E-Commerce Eludes the Tax Man: The Click-and-Mortar Artificial Advantage in the New Economy

By Sarah Anderson

E -commerce firms pose vexing new challenges to “old economy” regulators. Virtual merchants’ extreme mobility, remoteness from customers and ability to deliver some goods digitally rather than physically, have helped them stay far beyond the reach of most tax and customs authorities.

But the obstacles to taxing and regulating e-commerce are more political than technical. Information technology firms and tax-averse conservatives have lobbied hard to keep government hands off of what they claim is an “infant industry” in need of nurturing. U.S. officials, eager to curry favor with the hi-tech sector, have responded by promoting a de-regulated approach to e-commerce at home and abroad.

The U.S. Sales Tax Loophole

In the United States, the Supreme Court has ruled that state and local governments cannot force retailers to collect sales taxes unless they have a physical presence, such as a store or warehouse, in their jurisdiction. The Court has noted, however, that Congress has the power to change the policy by enacting legislation authorizing states to enter into an interstate compact to require remote sellers to collect and remit sales tax.

The National Governor’s Association and other state and local government groups have pressed Congress to do just that. They argue that if the existing loophole remains open, the shift to on-line purchasing will erode their revenue base, diminishing their ability to provide adequate health, education and other services.

Although e-commerce remains a tiny portion of the retail market (about 1 percent), it is growing faster than traditional brick-and-mortar business, with U.S. e-commerce rising 19.3 percent in 2001, to $32.6 billion in sales. And the recipients of privileged tax treatment are not just small start-ups struggling to survive the dot-com bloodbath, but also Amazon.com and the expanding online divisions of “click-and-mortar” giants such as Wal-Mart and Barnes & Noble. A September 2001 study by the Center for Business and Research at the University of Tennessee estimates that foregone revenues for states and localities could total as much as $54.8 billion by 2011, forcing them to raise their sales tax rates between 0.83 and 1.73 percent to make up for the loss.

State and local governments have found allies among traditional brick-and-mortar retailers, who resent the tax-free advantage enjoyed by their online competitors. A number of traditional retailers, including Ames, Lowe’s and RadioShack have formed the “e-Fairness Coalition” to lobby for a level playing field.

The American Booksellers Association, which represents independent bookstores, is a coalition member. “Our government should not be in the business of playing favorites,” says the American Booksellers Association's Chief Operating Officer, Oren Teicher. “Either require all retailers to collect sales taxes or none of us.”

State governments concede that the current state sales tax system is a cumbersome patchwork. There are 7,500 tax jurisdictions in the United States and often they define and tax products differently (with orange juice defined as a taxable fruit in one state, and a non-taxable beverage in another). However, 38 states are involved in a project to streamline the tax system through uniform product definitions and simplified administrative procedures.

Despite this progress, Congress remains reluctant to allow states to make sales tax collection by remote sellers mandatory. In October 1998, the U.S. Congress passed the Internet Tax Freedom Act, a three-year ban on new Internet taxes, such as taxes on access fees. Although the measure didn’t ban sales taxes on e-commerce, it didn’t do anything to address the loophole either, despite demands from the brick and mortar retailers and state governments.

When the moratorium approached expiration in the fall of 2001, Senator Byron Dorgan, D-North Dakota, took the lead in demanding that Congress close the sales tax loophole. Dorgan, a former tax administrator, co-sponsored a bill supported by state government groups and large retailers that would allow states and localities that adequately simplify their tax systems to require online retailers to collect sales taxes. However, Congress opted to extend the existing moratorium for two more years, leaving the loophole wide open.

Support for Dorgan’s bill was undercut by a competing proposal offered by Senator Ron Wyden, D-Oregon, from the hi-tech stronghold of the Northwest. Wyden’s approach did not explicitly oppose sales tax collection, but would have imposed much tougher conditions on local governments to simplify their tax systems before Congress would consider allowing them to collect sales tax on e-commerce. “State and local governments have a right to be concerned about where their revenue is coming from,” Wyden said, “but they should not be able to view the Internet as a cyber cash cow.”

A formidable coalition of hi-tech industry associations rallied behind Wyden, including the 500-member Information Technology Association of America; the more elite Information Technology Industry Council, which represents about 30 top firms, including Amazon.com, AOL Time Warner and IBM; and the Business Software Alliance, comprised of Adobe, Apple, Microsoft and other software developers.

The hi-tech bloc’s strategy of linking tax collection to sales tax simplification was “pure obfuscation,” says Teicher. “You can buy software off the shelf that will compute state and local sales taxes for you. This was all about the raw power of the electronic industry.”

Indeed, these firms’ clout on Capitol Hill has expanded along with their campaign contributions. According to the Center for Responsive Politics, computer/Internet firms’ donations jumped more than 700 percent between the 1992 and 2000 presidential election years, totaling about $40 million in 2000.

Dorgan faced additional opposition from a group of conservative think tanks and anti-tax groups that formed the “e-Freedom Coalition” (a not-so-subtle challenge to the retailers’ “e-Fairness Coalition”). One member group, Americans for Tax Reform, issued a hostile press release with the headline: “Dorgan to Internet Users: Drop Dead.” The coalition’s opposition to e-commerce taxes is a matter of democracy, says the libertarian Cato Institute’s Aaron Lukas: “When a local business collects sales taxes, there is a clear link among taxes paid, services provided and legislative representation. To force a wholly out-of-state business to collect taxes would be ‘taxation without representation,’ pure and simple.”

Main Street supporters, such as David Morris of the Minneapolis-based Institute for Local Self-Reliance, reject this perspective out of hand. Asks Morris, “Why should distant companies which contribute little to the communities where they do business enjoy a 5 to 8 percent price advantage over local stores?”

Dorgan plans to push for further progress in streamlining the state sales tax system and intends to re-introduce his legislation when the current moratorium expires in November 2003.

The e-Freedom Coalition will continue to oppose any “schemes to wring more tax money out of remote consumers,” responds Bartlett Cleland, a coalition spokesperson based at the Institute for Policy Innovation.

The Global “E-Freedom” Agenda

While the tax debate has raged in the United States, both the Clinton and now the Bush White Houses have busily promoted rules at the international level that would minimize governments’ ability to tax e-commerce. Within the World Trade Organization (WTO), U.S. officials have succeeded in obtaining a moratorium on tariffs on products transmitted electronically (downloadable software, printed material, videos, music, databases, architectural drawings, etc.). They are also advocating for a ban on new taxes on e-commerce in the WTO as well as in the negotiations around the Free Trade Area of the Americas (FTAA), the Asian Pacific Economic Cooperation and through bilateral agreements. As part of the FTAA process, the U.S. government has persuaded other countries to accept the formation of a joint private sector-government committee on e-commerce that allows Microsoft, AOL, IBM, Motorola and other hi-tech firms to sit side by side with public officials to hammer out recommendations for the negotiators.

The U.S. government claims that a de-regulated approach to e-commerce is particularly important for the economic future of the developing world.

By contrast, the United Nations Conference on Trade and Development (UNCTAD) has raised strong concerns about the potential impact of the tax-free approach on the global South. Because of U.S. dominance of this new technology, most online orders in developing countries are received as U.S. imports. Although governments technically have the right to impose customs duties on these imports if they are delivered across the border as physical goods, most developing countries lack the capacity to screen each individual package, calculate a duty and collect the revenue. With regard to digitized products, developing countries are at an even greater disadvantage. The WTO bans duties on these transactions and developing countries are heavy net importers of these products.

Customs duties are generally a much more important source of revenue for Third World nations than for rich countries. According to UNCTAD, these poorer nations’ losses in uncollected tariffs will amount to 64.5 percent of all countries’ e-commerce customs losses. Seven developing countries are expected to be among the top 10 losers, including India, Mexico, Malaysia, Brazil, China, Morocco and Argentina. In some countries the tariff losses may be as much as 20 percent of import duty revenues. Moreover, the WTO moratorium means that many countries will lose not only tariff revenues but also additional duties they collect on imports, such as customs surcharges and consumption taxes.

A major e-commerce report published by UNCTAD in 2001 concludes that “the development of efficient tax collection systems for e-commerce should be a priority for all developing countries.” However, the study laments the fact that developing countries have not participated much in discussions around Internet taxation, while the richer nations have largely ignored their concerns.

The EU Fights Back

The European Union has most strongly resisted tax-free e-commerce, largely because sales taxes, known as value-added taxes (VAT), account for about 30 percent of member states’ tax receipts. However, despite strong political support for taxing e-commerce, loopholes remain. Currently, the VAT (which ranges from 15 to 25 percent, depending on the country) is supposed to apply to all goods and services, regardless of the mode of delivery. But e-commerce firms based outside the EU can export material goods into the EU free of VAT or customs duties if they are worth less than about $27 (which would include many commonly ordered CDs and books). Moreover, non-EU firms have been able to export digitized products into the EU tax-free because such exports were treated as services, which under EU rules are taxed where they are provided.

In February 2002, EU finance ministers moved to close this service loophole by requiring non-EU companies that sell online digital products to collect VAT. The plan is scheduled to go into effect in July 2003, but the U.S. government appears poised to try to block it. Both the U.S. Treasury Department and industry groups have attacked the plan as discriminatory because it would force non-EU providers to apply tax rates depending on the location of the customer, whereas EU firms would continue to collect taxes based on the company’s country of establishment. The Europeans’ explanation is that if non-EU firms were allowed instead to collect taxes based on the rates of a single EU country, they would surely all opt for Luxembourg, which has the lowest VAT.

The United States is threatening to take the dispute to the WTO. Deputy Treasury Secretary Kenneth Dam says, “The United States and each country of the EU … has obligated itself in international treaties not to impose measures that discriminate against nationals of the other signatories. The EU proposal may be contrary to those agreements.”

Spanish Finance Minister Rodrigo Rato, who chaired the finance ministers’ meeting, dismissed the U.S. complaints, telling AFX news service, “We believe that the new directive is perfectly compatible with the WTO rules.”

In picking this fight with a major trade partner, the U.S. government is representing the interests of U.S. hi-tech firms. The president of the Information Technology Association of America, Harris Miller, for example, has likened the EU plan to a virtual deathblow to U.S. online service providers’ ability to operate in the EU. Referring to the time that it would take a U.S. vendor to verify an EU customer’s location and compute a tax, Miller says, “Anything that slows the processing of Internet transactions by more than a few seconds will result in the loss of significant revenue. There is the risk that the EU may prescribe rules of compliance that, in effect, will close the European market to U.S.”

Tax Havens — The Final Frontier

Beyond their ability to elude sales taxes, tariffs and customs duties, the extreme mobility of e-commerce firms offers potential opportunities for avoiding income taxes as well. As e-commerce tax expert David Hardesty points out: “A 13-year-old child can, in 10 minutes, move an entire web site from a server in one country to a server in another. This makes web sites highly mobile, and enables operators to move sites easily from unfriendly jurisdictions to ones that are friendly.”

The World Bank and the International Monetary Fund have raised similar concerns. For example, the Bank’s annual report “Global Economic Prospects” warned that “electronic commerce will pose difficult challenges for government regulation of tax and financial systems. ... Multinationals will find it easier to shift activities to low-tax regimes. Governments may find it more difficult to impose desired income tax levels on existing corporations, and competition among developing countries for investment by multinationals may rise.”

Already, scores of web sites offer assistance in setting up “offshore” web servers to take advantage of what they label “tax e-fficiency.” Although the extent of offshore e-commerce is not well-documented, Bermuda appears to be a major magnet. Long known as a tax haven, Bermuda has also attracted significant investment in telecommunications infrastructure. Offshore operations there range from small dot-coms to the international trading operations of online broker E*Trade. The legal issues of such operations remain murky, and accountants are relying on this ambiguity to help U.S. firms keep a few steps ahead of the authorities.

Even with the best efforts of policymakers, e-commerce firms may continue to elude the world’s regulators for some time to come. And it does not appear as though U.S. officials will ease up their efforts to block e-commerce taxation any time soon. At least as long as U.S. firms continue to dominate the information technology sector, U.S. officials are likely to work to advance their interests through every possible channel.

Sarah Anderson is director of the Global Economy Project at the Institute for Policy Studies in Washington, D.C. The Project is conducting a research project on e-commerce in collaboration with the International Forum on Globalization.