetshortfall. Many state and local groups andofficials point to a study conducted by DonaldBruce and William F. Fox, economists with theUniversity of Tennessee’s Center for Business& Economic Research. Bruce and Fox’s studyestimates the potential lost revenue for stateand local governments at $13.3 billion in 2001and suggests that this amount will more thantriple to $45.2 billion by 2006.60

But these numbers have been disputed byother economists and by the Direct MarketingAssociation in particular, which produced itsown study showing losses totaling only $1.9billion in 2001.61 The numbers differ radicallybecause of disputes about the tax treatmentB2B e-commerce sales and the definition ofwhat should count as “e-commerce sales” tobegin with.62

Regardless of how much e-commerceretailing activity grows in future, it is highlyunlikely that it will subsume all traditional

16

The real cause ofthe states’ fiscal

policy woesemanates fromtheir insatiable

appetite forspending.

retailing activity or displace a substantialportion of Main Street retail sales. But thisdebate should not be resolved solely on thebasis of economic projections in one direc-tion or the other; sound economic policy andconstitutional jurisprudence should governthe final outcome.

Congress Does Have a Role in ThisDebate

Despite what some state and local groupsor officials claim, Congress does have a veryimportant role to play in the debate over thetaxation of e-commerce. The FoundingFounders included several provisions in theConstitution dealing with federal oversightof the states in order to end factionalism andprotectionism among the states. These pow-ers, which were granted to the federal govern-ment to protect the economic liberties of thecitizenry and to aid in the promotion of amore integrated national economy, have abearing on the modern debate over e-com-merce taxation. They include the following:

• Article I, Section 8, Clause 3 (the“Commerce Clause”): [The Congressshall have power] “To regulate commercewith foreign nations, and among the sev-eral states, and with the Indian tribes.”

• Article I, Section 9, Clauses 5 and 6(nondiscrimination in shipping/ trad-ing): “No tax or duty shall be laid on arti-cles exported from any state. No prefer-ence shall be given by any regulation ofcommerce or revenue to the ports of onestate over those of another: nor shall ves-sels bound to, or from, one state, beobliged to enter, clear, or pay duties inanother.”

• Article I, Section 10, Clauses 2 and 3(additional shipping/trading protec-tions): “No state shall, without the con-sent of Congress, lay any imposts orduties on imports or exports . . . [or] layany duty of tonnage. . . . ”

• Article I, Section 10, Clause 3 (the“Compact Clause”): “No state shall,without the consent of Congress . . .

enter into any agreement or compactwith another state, or with a foreignpower. . . . ”

• Article IV, Section 2, Clause 1 (the“Privileges and Immunities Clause”):“The citizens of each State are entitledto all the Privileges and Immunities ofCitizens in the several States.” (Intendedto prevent states from discriminatingagainst constitutional rights of out-of-state citizens.)

• Article VI, Clause 2 (the “SupremacyClause”): “This Constitution . . . shallbe the supreme law of the land.” (Madeit clear that when state laws came intoconflict with each other or nationallaws, federal law was to prevail.)

The combined effect of these enumeratedconstitutional provisions was a clear declara-tion that state-based protectionism would notbe tolerated; the rights of individual con-sumers and companies would be protected byCongress and the courts when threatened byoppressive and unjustifiable state actionswhich adversely affected interstate commerce.The passage of the Fourteenth Amendment in1868 enshrined important due process andequal protection rights in the Constitution,providing greater protections for citizens fromoppressive state actions.63

In subsequent decades, these constitu-tional provisions have been cited by thecourts on numerous occasions in controver-sies related to the regulation of interstatecommerce by state and local governments.Congress has often drawn on these powers tojustify its oversight of numerous types ofinterstate activities and multistate disputes.

As debates over the tax treatment of remotevendors came to the fore with the rise of mailorder and catalog sales 30 years ago, somestate and local officials immediately attempt-ed to impose sales and use taxes on out-of-state vendors. Although the Court wisely for-bade such unjust taxation without representa-tion in cases such as Bellas Hess and Quill, theCourt also noted that the ultimate decisionregarding the tax treatment of interstate ven-

17

Regardless ofhow much e-commercegrows in future, it is unlikely tosubsume all traditional retailing activity or displace a substantial portion of MainStreet retail sales

dors fell to Congress. In Bellas Hess the Courtnoted, “Under the Constitution, this is adomain where Congress alone has the powerof regulation and control.”64 And in Quill, theCourt concluded that, “the underlying issue isnot only one that Congress may be betterqualified to resolve, but also one thatCongress has the ultimate power to resolve.”65

The famous 1965 Willis Commission reporton state taxation of interstate commerce alsoconcluded: “The [Commission’s] study ofsales taxation shows that the present system isexceedingly troublesome to business and fallsshort of accomplishing the purposes forwhich it was adopted. As a national problem,the task of making the sales tax effective andworkable for interstate sales inevitably fallsupon Congress.”66

Clearly then, the question of whetherCongress has a role to play in this debate canbe laid to rest with those statements. Butwhat should it do?

The 1999 ITFA moratorium was a fairlysensible first step since it put state and localgovernments on notice that “multiple ordiscriminatory” levies on the Internet, aswell as taxes on Internet access, would notbe tolerated. This action is importantbecause it prevents state and local govern-ments from automatically looking towardthe Internet as the latest communicationsor utility industry “cash cow” that can bemilked for billions of tax dollars. Althoughstate and local governments certainly havethe right to impose taxes on corporationswithin the confines of their jurisdictions,all too often they have viewed telecom com-panies as unique, captive businesses thatcan be used as a disproportionately largerevenue-generating sector.67 The risk now isthat the same mentality will be applied toInternet businesses and that state and localgovernments will impose a host of levies onInternet services or access in general.

For these reasons, Congress is consideringan extension of the existing ITFA moratori-um. Rep. Christopher Cox (R-Cal.) and wellover 100 co-sponsors have proposed H.R. 49,Internet Tax Nondiscrimination Act, which

would make the existing moratorium perma-nent. Sen. Ron Wyden (D-Ore.) has intro-duced a companion bill on the Senate side (S.52).68 And Sen. George Allen (R-Va.) has intro-duced legislation in the Senate (S. 150) that isidentical to the Wyden measure except that italso eliminates any Internet access taxes thatexisted prior to October 1, 1998, which weregrandfathered into law by the ITFA.

Although extending the existing morato-rium and making it permanent is the sensiblenext step for Congress to take, federal law-makers could go further and deal with theunderlying nexus or sales tax collectionissues in one of two decidedly different ways.On one hand, Congress could consider nexusclarification legislation that would largelycodify the Supreme Court’s Quill decisionand update it to deal with e-commerce ques-tions. On the other hand, federal lawmakerscould take up the question of current stateefforts to simplify sales and use tax collectionand determine whether to place their stampof approval on an official multistate compactsuch as the SSTP.

Each of these proposals was floated in theprevious session of Congress and may beentertained once again this session. For rea-sons outlined in the following section, itwould be far more sensible for Congress toundertake nexus clarification and codifica-tion than to get involved in the effort to sim-plify and harmonize state and local tax ratesand definitions. Congress should stay out ofthe latter fight and not approve any formalmulti-state compact for the taxation of inter-state commerce. Congress certainly has itwithin its power to authorize either of theseefforts. But better alternatives may be worthyof consideration.

Ten Sales Tax ReformOptions

Many misperceptions or misstatementshave clouded the debate over the taxation ofe-commerce as state and local governmentspersist in their attempts to rework their sales

18

The 1999 ITFAmoratorium put

state and localgovernments

on notice that“multiple or

discriminatory”levies on the

Internet, as wellas taxes on

Internet access,would not be

tolerated.

tax systems and design a system to captureremote sales activity. Whether or not theirfears regarding increased e-commerce activityare warranted, there are certainly good rea-sons for state and local officials to investigatelong-term sales and use tax reform alterna-tives. The 10 sales tax reform options listedbelow outline a broad spectrum of alterna-tives for state and local officials to consider.Some of these reform alternatives will begiven more extensive treatment than others,based on their importance or practicality.

Although Congress can and should exer-cise an oversight role when these sales taxreforms affect interstate commercial activity,it would be preferable if most of thesereforms sprang from the bottom up. To themaximum extent possible, federal authoritiesshould not dictate the direction state andlocal governments take except to protect thechannels of interstate commerce fromunconstitutional tax or regulatory burdens.

Option 1: Enact a Multistate “TaxSimplification” Compact

The goal here would be to harmonize taxbases and rates in order to impose use tax col-lection responsibilities on remote vendors ofinterstate commerce. Variations of this firstreform option have been widely touted bystate and local organizations such as theNational Governors Association and theNational Conference of State Legislatures asthe ultimate solution to the current sales taxpredicament. These groups have worked withstate and local tax administrators to craft aplan known as the SSTP or the “zero burden”sales tax proposal. In a meeting lastNovember, 31 state delegates agreed to moveforward with the SSTP plan—now formallyknown as the Streamlined Sales and Use TaxAgreement—and enact legislation in each oftheir member states to bring their state andlocal sales tax laws into conformity with theagreement.69

From the outset, the project focused on apossible compromise or quid pro quo involvinggreater simplification of the sales and use taxsystem in return for the blessing of Congress or

the Courts on a multistate tax collection com-pact for remote sales. State officials believe thiswould allow them to get around Quill and begintaxing remote sales activity by minimizing theburdens placed on remote vendors.

There are two core elements to theSSUTA.70 First, the proposal aims to addressthe lack of uniformity within the existingsales tax system for both rates and productdefinitions by requiring that participatingstates enter into a tax compact and abide bythe rules laid out under the SSUTA. Salesand use taxes would be administered at thestate level and all units of government withina state would need to adopt a common taxbase to simplify and harmonize tax adminis-tration.71 Among other things, the SSUTArequires uniformity of major tax base defini-tions, uniformity of state and local tax bases,and simplification of state and local taxrates.72 A “governing board,” composed offour representatives from each member state,would oversee administration of the com-pact. The agreement notes that the governingboard would have the power to, “employstaff, advisors, consultants or agents”; “pro-mulgate rules and procedures it deems neces-sary to carry out its responsibilities”; “takeany action that is necessary and proper to ful-fill the purposes of the Agreement”; and“allocate the cost of administration of the[SSUTA] among the member states.”73 TheSSUTA would take effect in a voluntary man-ner when at least 10 states, representing atleast 20 percent of the U.S. population, agreeto bring their sales and use tax regimes in linewith the agreement. (To gain the force of lawand move beyond the voluntary compliancestage, some sort of congressional authoriza-tion would likely be necessary.)

Second, the SSUTA plan would use severalversions of what John Mikesell calls a “tech-nofix”74 to achieve greater sales and use taxsimplification and get around the legal hur-dles preventing states from imposing collec-tion responsibilities on interstate vendors. Inorder to administer the sales tax and minimizecollection costs and other vendor burdens,participating states and local governments

19

The SSUTArequires unifor-mity of major taxbase definitions, uniformity ofstate and local tax bases, andsimplification ofstate and local tax rates.

could pay Certified Service Providers to han-dle compliance for vendors that opt to use aCSP as their tax collection agent. Vendorswould transmit necessary customer orderinformation to the CSP so that the CSP couldcalculate the tax owed. These independentthird-party organizations would be responsi-ble for remitting the taxes to the states, toremoving collection burdens on remote ven-dors. Alternatively, vendors could opt to usecomputer tax collection software and systemsknown as Certified Automated Systems,preapproved by the states to help calculate thetaxes due from purchases based on the tax rateof the state where the item is to be sent. A thirdoption would be for vendors to use their ownproprietary systems to calculate, collect, andremit the tax owed. In each case the basis fordetermining the appropriate tax rates wouldbe the zip codes of the buyers.

The SSTP/SSUTA scheme raises a host oftroubling questions. To begin, harmonization,uniformity, and simplification—the corner-stones of the SSUTA—have many downsides.“While simplicity sounds nice, the devil will bein the details,” argue Wagner and Anderson.“Centralized uniformity for sales tax alsoinvites additional pondering such as the desir-ability of uniformity and centralization ofproperty tax administration. At what pointdoes state and local revenue sovereignty andautonomy disappear?”75 For now, the SSUTAwill be limited to the harmonization of taxbases between states and some state and localtax rates.76 This system would entail some lossof state sovereignty and local autonomy overtax policy, especially if “harmonization” wastaken to the extreme under the SSUTA. AsCharles McLure, a leading simplification pro-ponent, explains, “The SSTP has made amaz-ing progress in achieving simplification. Yet itwould not achieve elegant simplicity or eco-nomic neutrality until it goes the full nineyards with harmonization.”77 Indeed, as a con-dition of its approval of the SSUTA, Congressmay actually require more harmonization—especially of tax rates—before giving its formalblessing to the compact. In the name of trulysimplifying tax administration for vendors,

Congress could require the ultimate in salestax harmonization—one rate per state with nolocal variations.

But as Fred L. Smith Jr. of the CompetitiveEnterprise Institute has aptly noted: “Har-monization of tax policy is not necessarilygood policy. Competition is useful in the mar-ketplace, but it is perhaps even more valuablein the political world.”78 Bringing greater uni-formity to the current system may have somepositive benefits, such as more straightfor-ward tax administration, but it would come atthe expense of tax competition between thestates and localities. Moreover, when support-ers of the SSUTA argue for greater uniformityin the sales tax system, they may just be mak-ing a covert effort to sustain higher tax ratesand expand the current system to incorporateremote vendors on interstate goods and ser-vices. But at what cost? The states are essen-tially proposing to abandon true federalismand jurisdictional tax competition inexchange for the power to potentially recoup asmall amount of tax revenue from interstatesales through a uniform system of third-partytax collection. Sadly, it appears that state andlocal officials would prefer to create a cozy taxcartel instead of relying on a “laboratories ofdemocracy” model of competition betweenthe states.

Many analysts have labeled the SSTP/SSUTA proposal “collusive federalism”79 or“cartel federalism,”80 because it runs counterto America’s true federalist structure of gov-ernment and has very little to do with protect-ing states’ rights. In fact, if a state wants tosimplify its sales tax base, it can do so and doesnot need to reach an agreement with otherstates. Federalism is about state indepen-dence, not state collusion. “It is unfortunatethat supporters of the SSTP cloak their argu-ments in federalism. Their arguments rendthe concept to the point of meaninglessness,”argues Michael Flynn of ALEC.81 AndEmpower America co-director Jack Kemp hasargued that the proposal “does not appear toconform to its proponents’ stated admirationfor states’ rights. . . . [It] turns over some of themost important state power—the power to

20

The SSTP/SSUTAscheme raises a

host of troublingquestions.

formulate tax policy among them—to an ill-defined board or commission empanelledwith representatives of unknown origin. . . . [It]would create a sub-national, supra-state, extra-constitutional (and possibly unconstitution-al) governance body that is inconsistent withthe principles of federalism and state sover-eignty.” Kemp concludes that the plan “is thevery antithesis of American Federalism.”82

Supporters of the SSUTA strongly disputethe claim that the proposed compact repre-sents a tax cartel, yet there seems to be littledoubt that the system would require a signifi-cant degree of collusion among the states towork. Participating states would have to agreeon tax collection responsibilities and worktogether to enforce taxes on each other’s com-panies and foreclose the opportunity for com-panies or consumers to escape taxes. Underthis system, when an individual in New Yorkbuys a book on Amazon.com, he would betaxed at the New York rate, and Amazon.comwould be required to collect that tax on thebasis of the buyer’s home zip code. It meansthat the buyer in New York will have no choicebut to pay the New York tax rate on his pur-chases unless he decides to take his car anddrive across the state lines to shop outside ofNew York. In other words, the individualwould no longer be able to shop online inorder to enjoy a lower tax rate or no tax,because he would systematically be chargedthe New York rate for every transaction. TheState of New York would not be able to placeits taxpayers in a situation where they areforced to pay New York’s high tax rate withoutthe help of other states that impose the collec-tion responsibility on retailers. The handful ofstates that did not initially go along with theplan would likely join in very short order oncethey realized that their companies were beingrequired to collect taxes from and remit themto far-off jurisdictions while they were not col-lecting taxes on out-of-state companies. Thislikelihood reinforces the collusive nature ofthe agreement.

Also, the harmonization and simplifica-tion envisioned by SSTP supporters wouldneed to be strictly enforced by a multistate

governance body to ensure that the systemwas truly simple enough to satisfy the Quillrequirement that undue burdens not beplaced on interstate commerce. Some remotevendors have argued that nothing short of onetax rate per state will satisfy that objective. Butto go that far would require the SSTP govern-ing board to demand that member states (andespecially local governments) surrender aneven bigger portion of their autonomy in thename of harmonization and simplification.(Again, Congress may require that anyway as acondition of SSUTA approval.) In fact, theSSUTA currently contains numerous provi-sions specifying how and when jurisdictionscan change their tax rates or rules as well assanctions for noncompliance.83 So efforts tobreak from the pack or break the rules of thecompact would be penalized by the governingboard. This also reinforces the collusive natureof the SSUTA.

For these reasons, many scholars haveexpressed concerns about the SSUTA andhave even gone so far as to label it a tax cartel.Semantics aside, at a minimum, what is cer-tain is that the SSUTA (or any destination-based tax system that calls for the collectionof taxes from out-of-state vendors) willrequire the blessing of Congress given itsramifications for interstate commerce andthe language of Article I, Section 10, Clause 3of the U.S. Constitution. An attempt by thestates to implement the SSUTA compactwithout the formal permission of Congresswould likely raise a court challenge. (Untilsuch formal recognition of the compact byCongress was received the SSUTA wouldremain voluntary for both states and partici-pating companies.)

Hopefully, Congress will carefully considerany plans to extend the power of the states tocollect taxes on out-of-state purchases and toreduce tax competition. Writing for theClaremont Institute, Kent Lassman and AnnaDuff note: “Congress must bear in mind theimportant point that the Constitution seeksprimarily to protect interstate commerce, notinterstate tax collection. One of the funda-mental purposes of the Commerce Clause was

21

Supporters of thSSUTA stronglydispute the claimthat the proposedcompact repre-sents a tax cartel,yet there seems tobe little doubtthat the systemwould require asignificant degreof collusion.

to promote healthy tax competition amongstates in terms of taxation and regulation.”84 IfCongress were to allow states to engage intheir tax harmonization plans, a key elementof limited government—jurisdictional compe-tition between states—might suffer.

Second, it bears repeating that the reasonthe states are going to such lengths to over-haul the current sales and use tax system isthat they remain wedded to a destination-based tax-sourcing scheme for interstate sales.A destination tax is levied on the full retailvalue of imports into a state. Interstate exportsare exempt, and any tax collected before theexport is refunded. Again, advocates of a desti-nation-based tax on interstate imports claim ithas several advantages.85 Most notably, it issupposed to ensure equality of treatmentbetween vendors in order not to distort thelocation of economic activity and to serve rel-atively well as a surrogate for user charges forthe consumption of public services.

As discussed earlier, however, a destina-tion-based sourcing methodology has manydeficiencies. First, many destination-basedadvocates seem to assume that individualsand society would be better off with a highertax burden. They reason that, under a desti-nation-based system, the consumer in NewYork will face the same tax rate whether hebuys a book at his local bookstore or over theInternet. The lack of distortion is supposedlyconsistent with economic efficiency. In otherwords, adding a tax to the good purchasedthough the Internet restores economic effi-ciency because it gets rid of the distortion.Advocates argue correctly that the con-sumer’s decision about where to buy thegood is distorted by differences in tax treat-ments. However, they forget that the taxintroduces distortions of its own, causingsubstantial waste that economists call thedeadweight loss of taxes. Then, they improp-erly assume that the efficiency loss from thedistortion (the difference in tax treatment) isbigger than the deadweight loss of the addedtax. Such a conclusion seems arbitrary. At thevery least, it is an empirical issue that desti-nation-based tax advocates have yet to prove.

People shop online because they want topay fewer taxes and use the money they didnot pay in taxes to buy something else thatthey really value. According to a study byAustan Goolsbee, “the people living in highsales tax locations are significantly more like-ly to buy online.”86 We can probably concludethat for those people getting rid of the dis-tortion by forcing them to pay the tax will beless efficient and lessen tax competition.

More important, if tax neutrality is theabsolute standard by which we should addressall policy problems, then destination-basedtax advocates may find themselves on a slip-pery slope. After all, the destination-based sys-tem found in the SSTP does not address thefact that an individual in Washington, D.C.,can still, at almost no cost, shop in Virginiawhere the sales tax rate is lower. Cross-bordershopping is still an option that induces a lot ofdistortions (in fact much more than theInternet considering how widespread cross-border shopping is).87 So logically—if they real-ly hold tax neutrality to be a sacrosanct princi-ple—advocates of a destination-based taxshould be in favor of equalizing or harmoniz-ing sales tax rates across state lines so con-sumers do not have an incentive to drive toother states to shop and benefit from lowertax rates. In fact, to ensure a strict applicationof the SSTP or any other destination-based taxsystem, a taxpayer should face their home-state tax rate regardless of where or how theyshop. To achieve perfect “fairness” or “neutral-ity,” Main Street vendors would need to askevery consumer where he or she resides orplans to consume the good.

Kaye Caldwell, public policy director forCommerceNet, says that as a legal matter thismay have to be the case for states to complywith constitutional jurisprudence on equalprotection. “If states are allowed to imposeuse tax collection obligations on out-of-stateeCommerce and mail order merchants thenin order to comply with the Equal Protectionclause they will have to impose those obliga-tions on Main Street merchants also.”88 Thepractical enforcement costs and difficulties ofsuch a requirement are obvious.89 “Imagine

22

States remainwedded to a

destination-basedtax-sourcing

scheme for interstate

sales.

the administrative nightmare for local storeswhen a convention comes to town!” notesCaldwell. Merchants would need to deter-mine the proper tax jurisdiction, rates, anddefinitions for every out-of-state visitor.90

While the SSUTA does not mandate a desti-nation-based methodology so sweeping thatall vendors will be required to collect suchinformation about consumers, it remains anopen question whether Caldwell is correct inthinking that eventual legal challengesbrought under the Equal Protection Clausemight force such a requirement.

Beside the significant enforcement costs,such a strict application of the destination-based tax principle would essentially elimi-nate most vestiges of legitimate tax competi-tion and thereby the downward pressure suchcompetition places on overall sales tax rates.Protected from the threat of seeing taxpayersshop in other states because taxes may belower, tax authorities would have no incentiveto keep their own tax rates low. In fact, themost fervent advocates of a destination-basedtax explain how its alternative—an origin-based tax system—“while simpler to imple-ment would induce a race to the bottom, asstates compete to attract footloose industryby lowering taxes.”91

A final concern related to the SSTP pro-posal involves the use of CSPs as tax collectorson behalf of the states. Deputizing third par-ties to collect taxes on behalf of the govern-ment is an idea with an unsettling history. Inthe study of economics, third-party tax collec-tion systems are more commonly known as“tax farming” systems. Tax farming is the con-tracting-out of tax collection duties to privateparties. Third-party agents typically bid for theright to collect taxes on behalf of the govern-ment and then take a certain share of the taxescollected to make it a profitable endeavor.Since antiquity, tax farming was viewed bymany governments as a more efficient way tocollect taxes. In practice, however, tax farmingrarely worked as well as promised, and when itdid, citizens came to despise it.92

This is because third-party tax collectionsystems create a perverse incentive for the dep-

utized private-sector tax collectors to engagein overzealous enforcement activities in aneffort to increase their own profits. To raisemore revenues, tax farmers often engaged indisturbing practices. Consequently, citizenshave rebelled against tax farming schemes orat least protested their existence. And withgood reason. Third-party tax collectionschemes pose a serious threat to citizens’ prop-erty and privacy. Furthermore, the possibilityof rampant fraud is always present in suchschemes. Simply stated, there are many gov-ernment functions that should be privatized,but tax collection is not one of them.

Despite claims to the contrary and ahandful of safeguards included in theSSUTA, the CSP tax collection system beingproposed under the compact could pose anequally serious threat to individual and cor-porate privacy, especially if certain CSPsbecome overzealous tax collectors or divulgepersonal data. Under the SSUTA, the CSPswould need to collect a variety of informa-tion to successfully collect taxes on interstatecommercial transactions. This is quite unlikecurrent intrastate, origin-based sales taxtransactions, which do not require the disclo-sure of similar information as part of thetransaction.

In a typical transaction in a retail store,the buyer and seller exchange little more thanmoney. Occasionally a vendor will ask for thezip code of the buyer, but such information istypically not required to be given by the buyerin order to complete the transaction. Underthe SSUTA, there would have to be some wayto track the location of the buyer at all timesin order to remit money to the appropriatetax collectors. Other forms of consumerinformation would also be collected by theCSPs to facilitate the sale, including personalinformation about the consumer and thegoods or services purchased. These thingscould compromise online confidentiality oranonymity and, in turn, discourage e-com-merce. “Since most online consumers valuetheir privacy, knowledge that a governmentcontractor’s software is embedded in themerchant’s software and is recording the

23

Third-party taxcollectionschemes pose aserious threat tocitizens’ propertyand privacy.

name and address of each purchaser, alongwith the substance of each purchase—includ-ing book selection, the purchase of on-linecontent and entertainment, and procure-ment of drugs and other personal items—could inhibit online shopping,” concludesattorney Lee Goodman.93

To summarize, the tax collection schemethe SSUTA envisions is neither as adminis-tratively simple as supporters claim, nor is itfree of potential privacy violations. TheSSUTA system would place substantial newtax collection obligations on vendors (includ-ing, possibly, Main Street merchants)94 andrequire consumers to divulge more personalinformation than is currently required tocomplete a sale.

In terms of the practical question ofimproved sales tax administration, one won-ders whether the benefits of the SSUTA sys-tem would outweigh the costs and complexi-ties associated with its creation. The currenteffort to “simplify” the sales tax system looksawfully complex. As Andrew Wagner andWade Anderson summarize: “Efforts to over-ly complicate our existing destination-basedtax system simply to capture one potentiallysmall area of revenue escaping taxation is tan-tamount to shooting a mouse with an ele-phant gun. That is to say, is a radical overhaulof the entire destination-state sales tax reallyneeded?”95

Option 2: Expand Efforts to Enforce UseTax Collection

As previously discussed, every state thathas a sales tax also has a use tax on its books,but use taxes remain difficult to collect andare seldom enforced. The level-playing-fieldconcern that has animated state and localefforts to create a harmonized collectionscheme for remote commerce such as theSSTP stems from the inability of states andlocalities to enforce existing use taxes. In the-ory, therefore, it seems that expanding effortsto collect use tax would address the collec-tion problem and end level-playing-field con-cerns. It would also get around many of theconstitutional concerns raised by state and

local attempts to impose collection burdenson remote vendors of interstate commerce.Because use taxes instead impose the collec-tion burden on the individual citizens withina jurisdictions, state and local governmentscan justly claim they have a right to take stepsto collect those taxes.

In recent years some states have takensteps to increase compliance with use tax bystepping up oversight efforts by tax agenciesemploying new enforcement techniques andeducating their citizenry about use taxresponsibilities in general. For example, taxauthorities in both Michigan and NorthCarolina have taken steps to make their usetax easier to apply to purchases made over theInternet.96 They join states such as Connect-icut, Idaho, Indiana, Kentucky, Maine, andWisconsin, which have been trying for yearsto improve their collection mechanisms foruse taxes.

Unfortunately, although this optionaddresses some of the concerns about neu-trality and fairness, it raises other practicalquestions. To begin, despite stepped-up edu-cation and enforcement efforts, experiencesuggests that the use tax will remain very dif-ficult to enforce. As Saba Ashraf noted in theFlorida State University Law Review in 1997:“Collecting the use tax from the purchaser,particularly where the purchaser is an individ-ual, is often inefficient and not cost-effective.This is especially so because many consumersdo not realize they are subject to the tax.”97

Also, if enforcement efforts are steppedup, what will happen to taxpayers who havenot purchased any goods on the Internet? Ifa taxpayer reports “zero” in the new line onthe income tax form for out-of-state pur-chases, will he be systematically subjected toan audit? Who will bear the burden of theproof? Will taxpayers have to prove that theydid not buy anything on the Internet? Howwould one challenge the estimate of out-of-state purchases made by tax authorities?

Just how far are state and local officialswilling to go to collect the use tax? Theeagerness of some officials to capture thisrevenue was evidenced dramatically during a

24

The SSUTAsystem wouldplace new tax

collection obligations on

vendors andrequire

consumers todivulge more

personal information.

December 1999 meeting of the ACEC, whenGov. William Janklow (R-S.D.), now a mem-ber of the U.S. House of Representatives, tes-tified on behalf of the National Governors’Association, warning that, ultimately, “we’regoing to start stopping little brown trucksand going to start examining these pack-ages,” to determine whether taxes were paidon each purchase.98 Although it is unclearwhether America’s governors and mayors willbegin taking such drastic steps to monitorcommercial transactions, Rep. Janklow’sfears and frustrations regarding e-commerceillustrate the prevailing mood among stateand local officials.

Finally, expanded enforcement of usetaxes raises serious privacy concerns, becauseit would require a considerable increase inindividual audits and the collection of per-sonal data by state revenue officials. As DanaMayton, a Kentucky state revenue official,told USA Today in 2000, “People really feelthat use tax compliance is Big Brother at itsfinest.”99 In fact, history teaches that we havereason to be concerned about personal datacollection by governments. Moreover, thereseems to be little sense in going to suchextremes to save a tax that is fundamentallyunenforceable. “From the average con-sumer’s standpoint, the use tax is probablythe most ludicrous and patently unenforce-able tax on the books,” argues DougLathrop.100 “It requires the citizen to become,in effect, a state tax collector. From what weknow of human behavior, it defies logic toexpect people to save all their sales receiptsfrom trips to other states, calculate the salestax of their home state, and then write acheck for the amount.”

This explains why, in order to effectivelylevy and collect use taxes on their citizens,states have sought to impose a collectionobligation on out-of-state vendors requiringthem to calculate, collect, and remit the taxesowed by in-state consumers. But under exist-ing Supreme Court precedent, the states areforbidden to impose such a collection bur-den on remote vendors unless those vendorshave a “nexus,” such as a store or shipping

center, in the taxing jurisdiction. States andlocal governments would need Congress torelax or lift the Supreme Court Quill restric-tion that forbids them to impose collectionresponsibilities for use taxes in such anextraterritorial fashion.

Option 3: Maintain the Status QuoA third option is to maintain the status

quo. If nothing were to change at the state orthe federal level, Supreme Court nexus prece-dents would continue to provide the generalguidelines for how sales and use taxes areapplied to interstate commercial activity,including mail order, catalog sales, and 800-number sales, as well as e-commerce.

Clearly, maintaining the status quo is avery appealing option, and policymakerswould be wise not to abandon it hastily if thealternatives result in higher tax burdens.More specifically, the status quo would clear-ly be preferable to the other reform optionscurrently being given serious consideration,such as the SSUTA. For one thing, the currentlegal arrangement has enabled the interstatemarket for mail order, catalog, and e-com-merce activity to thrive, free of burdensometax collection duties. Although it would bewrong to make an “infant industry” argu-ment for special treatment for these sectors, itseems logical that an increase in the tax bur-den would have a debilitating effect, especial-ly on the struggling “dot-com” sector. Anempirical study by Austin Goolsbee showsthat local taxation plays an influential role inonline commerce and that “applying existingsales taxes to the Internet might reduce thenumber of online buyers by 24 percent ormore.”101

Although maintaining the status quo forthe interstate market and remote sales taxcollection remains an appealing option, stateand local officials will continue to bemoanthe supposed un-level playing field betweenremote sellers and Main Street vendors. Eventhough remote commerce does not pose aserious threat to Main Street businesses orthe sales tax base, the argument that the salestax regime should not artificially favor some

25

Maintaining thestatus quo is anappealing optionand policymakerwould be wisenot to abandon it hastily if thealternatives result in highertax burdens.

sales channels over others possesses consider-able force. As discussed below, however, thereare better ways to address this problem thanby adopting a multistate tax compact such asthe SSUTA.

Option 4: Reinforce Current NexusGuidelines

A better option than merely maintainingthe status quo would be to reinforce and clar-ify nexus standards in light of the rise of e-commerce and the many confusing tax nexusquestions that have resulted. Building on theSupreme Court’s Quill decision, the ideawould be for federal policymakers to fleshout and clarify situations and activities inwhich the use of the Internet (as a means ofcommunications and sales solicitation)would not be considered evidence of physicalpresence and therefore would not establish abusiness’s nexus in a state for tax purposes.This is commonly referred to as establishing“bright-line” nexus tests or standards,because it would provide safe harbors for cer-tain types of commercial transactions whilemaking clear which activities would cross thenexus threshold and establish physical pres-ence so that a tax jurisdiction could imposeduties to collect sales or use taxes.

This option was outlined in a bill (S.2401)102 introduced in the 106th Congress bySens. Judd Gregg (R-N.H.) and Herb Kohl (D-Wis.) based on a plan created by Dean Andalof the California State Board of Equalization,a former member of the Advisory Commis-sion on Electronic Commerce.103 The Gregg-Kohl bill and the Andal plan would havebroadened the protections provided by Quillby specifically enumerating the types ofInternet transactions or activities that couldand could not be taxed. Gregg-Kohl wouldhave substituted a “substantial physical pres-ence” standard for the less inclusive “physicalpresence” test outlined in Quill, so it wouldbecome clear that without a significant pres-ence in a particular state, companies wouldnot be forced to collect taxes for that taxingjurisdiction. In particular, under the Gregg-Kohl proposal, the following activities would

not, in and of themselves, establish tax nexusfor interstate vendors of e-commerce:104

• The solicitation of orders or contractsfor tangible or intangible property orservices that are approved outside astate and are fulfilled from a point out-side the state.

• The presence or use of intangible prop-erty in a state, such as patents, copy-rights, trademarks, logos, securities con-tracts, money, deposits, electronic ordigital signals, and Web pages.

• The use of the Internet to maintain aWeb site accessible by customers in astate.

• The use of an Internet service provider,online service provider, or other types ofInternet access providers, or WorldWide Web hosting services to maintain,take, or process orders via a Web pagesite or server located in a state.

• The use of any service producer fortransmission or communication bycable, satellite, radio, telecommunica-tion, or similar systems.

• The affiliation with a person located ina state, unless the person is an “agent”of the business entity who meets thesubstantial physical presence standard.

• The use of independent contractors orrepresentatives for warranty or repairservices.

Nexus clarification along those lineswould certainly benefit consumers and busi-nesses by answering many complicated ques-tions surrounding the tax treatment ofremote sales and e-commerce. As SupremeCourt precedents have shown, determiningnexus is a messy business, an imprecise sci-ence to say the least. Although the courtshave struck a reasonable balance when con-fronted with complicated disputes, thereremains a substantial degree of ambiguity inmodern nexus jurisprudence. Efforts such asthe Andal proposal and the Gregg-Kohl billclearly cannot anticipate all the possible dis-putes or future developments involving

26

A better optionwould be to

reinforce andclarify nexus

standards in lightof the rise ofe-commerce

and the manyconfusing tax

nexus questionsthat haveresulted.

remote commercial tax disputes, but theycan at least attempt to bring nexus law intothe 21st century by clarifying the applicationof Supreme Court and constitutional princi-ples to the more complicated technical issuesof the day.

Even though many remote vendors wouldendorse such a proposal, most state and localofficials and tax groups continue to opposeany effort to clarify or refine the Quill deci-sion or expand nexus guidelines in general.According to a CRS Report for Congress onInternet tax legislation, “state and local gov-ernments generally oppose federal efforts tocodify nexus standards, which they view asunduly restricting states’ ability to levy busi-ness activity (income) taxes as well as salesand use taxes.”105 This is highly unfortunatebecause a nexus clarification proposal wouldprovide exactly the sort of certainty the cur-rent system lacks and offer remote sellers theprotection they deserve from unwarrantedextraterritorial tax schemes.

Option 5: Specifically Exempt AllInternet Sales/E-Commerce from Salesand Use Taxes

Some federal legislators have suggestedthat the easiest way to solve the problemsraised by the imposition of sales and use taxeson the Internet is simply to prohibit the taxa-tion of e-commerce altogether. For example,in the 106th Congress, such outright prohibi-tions of state and local sales taxation of e-com-merce were proposed by Rep. John Kasich(H.R. 3252) and Sen. John McCain (S. 1104).Such reform alternatives were defended on thegrounds that e-commerce is the source ofincreased productivity and as such should beexempted to provide a chance for this impor-tant new sector to flourish.

Even though this option might soundappealing to some, it is highly improbablethat it would be proposed by many state orlocal level officials; only federal legislatorswould be ever be likely to consider seriouslysuch an outright ban on all such taxes. Andstate and local leaders would certainly chal-lenge the constitutionality of such a move

since it would prohibit them from collectingtaxes on sales made within their own borders.And, once again, fundamental tax fairnessconcerns would be left undressed by such aproposal. In fact, a federal ban on all e-com-merce taxes would obviously exacerbate exist-ing tax exemptions and asymmetries.

Option 6: Provide Sales Tax Exemptionsfor Tangible Products with DigitalEquivalents

Main Street retailers continue to claimthat they suffer a competitive disadvantagerelative to their Internet counterparts who donot face the same tax collection burdens. Onepotential partial solution would be toexempt those items sold by traditional ven-dors that cyber-retailers sell in digital format,such as musical compact discs, digital videos,books and magazines, and other forms ofentertainment. In other words, exempt thesale of all digitized goods, and also exempttheir non-digitized counterparts that are soldby traditional vendors.

This was an option debated by the AdvisoryCommission on Electronic Commerce andsubsequently embodied in a legislative propos-al (H.R. 4267) put forward by Reps. Henry Hyde(R-Ill.) and John Conyers (D-Mich.) in the 106thCongress.106

The problem with this solution is that theconcern about a level playing field wouldremain since many goods not sold throughthe Internet would still be subjected to a tax.In fact, those goods, and the providers ofthose goods, would then face a dispropor-tionate sales tax burden as the list of exempt-ed goods expanded. Moreover, even if stateand local officials were to consider such areform option, which seems highly unlikely,it would be extremely difficult for them todecide where to draw the line to determinewhich goods would be exempted and whichwould not. Finally, as the universe of goodsoffered online continues to grow, providingmatching online and offline exemptions inthe name of tax fairness would place anotherserious strain on the already diminished salestax base. For these reasons, this option is not

27

A nexus clarification proposal wouldprovide the sortof certainty thecurrent systemlacks.

likely to be considered seriously by most stateor local officials or Congress.

Option 7: Reform Sales Tax Policies orEnd Exemptions to Broaden the Base

The current sales and use tax base is rid-dled with holes largely because state andlocal officials have spent decades playing pol-itics with the tax code to favor certain indus-tries or interests. In one sense, therefore, ifstate and local officials wanted to get reallyserious about tax neutrality and create a per-fectly level tax playing field, they would needto end all exemptions for favored productsand industries (e.g., food, groceries, prescrip-tion drugs, and clothing), and all serviceindustry activities.

This reform option is highly improbable,however, simply because it is such a political-ly sensitive solution. There is a reason whythe sales tax base ended up the way it did,replete with loopholes and exemptions.Politicians love to tinker with the tax code inorder to grant special treatment to interestgroups and businesses in exchange for votes.Those interest groups and businesses havelittle incentive to stop lobbying politiciansfor such exemptions. In fact, on the rare occa-sions that state and local officials haveattempted to end certain goods- or service-based exemptions, the affected interestsfought back with a vengeance and in almostevery case killed the proposals or forced therepeal of the reform efforts shortly after theywent into effect.107

The more serious problem from a con-sumer perspective is that it would lead to taxincreases on a wide variety of popular goodsand services. If the affected industries did notlead the revolt against such proposals, con-sumers likely would. And practically speaking,taxing services would create significantenforcement burdens and potentially raise pri-vacy questions, especially for digital services.

Option 8: Adopt a Uniform Origin-BasedSystem of Sales Tax Collection

The existing sales and use tax regimes—and most proposals to reform Internet taxa-

tion—are based on sourcing interstate salestransactions to the destination of sale (thecustomer’s shipping or billing address).108 Asmentioned previously, relying on a destina-tion-based sourcing methodology raises avariety of problems, especially when thechanging nature of the economy is takeninto account. “All the seemingly intractableproblems of the e-tax debate—in particular,the differential treatment of ‘Main Street’and ‘remote’ sales, as well as the extravagantcompliance and administrative costs—stemfrom the choice of destination as the regula-tory principle,” notes Michael Greve.109

By comparison, under an origin-basedsourcing rule—also referred to as a “seller-state,” “vendor-state,” or “source-based” ruleby some scholars—all interstate sales throughall channels (traditional stores or cyber-retail-ers) would be taxed at the point of sale(meaning the company’s “principal place ofbusiness”) instead of at the point of destina-tion, if the state or locality chooses to imposea tax. All goods within a given state or locali-ty would be taxed at the locally applicablerate no matter how they were purchased andno matter where they were consumed.

This option would take care of most ofthe problems posed by the destination-basedmethodology that is favored by most stateand local policymakers today. Terry Ryan andEric Miethke, and many other sales tax schol-ars, have detailed the many advantages of anorigin-based system.110 According to its pro-ponents, an origin-based or seller-state sys-tem would do the following:

• Minimize the burden on sellers byrequiring sellers to know and abide bythe tax rates and regulations within theirprincipal place of business instead of therates and definitions of 7,500 differenttaxing jurisdictions. This is “an especiallyimportant advantage for smaller firmswith relatively high compliance costs.”111

• Ensure tax parity between MainStreet vendors and remote sellers:“An origin-based sales tax is not dis-criminatory because it can be applied to

28

The current salesand use tax base

is riddled withholes largely

because state andlocal officials

have spentdecades playingpolitics with thetax code to favor

certain industriesor interests.

all sales within a state in a uniform andnondiscriminatory manner. By its verynature it tends to level the playing field,”argue Andrew Wagner and WadeAnderson.112 This would eliminate con-cerns about neutrality and fairnessbecause no difference in tax treatmentwould occur; in-state Internet vendorswould be taxed on the same terms as in-state bricks-and-mortar merchants. Forinstance, if a consumer purchases abook from Amazon.com, whose princi-pal place of business is Seattle, the salestax rate for the city of Seattle and thestate of Washington would apply, just asif the consumer walked into a tradition-al store in Seattle and purchased a bookwhile visiting the city.

• Do away with the need for a multi-state collection arrangement such asthe SSTP by eliminating any need totrace interstate transactions to the finalpoint of consumption. Frieden notesthat “if sales are sourced to the vendorstate, there is no Quill Corp. v. NorthDakota or constitutional nexus problem.The vendor state already has the consti-tutional authority to require the seller tocollect sales or use tax in the state of ori-gin.”113

• Remove nexus uncertainties and con-stitutional concerns, because only com-panies within a state or local government’sborders would be taxed. “An origin-basedsystem wipes away all the questions aboutnexus and liability for multiple tax juris-dictions,” notes Doug Lathrop.114 Indeed,Paul Gessing of the National TaxpayersUnion writes, “This would in essence bethe ultimate form of nexus simplifica-tion.”115 Although he is not a proponentof an origin-based rule, Karl Friedennonetheless notes: “If the state-of-originrule is used, then there need be no bur-densome administrative rules on how toidentify the state of consumption or, as analternative, the location of the consumer’sbilling address. Likewise, there is no needto develop rules for sourcing sales that

involve multiple users because these salesare all sourced back to the state of ori-gin.”116 Indeed, opting for an origin-basedsourcing rule would likely be a superioralternative to nexus clarification becausenexus clarification schemes will always failto conceive of all the ways in which cre-ative tax collectors might attempt toimpose collection duties on remote sellers.By contrast, an origin-based sourcing rulewould simply need to define the “principalplace of business” for sourcing purposes,and then no additional tax obligationscould be imposed. Finally, the constitu-tionality of an origin-based system shouldcertainly not be a problem, especially inlight of the Supreme Court’s 1995 deci-sion in Oklahoma Tax Commission v. JeffersonLines,117 which held that a state couldimpose a tax on the full value of a bus tick-et purchased in Oklahoma even thoughpart of the trip took place out of state. Inessence, the Court reasoned that the salestax should be an unapportioned tax onthe full value of a good or service that isaffixed at the point where the service isperformed or the good is sold.118 This isbasically an endorsement of an origin-based sourcing methodology.119

• Largely remove any need for continuedreliance on the use tax because all trans-actions would henceforth be sourced tothe origin of sale and collected immedi-ately by the vendor at that point. Evenproponents of a destination-based systemlike William Fox and Matthew Murray areforced to admit that origin-based taxes“have clear compliance and administra-tive cost advantages over their destina-tion-based counterparts through theelimination of the use tax problem.”120

• Respect buyers’ privacy rights by elim-inating the need to collect any special orunique information about a buyer, andby not using third-party tax collectors togather information about buyers. Underan origin-based scheme, vendors needonly know the tax rates and rules oftheir principal place of business.121

29

Under an origin-basedsourcing rule all interstate sales through allchannels wouldbe taxed at thepoint of sale.

• Respect federalism principles andenhance jurisdictional tax competi-tion by permitting each state to deter-mine its own tax policies and encourag-ing healthy state-by-state tax rivalry.Under an origin-based tax system, taxjurisdictions have an incentive to lowertax rates to attract businesses and henceconsumer purchases. Such tax competi-tion between jurisdictions lowers overalltax rates and reduces the inefficiency ofthe tax system as a whole. In economicterms, origin-based tax systems lead tolower marginal tax rates and to smallerdeadweight losses from taxes. In addi-tion: “An origin-based system is fullyconsistent with sound federalism prin-ciples. Each state would be free to taxand regulate its own businesses and cit-izens as it saw fit. Each state’s regulato-ry autonomy and authority, however,would stop at the border—which iswhere the state ought to stop,” arguesGreve.122 An origin-based system wouldnot require the extensive harmonizationor centralized, collusive multistate taxadministration efforts envisioned in adestination-based plan like the SSTP.

• Preserve local jurisdictional taxauthority where a harmonization pro-posal like the SSTP plans would create ade facto national sales tax system andrun roughshod over local governments.Under an origin-based plan, local gov-ernments could retain whatever tax rateand tax base schemes they want; no har-monization or centralization would berequired.

• May be more politically feasiblebecause it remains unclear whetherCongress or the courts will alter existingnexus standards and allow extraterritor-ial taxation by state and local govern-ments according to a destination-basedscheme.

• May maximize the amount of tax col-lected for states by making complianceeasier and incorporating activities thatare currently untaxed. Simply stated, an

origin-based methodology would atleast offer state and local governmentsthe ability to collect taxes on remotesales activities that originate withintheir jurisdictional boundaries ratherthan continue a potentially futile effortto concoct multistate harmonizationschemes to enforce use taxes.

Given the many advantages of an origin-based scheme over destination-based alterna-tives, why haven’t many state or local officialsconsidered it as a serious alternative in thisdebate? State and local officials remain wed-ded to a destination-based system mostlybecause they believe that an origin-based sys-tem of sales taxation would constrain theirability to tax out-of-state vendors and forcethem to make tough political decisions with-in their own jurisdictions regarding how thetax burden is to be assessed. Governors, may-ors, and other local tax officials fear theprospect of dealing with the vigorous juris-dictional tax competition that would existunder an origin-based system, because com-panies could “shop around” for the more hos-pitable tax environments. Some critics positthat increased tax competition would lead toa “race to the bottom” in terms of tax rates, asstate and local governments attempt toattract new companies by lowering rates.123

But tax competition is a healthy part of afederalist system of government, and itshould be viewed as a benefit, not a draw-back, of an origin-based system. Competitionbetween governments serves the same func-tion as competition between private busi-nesses and can help protect taxpayers againstabuses or excessive tax burdens. Moreover,the “race to the bottom” fear is probablyoverblown. Tax policy is only one of manyfactors consumers or corporations considerwhen determining where to live or locatetheir businesses. Proximity to consumers orsuppliers, quality of local educational systemor worker base, loyalty to local employees andcommunities, and other general issues relat-ed to standard of living are values or consid-erations that also bear on the minds of busi-

30

An origin-basedsystem would

not require the extensive

harmonization or multistate tax

administrationefforts envisioned

in a destination-based plan.

nesspeople and consumers when decidingwhere to reside. Some companies may chooseto “pick up shop” and move to more hos-pitable jurisdictions if tax rates becomeexcessive under an origin-based system, but itis unlikely that there will be a mass exodus offirms from one state to another, or offshore.

A more sophisticated critique of an ori-gin-based methodology for remote sales isthat it fails to achieve the primary goal of thesales tax—to assess the tax on those userswho benefit from the consumption of publicservices. Again, in theory, the sales tax is a levyon the consumption or use of goods within agiven jurisdiction in return for which theconsumer of those goods receives some bene-fit. An origin-based tax methodology forremote commerce actually better honors this“benefit principle” than does a destination-based system. After all, who is really benefit-ing more from the taxes that are being paidin the case of an interstate transaction—theseller or the buyer? For the most part, thepublic services used to facilitate an interstatetransaction are primarily “depleted” or con-sumed in the seller’s state, not the buyer’s. Ifremote sellers are forced to collect taxes onbehalf of far-off jurisdictions, as the SSTPenvisions, the benefit principle is violated,because a remote vendor is in no way benefit-ing from the public services paid for by thosetaxes. Moreover, this supposed drawback ofthe origin-based system has to be measuredagainst the many downsides associated withthe current destination-based system, whichdoesn’t work very well in practice and raises anumber of constitutional concerns becauseof the extraterritorial character of remote col-lection of sales and taxes. An origin-basedsystem, by contrast, raises no such problems.

Of course, an origin-based tax system doesraise some technical issues that will need tobe worked out. For instance, how do wedefine the point of origin? In the case ofgoods purchased over the Internet, is thepoint of origin the place where the companyis headquartered, or the place where thegoods are produced? Is it the place fromwhich the good is shipped or the place where

the good is received? The origin-basedmethodology could be worked out amongthe states or outlined by Congress. Indeed,there already are a few examples of such ori-gin-based systems in place for interstateflower orders,124 the sale of prepaid long dis-tance calling cards,125 and the taxation ofmobile cell phones.126 A “principal place ofbusiness” rule would likely be the result,determining the origin of sale by calculatingwhere a seller had the bulk of its employeesand generated most of its profits.

As long as state and local policymakersremain committed to preserving the sales taxsystem as their primary tax base, the pure ori-gin-based rule outlined here offers them aneconomically sensible and constitutionallypermissible method of taxing e-commercesales. And an origin-based system would alsobe a better alternative for taxpayers and ven-dors of interstate commerce because it offersthem a straightforward tax rule that they canunderstand and comply with. Regrettably,however, it is not clear where the political sup-port will come from to transform this conceptinto law. The support is not likely to comefrom the state governments supporting theSSTP, nor will it come from states that have alimited base of technology companies withintheir borders. Such states would fear theywould be on the losing end of the battle toattract a greater high-tech base, or that an ori-gin-based approach would produce ruinouslevels of tax competition. Although such fearsare greatly overblown, perception sometimesdrives reality in the debate over tax policy andwill make it difficult for an origin-based pro-posal to gain much support.

Option 9: Abolish All Sales and UseTaxes

Because many economists agree that thesales and use tax system seems seriously threat-ened by its eroding base and potentiallyintractable compliance problems regardinginterstate sales, one radical option to resolvethis debate would be for states and localitiessimply to abolish sales and use taxation alto-gether. This option could be achieved by find-

31

As long as stateand local policy-makers remaincommitted topreserving thesales tax, the origin-based ruleoffers them asensible methodof taxing e-com-merce.

ing alternative revenue mechanisms to provideneeded government revenues. Correspond-ingly, of course, government budgets could betrimmed to bring spending down to more rea-sonable and limited levels.

But although total repeal of the sales taxsystem is theoretically appealing, practicallyspeaking it is highly improbable. Even in themidst of a general erosion of the sales taxbase, most state and local governmentsremain committed to preserving the sales taxas a revenue mechanism, given their histori-cal reliance on it. Moreover, abolishing thesales tax would pose special problems forstates such as Tennessee, Washington, orFlorida that do not have an income tax.Abolishing the sales tax in those states wouldalmost certainly lead to calls for the adoptionof an income tax, which would not be opti-mal. However, if states were to entertain theidea of eliminating their sales tax system andmoving to an income tax system, there areways to structure the income tax code to cap-ture consumption activity more efficientlyand effectively, as the final option reveals.

Option 10: Adopt a Savings-ExemptIncome Tax to Tax IndividualConsumption

“If indeed the administrative problems ofimposing sales and use taxes through theInternet are insurmountable, exempting elec-tronic commerce from transaction taxes anddeveloping another method of reaching thewealth added by such commerce may beappropriate,” argue Ryan and Miethke.127

Moreover, if the sales tax base continues toexperience steady erosion and average salestax rates continue to rise over time, the salestax system may become increasingly unwork-able and an unfair burden on taxpayers andbusinesses. If this proves to be the case andno reforms are undertaken in the near termto address the issue, state and local officialsmay eventually have to consider abolishingproduct-based (or transaction-based) con-sumption taxation altogether.

But alternative methods of taxing con-sumption exist. As Varian has noted, “If you

want a consumption tax, there is a much eas-ier way to do it than to track and tax each andevery purchase.”128 Like many other econo-mists, Varian endorsed some variation of asavings-exempt income tax (SEIT) or “con-sumed income tax” as a superior method oflevying taxes on individual consumption. Asany Economics 101 textbook makes clear,consumption is simply income minus sav-ings. Consequently, taxing consumptionthrough the income tax code presents analternative way to achieve the same end thesales tax attempts to accomplish. Under aSEIT, after all savings activity was exemptedfrom taxation, the remainder would be con-sider an individual’s consumption activityand taxed by governments at rates of theirown choosing. Varian continues:

Since many forms of savings, like Keoghplans, I.R.A.’s and pension contributions,are deducted from income before the taxis computed, our current federal andstate “income” taxes are effectively con-sumption taxes, at least for many taxpay-ers. Making savings tax-deductible is bet-ter than direct taxation of consumptionsince it has much lower administrativecosts. And the definition of savings canbe adjusted so that only saving that leadsto real capital formation qualifies for adeduction.129

The real advantage of a SEIT is that byshifting consumption taxes to the incomecode, a greater proportion of actual individ-ual consumption would likely be capturedsince there would be fewer exemptions forpolitically favored goods or industries. Andall individual consumption of services andinterstate goods (including e-commerce)would be captured by a SEIT. So any “levelplaying field” concerns associated with thecurrent system would disappear. As a result,whereas the current sales tax system inAmerica captures less than 50 percent of realindividual consumption by some measures, aSEIT would likely capture most consump-tion that took place within the economy.

32

The goal shouldbe to move

toward a systemof consumption

taxation that is both economi-

cally efficient andconstitutionally

permissible.

And supporters also claim it would accom-plish this without entailing the administra-tive complexity associated with the currentsales and use tax system. For these reasons, aSEIT is certainly a feasible alternative to thecurrent sales tax system and has beenendorsed by a number of economists.130

As with the other options discussed here,however, there are some serious drawbacks tothis reform option. Most notably, abolishingthe sales tax outright remains very unpopu-lar among politicians and would present spe-cial problems for states that rely exclusivelyon sales taxes as a revenue-generatingmethod. Until the situation grows moregrave for them, many state and local govern-ments will reject any suggestion that the salestax system should be abandoned. Of course,if they already have an income tax system tofall back on, they may be able to make a tran-sition work over time without much pain.But for states without an income tax, such atransition would be much more difficult andpotentially very unpopular with the citizenry.There may also be some difficulty in how“savings” is defined from one taxing jurisdic-tion to another when creating a SEIT,although this would not likely prevent such asystem from being effective. Finally, likeother income tax systems and proposals, aSEIT would continue to require the presenceof the IRS at the federal level and equivalentbodies at the state level. Supporters of salestax systems, including a national retail salestax, point out that sales tax systems wouldnot necessarily require as much bureaucracy,and would therefore pose less of a threat toprivacy or civil liberties.

Conclusion

The goal of current sales tax reform effortsshould not be to rework America’s sales taxsystem only to create a more Byzantine, intru-sive, or anti-competitive system of taxation.The goal should be to move toward a systemof consumption taxation that is both eco-nomically efficient and constitutionally per-

missible. And tax competition should beregarded as a virtue, not a drawback, withinany new system.

The debate over the taxation of remotesales and e-commerce in particular hasbrought these issues to the fore. It would bewrong, however, for state and local officialsto pin the blame for their sales tax woes onthe Internet, which has only recently beganposing any sort of threat to the sales tax sys-tem, and only a marginal one at that. Most ofthe issues that state and local officials arebeing forced to deal with today are long-standing problems largely created by years ofmeddling with the sales tax code and anunwillingness to adapt to changing econom-ic realities. More specifically, states’ fiscalproblems have been brought on by theirprofligate spending habits.

Although all the solutions on the tablehave a serious downside, a pure origin-basedsourcing rule for all sales taxes presents an eco-nomically efficient and constitutionally sensi-ble solution to the nagging tax “fairness” and“neutrality” concerns expressed by many poli-cymakers and Main Street vendors. Moreover,an origin-based sourcing rule is vastly superiorto a collusive multistate tax compact such asthe SSUTA. Preserving the Supreme Courtnexus jurisprudence would be a better optionthan moving forward with the SSUTA plan.Clarifying and codifying those nexus stan-dards would be an even better option.Alternatively, if some states or localities seek tomove away from transaction-based consump-tion taxation, then a savings-exempt incometax might present an alternative method oflevying taxes on individual consumption. Theimportant point to recognize is that alterna-tives exist to the SSUTA plan. But each ofthem has advantages and disadvantages.

In the end, states and localities may con-tinue to experiment with varying systems ofenforcing collection of sales and use taxesand try to make the current system work. Butif they choose to do so, they must abide bythe constitutional protections and nexusguidelines that have protected the channelsof interstate commerce in previous decades.

33

The guiding ethiof this debatemust remain taxcompetition, nottax collusion.

It would be wrong for members of Congressto abdicate their responsibility to safeguardthe national marketplace by giving the statescarte blanche to tax interstate commercialactivities through a tax compact. The guid-ing ethic of this debate must remain taxcompetition, not tax collusion.

Notes1. See U.S. Department Of Commerce, www.census.gov/mrts/www/current.html.

2. James S. Gilmore III, “No Internet Tax,” A pro-posal submitted to the Policies & Options Paper ofthe Advisory Commission on Electronic Com-merce, November 8, 1999, www.ecommerce com-mission.org/document/107gilmoreProposal.doc.Emphasis in original.

3. Michael O. Leavitt, “Streamlining the Sales TaxSystem,” Address to the National Press Club,Washington, D.C., November 16, 1999.

4. For more information on the evolution of thesales tax see John Due and John Mikesell, SalesTaxation: State and Local Tax Structure andAdministration, 2nd ed. (Washington: Urban InstitutePress, 1994).

5. Alaska, Delaware, Montana, New Hampshire,and Oregon currently do not impose general salestaxes at the state level. However, numerous bor-oughs and cities in Alaska have their own localsales taxes. Also, the other four states imposesales-type taxes on specific transactions, such asaccommodations.

6. See General Accounting Office, “Sales Taxes:Electronic Growth Presents Challenges; RevenueLosses Are Uncertain,” GAO Report to Congression-al Requesters, June 2000, p. 14.

7. Robert J. Cline and Thomas S. Neubig, “Mastersof Complexity and Bearers of Great Burden: TheSales Tax System and Compliance Costs forMultistate Retailers,” Ernst & Young White Paper,September 8, 1999, p. 12, www.ecommercecommission.org/document/MastersOfComplexity.pdf.

8. See Ariana Eunjung Cha, “Main Street TakesOn the Internet,” Washington Post, September 20,2000, p. G10; and Louis Jacobson, “Main StreetMarshals Its Troops,” National Journal, April 29,2000, p. 1364.

9. Karl Frieden, Cybertaxation: The Taxation of E-Commerce (Chicago: CCH, 2000), p. 134.

10. National Bellas Hess v. Department of Revenue ofState of Illinois, 386 U.S. 753 (1967).

11. Complete Auto Transit, Inc. v. Brady, 430 U.S. 274(1977).

12. Quill Corporation v. North Dakota, 504 U.S. 298(1992).

13. Miller Bros. Co. v. State of Maryland, 347 U.S.340 (1954).

14. See Felt & Tarrant Mfg. Co. v. Gallagher, 306 U.S.62 (1939); Nelson v. Sears, Roebuck & Co., 312 U.S.359 (1941); and Nelson v. Montgomery Ward & Co.,312 U.S. 373 (1941).

15. Bellas Hess at 753.

16. Bellas Hess at 753.

17. State of Wisconsin v. J.C. Penney Co., 311 U.S. 435(1941).

18. Bellas Hess at 753.

19. Article I, Section 8, Clause 3 of the U.S. Consti-tution empowers Congress to keep the lanes ofinterstate commerce free of burdensome state taxa-tion and regulation. It reads: “Congress shall havethe power . . . to regulate commerce with foreignnations, and among the several States, and withIndian tribes.”

20. For more information on dormant CommerceClause jurisprudence, see Adam D. Thierer, TheDelicate Balance: Federalism, Interstate Commerce, andEconomic Freedom in the Technological Age (Washing-ton: The Heritage Foundation, 1999), pp. 58–61. AsJustice Stephen Field concluded in the SupremeCourt’s 1875 Welton v. Missouri decision, “The factthat Congress has not seen fit to prescribe any spe-cific rules to govern inter-State commerce does notaffect the question. Its inaction on this subject . . . isequivalent to a declaration that inter-State com-merce shall be free and untrammelled.” Welton v.Missouri, 91 U.S. 275 (1875). For other examples ofsuch dormant Commerce Clause decisions, seeGibbons v. Ogden, 22 U.S. (9 Wheat.) 1 (1824); Willsonv. Black Bird Creek Marsh Co., 27 U.S. 252 (1829);Cooley v. Board of Wardens, 53 U.S. (12 How.) 299(1851); Philadelphia v. New Jersey, 437 U.S. 617 (1978);Pike v. Bruce Church, Inc., 397 U.S. 137, 142 (1970);Bibb v. Navajo Freight Lines, Inc., 359 U.S. 520, 529(1959); Dean Milk Co. v. City of Madison, 340 U.S. 349,354 (1951); Hunt v. Washington State Apple AdvertisingCommission, 432 U.S. 333, 350 (1977); New EnergyCo. of Indiana v. Limbach, 486 U.S. 269 (1988); WestLynn Creamery, Inc. v. Healy, 512 U.S. 186 (1994);Bendix Autolite Corp. v. Midwesco Enterprises, Inc., 486U.S. 888 (1998).

34

21. Quill Corporation at 298.

22. Ibid.

23. See Terry Ryan and Eric Miethke, “The Seller-State Option: Solving the Electronic CommerceDilemma,” State Tax Notes, October 5, 1998, pp.889–91.

24. Sen. Dale Bumpers (D-Ark.) introduced legis-lation in the 103rd (S. 1825), 104th (S. 545), and105th (S. 1586) Congresses that would haveauthorized state and local collection of taxes fromremote vendors.

25. Bellas Hess at 753.

26. Quill Corporation at 298.

27. Charles Tiebout, “A Pure Theory of Local Expen-diture,” Journal of Political Economy, October 1956. Acomprehensive discussion can be found in DaphneA. Kenyon, “Theories of Interjurisdictional Compe-tition,” New England Economic Review, March/ April1997, pp. 13–31.

28. Doug Lathrop, “A Square Peg in a Round Hole:The Internet’s Challenge to State Tax Systems—PartOne,” American Legislative Exchange Council,ALEC Issue Analysis, March 2000, p. 2.

29. “While agricultural interests have lost much oftheir clout in many state capitals today, they onceexercised powerful influence on state and local taxpolicies, and those historical taxing patterns have notbeen erased.” Ronald John Hy and William L. WaughJr., State and Local Tax Policies: A Comparative Handbook(Westport, Conn.: Greenwood, 1995), p. 96.

30. See David Brunori, “Dumber Than a Bag ofHammers,” Tax Analysts, Tax.org, 2001 STT 48-63, March 5, 2001, www.tax.org/readingsintaxpolicy.nsf/55ae6f9cd4c03e08852566cf00659cb9/6f430cfd65f7e30785256b8200802564.

31. Doug Abrahms, “Hurdles Remain in Hammer-ing Out Online Tax Laws,” USA Today, January 22,2003, www.usatoday.com/tech/news/techpolicy/2003-01-22-online-taxes_x.htm.

32. Karl Frieden notes: “Most states . . . still taxvirtually no services (other than telecommunica-tions services). In the last 15 years, only twostates—Florida and Massachusetts—have made alarge-scale effort to expand their tax base toinclude a wide range of services. Both effortsresulted in a political maelstrom, with the Floridalegislation being repealed after six months andthe Massachusetts legislation being repealed afterthree days.” Frieden, p. 64.

33. Andrew Wagner and Wade Anderson, “Origin-

Based Taxation of Internet Commerce,” State TaxNotes, July 19, 1999, p. 188.

34. Charles E. McLure Jr., “Rethinking State andLocal Reliance on the Retail Sales Tax: Should WeFix the Sales Tax or Discard It?” Brigham YoungUniversity Law Review, 2000, p. 88.

35. Typically a use tax is defined as a tax on thestorage, use, or consumption of tangible personalproperty in the state.

36. Wagner and Anderson, p. 190. Dean Andal, for-mer chairman of the California Board ofEqualization, agrees, noting: “The use tax is not a sur-rogate consumption tax as some would suggest. Itwas a device conceived to protect in-state merchants.”Dean Andal, “A Uniform Jurisdictional Standard:Applying the Substantial Physical Presence Standardto Electronic Commerce,” Presentation to theAdvisory Commission on Electronic Commerce,September 15, 1999, revised November 5, 1999, p. 13.

37. House Committee on the Judiciary, “StateTaxation of Interstate Commerce, Part III, Salesand Use Taxes,” Report of the Subcommittee onState Taxation of Interstate Commerce, U.S. Houseof Representatives report no. 565, vol. 3, 89thCongress (Washington: U.S. Government PrintingOffice, June 30, 1965), p. 613.

38. Ryan and Miethke, “The Seller-State Option:Solving the Electronic Commerce Dilemma,” StateTax Notes, October 5, 1998, p. 881. Ryan andMiethke continue: “In essence, the remote sellerhas made it possible for the purchaser to electroni-cally leave its home state and travel to the seller’splace of business, look through the merchandise atthe store, and bring it to the electronic cash registerfor purchase.” Ibid., p. 882.

39. Andal, p. 13. Cline and Neubig also note:“Identifying where consumption occurs willbecome increasingly more difficult in the Internetenvironment where products can be delivered elec-tronically without knowledge of the purchasers’residence and payment can be made in e-cash. E-commerce has the potential to create a large andgrowing set of retail transactions that may beimpossible or costly to attribute to a specific loca-tion.” Cline and Neubig, p. 24.

40. Frieden, p. 180.

41. See David R. Burton and Dan R. Mastromarco,“Emancipating America from the Income Tax: Howa National Sales Tax Would Work,” Cato InstitutePolicy Analysis no. 272, April 15, 1997, www.cato.org/pubs/pas/pa-272.html.

42. Even if America did have a national sales taxit does not mean that it would completely pre-

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empt state and local administration of the salestax. Would states seek to conform their existingtax systems (especially their tax base and defini-tions) to the national sales tax, or instead workwithin the confines of the national sales tax sys-tem to administer sales taxes according the a fed-erally defined tax base?

43. The complexity of the sales and use tax systemfor interstate vendors is hardly a recent phenome-non. It was described in similar terms almost 40years ago by the Willis Commission: “Significantproblems have been encountered in the applicationof the tax to interstate transactions. Viewed broad-ly, these problems appear to stem from a tax systemwhich tends to divide a national market into insu-lated blocks of consumers, with each sales tax Stateerecting its own scheme for taxing consumptionwithin its borders. Could the tax be collected fromeach individual and business as goods were con-sumed by them, differences in schemes from Stateto State would be of little consequence. However,the usual method of imposition everywhere is col-lection of the tax by the seller at the time of sale. Asa result, a firm selling in a number of States isrequired to meet the peculiarities of the law in eachState. If the seller is beyond the jurisdiction of theState or otherwise does not collect the tax, the saleis likely to end up tax free. For local businessmen,this raises the specter of competitive disadvantage;for the States it means a loss of revenue.” See HouseCommittee on the Judiciary, p. 879.

44. Cline and Neubig, p. iii.

45. Ibid., p. iii.

46. Michael Mazerov, “A Five-Year Extension of theInternet Tax Moratorium Would Further ErodeThe Tax Base of States and Localities,” Center onBudget and Policy Priorities, September 4, 2001.

47. See U.S. Department of Commerce, www.census.gov/mrts/www/current.html.

48. Quoted in “Minor Concessions: Governors AreStill Itching to Tax the Internet,” Las Vegas Review-Journal, March 3, 2000, www.lvrj.com/lvrj_home/2000/Mar-03-Fri-2000/opinion/13069957.html.

49. “State Legislatures React to Changing Econo-my,” NCSL News Release, February 28, 2001, www.ncsl.org/ programs/press/2001/pr010228.htm.

50. Office of Management and Budget, HistoricalTables of the Budget of the United StatesGovernment—fiscal Year 2001, Table 1.30.

51. Chris Edwards, Stephen Moore, and Phil Kerpen,“States Face Fiscal Crunch after 1990s SpendingSurge,” Cato Institute Briefing Paper no. 80, Feb-

ruary 12, 2003, p. 1, www.cato.org/pubs/briefs/b p-080es.html.

52. Michael Flynn, “$74 Billion Windfall: SurplusRevenue in the States,” American LegislativeExchange Council, The State Factor 24, no. 5,(December 1998): 1.

53. Nicholas W. Jenny and Elizabeth I. Davis, “Fiscal2000 Tax Revenue Growth, Strongest of the LastDecade,” Nelson A. Rockefeller Institute ofGovernment, State Fiscal Brief, no. 61, www.rock-inst.org/publications/fiscal_studies/FB_61.pdf .

54. David Broder, “States in Fiscal Crisis,” Washing-ton Post, May 22, 2002, p. A37.

55. Bob Herbert, “For Struggling States, All Solu-tions Point to Washington,” New York Times,December 2, 2002, p. A21.

56. “States Want Federal Bailout, But FinancialHelp Unlikely,” Investors’ Business Daily, March 14,2003, p. A18.

57. National Association of State Budget Officers,“Fiscal Survey of the States,” November 2002.

58. See Edwards, Moore, and Kerpen, “States FaceFiscal Crunch after 1990s Spending Surge, CatoInstitute Briefing Paper no. 80, February 12, 2003,pp. 2–3, www.cato.org/pubs/briefs/bp-080es.html.

59. Quoted in “States Want Federal Bailout, butFinancial Help Unlikely,” p. A18. For additionalinformation on state spending and the questionof a federal bailout, see Richard Vedder, Should theFeds Bail Out the States? American LegislativeExchange Council, February 2003. Vedder, anOhio University professor of economics con-cludes, “during the prosperity of the 1990s, stateand local government dramatically increasedexpenditures when there was a reduced need forsome government spending, like public assis-tance,” pp. 2–3.

60. Donald Bruce and William F. Fox, “State andLocal Sales Tax Revenue Losses from E-Commerce: Updated Estimates,” Center forBusiness and Economic Research, University ofTennessee, September 2001, p. 1.

61. Direct Marketing Association, “The Truth AboutOnline Sales Taxes,” www.the-dma.org/cgi/dispnewsstand?article=1012.

62. Cline and Neubig note: “An estimated 80 per-cent of current e-commerce is either business-to-business sales that are either not subject to salesand use tax or are effectively subject to use tax pay-ments by in-state business purchasers.” They add:

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“Our experience, and that of the states, is that busi-nesses are highly compliant with use-tax payments.They are audited too often, and the penalties aretoo high, not to do so.” In effect, approximately$2.6 billion or only 13 percent of total e-commerceretail sales raise potential sales and use tax collec-tion issues. The two economists also argue thatapplying state and local sales and use tax rates tothe potential tax base might have resulted in salesand use tax erosion of less than $200 million in1998. This represented merely one-tenth of onepercent of total sales and taxes collected by all stateand local governments. See Robert J. Cline andThomas S. Neubig, “ The Sky is Not Falling: WhyState and Local Revenues Were Not SignificantlyImpacted by the Internet,” Ernst and YoungEconomics Consulting and Quantitative Analysis,June 18, 1999, www.ecommercecommission.org/document/skyIsNotFalling.pdf.

63. Section 1 of the Amendment reads: “No Stateshall make or enforce any law which shall abridgethe privileges and immunities of citizens of theUnited States; nor shall any State deprive any per-son of life, liberty, or property, without dueprocess of law; nor deny to any person within itsjurisdiction the equal protection of the laws.” AsBernard Siegan has noted: “The importance of[the Fourteenth Amendment] derives from thefact that there are few other provisions in theConstitution that protect citizens or other per-sons against violation of their rights by the states. . . . The provision under discussion was designedto accord maximum protections for liberty at thestate level. Each of its three clauses—privileges andimmunities, due process, and equal protection—was directed toward this end, and collectively theyconstitute a formidable barrier against stateexcesses and oppression.” Bernard H. Siegan,“Economic Liberties and the Consti-tution:Protection at the State Level,” in Economic Libertiesand the Constitution, ed. James A. Dorn and HenryG. Manne (Fairfax, Va.: George Mason UniversityPress, 1987), p. 138.

64. Bellas Hess at 753.

65. Quill Corporation at 298.

66. House Committee on the Judiciary, p. 895.

67. See Jeffrey A. Eisenach, “The High Cost of Tax-ing Telecom,” Progress and Freedom Foundation,Progress on Point 6.6, September 1999, www.pff.org/telecomtax.htm.

68. See Patrick Ross, “Internet Tax MoratoriumWill Be Permanent This Time, Backers Believe,”Washington Internet Daily, April 1, 2003, pp. 3–4.

69. Brian Krebs, “States to Vote Today on InternetSales Tax Plan,” Washingtonpost.com, November

12, 2002.

70. For the complete text of the final agreement,see “Streamlined Sales and Use Tax Agreement,”November 12, 2002, www.streamlinedsalestax.org/FinalAgreementAdopted11-12-02.pdf.

71. The Willis Commission advocated similar salestax simplification reforms almost 40 years ago, butfew steps were taken by state or local governmentsto achieve this goal. Instead, the sales tax systemgrew far more complex. See House Committee onthe Judiciary, pp. 879–95.

72. Streamlined Sales and Use Tax Agreement,Fundamental Purpose.

73. Ibid., p. 42.

74. John L. Mikesell, “Remote Vendors and Ameri-can Sales and Use Taxation: The Balance betweenFixing the Problem and Fixing the Tax,” National TaxJournal 53, no. 4 (December 2000).

75. Andrew Wagner and Wade Anderson, “Guidelinefor Establishing an Origin-Based Sales Tax,” tax.org,2000 STT 54-42, March 15, 2000, www.tax.org/federal/Federal_Readings/Fed_Readings_Frames.htm.

76. Streamlined Sales and Use Tax Agreement,Fundamental Purpose, p. 6.

77. Charles E. McLure Jr., “SSTP: Out of the GreatSwamp, But Whither? A Plea to Rationalize theState Sales Tax,” www.nga.org/cda/files/SSTP121701.pdf.

78. Fred L. Smith, “Rush to Tax Could ProduceNet Loss,” Competitive Enterprise Institute, CEIUpdate12, no.10 (November 1999): 9.

79. Lawrence A. Hunter and George Pieler, “NewEconomy @ Old Constitution: Internet Taxes andthe Constitution,” Institute for Policy InnovationPolicy Report no. 153, March 2000, p. 21.

80. Michael Flynn, “The Rise of Cartel Federalism,”American Legislative Exchange Council, ALEC PolicyForum, Winter 2002/2003, pp. 39–42.

81. Ibid., p. 42.

82. Jack Kemp, “Taxation and the Cyber-Frontier: AFramework for Economic Growth,” Submission tothe Advisory Commission on Electronic Commerce,December 14, 1999, pp. 14, 19. Kemp also noted intestimony before the Subcommittee on Commercialand Administrative Law of the House Committee onthe Judiciary on April 1, 2003: “If you want an idea ofthe negative consequences of tax harmonizationschemes simply look across the ocean to ourEuropean friends. Tax harmonization is nothing

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more than a euphemism for high taxes and is a recipefor economic stagnation. These issues should bedealt with head-on and resolved decisively in favor ofwhat is Constitutional; while focusing on economicgrowth and not increasing the tax burden; and safe-guarding the proper roles of government.” www.house.gov/judiciary/kemp040103.htm. Likewise,Lawrence Hunter and George Pieler note: “TheMadisonian model of American government, as laidout in The Federalist Papers, is a model of competition,not collusion; friction, not harmony; a calculateddivision of power, not a unification of it across all lev-els of government. For different units of governmentto collude in their exercise of power is not just radi-cally different than federalism, it tramples on themost basic protection of American liberty thefounders envisioned: the allocation of power in dif-ferent areas to different units of government, so thatgovernment could never achieve total authority overthe individual citizen. Government collusion in thearena of taxation, therefore, is a very troubling con-cept and not something that should be counte-nanced except in the most extreme circumstances.”Hunter and Pieler, p. 21.

83. See www.streamlinedsalestax.org/FinalAgreementAdopted11-12-02.pdf.

84. Kent Lassman and Anna Duff, “The Internet,Taxation and the Constitution,” The ClaremontInstitute for the Study of Statesmanship andPolitical Philosophy, September 2001, www.claremont.org.

85. Charles E. McLure Jr. has written extensively onthe benefit of the destination-based tax. See forinstance, “Rethinking State and Local Reliance onthe Retail Sales Tax: Should We Fix or Discard It?” or“Electronic Commerce, State Sales Taxation, andIntergovernmental Fiscal Relations,” National TaxJournal 49, no. 4 (1997).

86. Austan Goolsbee, “In a World without Borders:The Impact of Taxes on Internet Commerce,”Quarterly Journal of Economics, May 2000, pp. 561–76.

87. For instance, according to the U.S. Departmentof Commerce, more than 100,000 Canadians crossthe Canada–U.S. border each week for what theyconsider to be shopping bargains: milk, butter, andeggs at at least 50 percent off what they pay athome and a wide selection of cheeses at up to 80percent off.

88. Kaye Caldwell, “A Message to Main StreetMerchants: Be Careful What You Ask For,” Com-merceNet, The Public Policy Report: Electronic CommerceCore Series 1, no. 9 (September 1999): 3.

89. We should mention that North Carolina hasimplemented an alternative method. Because thestate government recognizes that if the retailer is

located out of state and does not have a physicalpresence in North Carolina, the state cannotrequire the retailer to collect North Carolina’s tax,it passed legislation requiring individuals to paythe use tax on their income tax returns. TheDepartment of Revenue in North Carolina prede-termines the amount of use tax due by each indi-vidual. This system, of course, also has a great costfor taxpayers. For one thing, if a taxpayer rarelymake purchases from out-of-state vendors, theburden of proof will be on his shoulders to provethat he does not owe the tax. See www.dor.state.nc.us/faq/use.html.

90. Caldwell, p. 3.

91. See McLure, “Rethinking State and LocalReliance on the Retail Sales Tax: Should We Fix theSales Tax or Discard It?” p. 84.

92. See Charles Adams, For Good and Evil: TheImpact of Taxes on the Course of Civilization (Lanham,Md.: Madison Books, 1993).

93. Lee Goodman, “National Sales Tax ReformRaises New Customer Privacy Issues,” in Privacy inFocus, May 2002, p. 3.

94. As Kaye Caldwell concludes: “The message forMain Street is: That level playing field you want sobadly? It will be much more level than you haveyet imagined. You too will get to participate in themassively burdensome and costly use tax system,imposed on you by governments in other stateswhere neither you nor your employees even get tovote.” Caldwell, p. 4.

95. Wagner and Anderson,” “Origin-Based Taxationof Internet Commerce,” p. 189.

96. For the North Carolina system, see www.dor.state.nc.us/faq/use.html, and for Michigan, seewww.michigan.gov/treasury/1,1607,7-121-1750-5929—,00.html.

97. Saba Ashraf, “Virtual Taxation: State Taxationof Internet and On-Line Sales,” Florida StateUniversity Law Review 24, no. 3 (Spring 1997): 611.

98. Quoted in Joyce E. Cutler, “State, Local Govern-ments Fear Tax Ban Will Threaten Revenues,Sovereignty,” BNA Daily Report for Executives,December 16, 1999, p. GG-1.

99. Quoted in Richard Wolf, “Status of Use TaxLikely to Rise,” USA Today, April 11, 2000, p. A4.

100. Lathrop, p. 2.

101. Goolsbee, pp. 561–76.

102. The New Economy Tax Simplification Act, S.

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2401, 106th Cong., 1st sess.

103. Andal.

104. For additional details see Adam D. Thierer,“After the Net Tax Commission: The Gregg-KohlNexus Solution,” Heritage Foundation Back-grounder no. 1363, April 25, 2000.

105. Nonna A. Noto, “Internet Tax Legislation:Distinguishing Issues,” CRS Report for Congress:RL30667, November 24, 2000, www.ncseonline.org/NLE/CRSreports/Economics/econ84.cfm?&CFID=6067239&CFTKEN=4325961#Back33.

106. The Internet Tax Reform and Reduction Act,H.R. 4267, 106th Congress, 1st sess.

107. Frieden, p. 64.

108. A far more extensive discussion of origin-basedtaxation is contained in Michael S. Greve, “If It Ain’tBroke, Why Is Everyone Trying to Fix It? Taxing E-Commerce in a Destination Based World,” in WhoRules the Net? Internet Governance and Jurisdiction, ed.Adam Thierer and Clyde Wayne Crews Jr. (Washing-ton: Cato Institute, 2003), pp. 269–95.

109. Michael S. Greve, “E-Taxes: Between Carteland Competition,” AEI Federalist Outlook, no. 8,September 2001, www.federalismproject.org/outlook/9-2001.html.

110. Ryan and Miethke, p. 884.

111. William F. Fox and Matthew W. Murray, “TheSales Tax and Electronic Commerce: So What’sNew?” National Tax Journal 50, no. 3 (September1997): 573.

112. Wagner and Anderson, “Origin-Based Tax-ation of Internet Commerce,” p. 188.

113. Frieden, p. 182.

114. Lathrop, p. 1.

115. Paul J. Gessing, “The Race to Cyberspace:Internet Taxation and State Tax Competition,”NTU Policy Paper 103, November 21, 2000.

116. Frieden, p. 182.

117. Oklahoma Tax Commission v. Jefferson Lines, 514U.S. 175 (1995).

118. “In reviewing sales taxes for fair share, however,we have had to set a different course. A sale of goodsis most readily viewed as a discrete event facilitatedby the laws and amenities of the place of sale, and thetransaction itself does not readily reveal the extent towhich completed or anticipated interstate activity

affects the value on which a buyer is taxed. We havetherefore consistently approved taxation of saleswithout any division of the tax base among differentStates, and have instead held such taxes properlymeasurable by the gross charge for the purchase,regardless of any activity outside the taxing jurisdic-tion that might have preceded the sale or mightoccur in the future.” Oklahoma Tax Commission.

119. In general, see Arthur Angstreich, James R.Fisher, and Eric J. Meithke, “Jefferson Lines as theTicket to Cyberspace? A Proposal for the Taxationof Electronic Commerce Services,” State Tax Notes,June 22, 1998, pp. 1993–96.

120. Fox and Murray, p. 573.

121. “Unlike with a market-state rule, there is noneed in a vendor-state rule to identify preciselywhere a company’s customers are using its ser-vices. Whether a company’s customers are locatedin 5 jurisdictions or 25 jurisdictions does notchange the outcome. Even if it is difficult to iden-tify a customer’s location, because of the use of aWeb address and/or the involvement of a finan-cial intermediary in the transaction, nothingchanges.” Frieden, p. 247.

122. Michael S. Greve, “E-Taxes: Between Carteland Competition,” p. 3.

123. See Charles E. McLure Jr., “Rethinking Stateand Local Reliance on the Retail Sales Tax: ShouldWe Fix the Sales Tax or Discard It?” p. 84.

124. “In general, when a purchaser contacts aflorist by telephone, telegram, or other means ofcommunication for delivery of flowers or othermerchandise to another city or state, the sales tax isbased on the location of the florist who initiallyreceived the order. The florist who delivered thegoods to the consumer is not subject to tax.” Ryanand Miethke, “The Seller-State Option: Solving theElectronic Commerce Dilemma,” State Tax Notes,October 5, 1998, p. 883, f. 11.

125. See Frieden, pp. 156–61. Frieden notes: “Giventhe practical difficulty of the point-of-consump-tion approach, an increasing number of states takea vendor-state-oriented approach and now tax thecards at the point of sale of the card from the retailoutlet. . . . The place of sale for local sales tax pur-poses will be the location at which the retailertransfers possession of the card to the customer,not where the customer actually uses the telecom-munications service.” Ibid., p. 158.

126. Under the Mobile TelecommunicationsSourcing Act of 2000, Congress established the fol-lowing sourcing rule for the tax treatment of cellu-lar telecommunications services: “All charges formobile telecommunications services that are

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deemed to be provided by the customer’s home ser-vice . . . are authorized to be subjected to tax, charge,or fee by the taxing jurisdictions whose territoriallimits encompass the customer’s place of primaryuse, regardless of where the mobile telecommunica-tion services originate, terminate, or pass through,and no other taxing jurisdiction may impose taxes,charges, or fees on charges for such mobile telecom-munications services.” For more information, seeMichael S. Greve, “Opportunity Rings: NewCellphone Law Shows Way on Internet Taxation,Competitive Enterprise Institute, CEI On Point, no.72, September 14, 2000.

127. Ryan and Miethke, p. 883.

128. Hal R. Varian, “Forget Taxing Internet Sales.In Fact, Just Forget Sales Taxes Altogether,” NewYork Times, March 8, 2001, p. C2.

129. Ibid, p. C2.

130. For example, see Murray Weidenbaum, “ATax System for E-Commerce Economy,” Centerfor the Study of American Business, Policy Briefno. 205, June 2000, http://wc.wustl.edu/csab/CSAB%20pubs-pdf%20files/Policy%20Briefs/pb205-mlw%20e-comm%20tax.pdf; Stephen J. Entin,“Tax Reform to Handle the E-Tax Controversy,”Institute for Research on the Economics of

Taxation, Congressional Advisory no. 104, May 15,2000, www.iret.org/pubs.html; Bruce Bartlett,“Tax Reform Resuscitation?” Washington Times,June 21, 2000, p. A18; Varian, p. C2. Also, duringthe 2000 presidential election, candidate JohnMcCain flirted with such a proposal thanks toefforts by American Enterprise Institute econo-mist Kevin Hassett, who helped him formulatehis tax policy. As Weekly Standard reported at thetime: “The best regime, Hassett believes, wouldplace almost no tax burdens on savings. Instead itwould tax consumption (George W. Bush’s taxplan in Texas in 1997 also shifted the burden toconsumption). Hassett says that if you give mid-dle-class people more reason to save, you willunleash more capital for investment than youwould by reducing the top marginal rate onincome. . . . This is a step toward a consumptiontax. Since income minus savings equals consump-tion, Hassett says, if you reduce the tax on thatportion of income that goes to savings, you areshifting the burden onto consumption. This is abetter way of taxing consumption than the old-fashioned way, a sales tax collected at the cash reg-ister. In the age of e-commerce, he says, it doesn’tmake sense to try to impose an old-fashionedconsumption tax at the point of sale. Better tocollect it up top, at the point of income.” SeeDavid Brooks, “The McCain-Bush Tax Wars,”Weekly Standard, January 24, 2000, p. 10.

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