November 10, 1997

Online Sales Collide With Off-Line Tax Questions

By DAVID CAY JOHNSTON

arry Smith and Ron Wyden look at the Internet and see a tax nightmare. But what arouses their anxiety are different visions regarding taxes in cyberspace.

Smith is the mayor of Greenwood, a town of 19,000 people in Mississippi that relies on sales taxes for 55 percent of its budget, a revenue stream that he fears will shrivel as more business is done over the Internet and less in local stores.

Related Article Committees Move Internet One Step Closer to Tax Freedom (October 10, 1997)

Wyden is a U.S. senator from Oregon, where Internet businesses are springing up every day. He fears they could be inundated by demands from every other state, county and mosquito abatement district in the country to pay taxes, file forms and follow regulations.

The senator, a Democrat, is sponsoring the Internet Tax Freedom Act, a companion to a House bill of the same name sponsored by Rep. Christopher Cox, R-Calif.

Wyden's bill, which was approved by the Senate Commerce Committee last week and will come before the full Senate next year, creates a moratorium on new taxes intended specifically to tap the Internet. The legislation would affect not only state efforts to tax sales of goods over the Internet -- as Michigan does -- but also efforts to put a use tax on Internet service providers, as several states do. Cox's bill has been approved in two subcommittees and is now before the judiciary and commerce committees.

The bills have become hot buttons in the growing national debate over taxes, with attention focused last week on an issue that goes to the heart of the different nightmares envisioned by the senator and the mayor, who went to Washington earlier this month with other small-town mayors from Mississippi hoping to kill the bill.

Taxing Internet Commerce

Legislation like the Internet Tax Freedom Act is intended to free fledgling companies from a crippling tax burden. But local government officials worry that as electronic commerce becomes big business, the local mall — and the sales taxes generated there — will disappear. Above are the states that tax Internet commerce; details of the tax systems vary widely.

Small but growing numbers of people are buying products over the Internet from mail-order houses, which have already been taking sales away from stores on Main Street and at malls through toll-free phone ordering services. Computer companies, whose customers are more Internet-savvy than the average shopper, do a significant portion of their sales on line.

Mail-order companies and their customers now benefit from a loophole that allows customers to avoid paying sales taxes when customer and company are in different states. The loophole was to be tightened under an agreement reached in principle between the direct-marketing industry and the states last week, though the deal is less certain since disclosure of the terms provoked an angry response from some customers.

Sales taxes are increasingly important to states and local governments. General sales taxes raised $132.2 billion for states in 1995, one-third of their $399 billion in tax revenue, said Liz Davis of the Center for the Study of the States, a nonprofit research organization in Albany. In 1950, the states counted on sales taxes for just 20 percent of their revenue, she said.

The Internet Tax Freedom bill thus pits state and local government officials who have grown used to sales taxes as a reliable source of money in good times and bad against those who think that the new world of cyberspace requires a complete rethinking of tax regimes. The National Governors' Association and the National League of Cities oppose it.

Mark Schwartz, president of the National League of Cities and an Oklahoma City councilman, called it "offensive to local governments."

But Wyden says the tax system cannot remain the same when the way that money changes hands is starting to go through a fundamental transformation. "The Internet will be the business infrastructure of the 21st century," Wyden said last week. "To subject it to as many as 30,000 taxing jurisdictions applying different rules of taxation would be a mistake."

David McClure, executive director of the Association of On-Line Professionals, which represents large and small Internet service providers and some of their employees, said, "The Internet means that we may not be able to think of taxation in the ways we are used to, that maybe we need to shift to another form of taxation."

Some critics of the bill have questioned why the Internet should get a moratorium on new taxes when state and local governments have attached a host of new taxes and fees to another high-technology industry, cellular telephones, which has flourished anyway.

Wyden's bill only deals with a portion of the tax issues involved in electronic commerce. The bill has gone through significant revisions since it was introduced in February. Originally, critics say, it would not have allowed the imposition of property taxes on the physical possessions of an Internet company. And there was no time limit to its moratorium on new taxes. Wyden said his intent was to limit the moratorium to about five years if Congress failed to enact a broader Internet taxation system and to prohibit only those new taxes that are specifically aimed at Internet business.

In July, the Clinton administration proposed that there be no new taxes aimed at Internet businesses, that taxes be consistent across state lines and that they be easy to administer and understand. The administration also said study was needed to determine how to identify parties in electronic commerce so taxes could be assessed. One concern is that a business that specializes in software or other digital products can operate offshore, generating revenue and profits but not taxes and that authorities might have no efficient way to identify the responsible party.

Some critics of the bill have questioned why the Internet should get a moratorium on new taxes when state and local governments have attached a host of new taxes and fees to another high-technology industry, cellular telephones, which has flourished anyway.

But Jeff Friedman, a tax lawyer and accountant with the Committee on State Taxation, a business group that supports the Wyden bill, said there were important differences. "The cell phone companies generally are large companies, like Sprint and AT&T, who are sophisticated taxpayers with the manpower to handle these tax filings," Friedman said. "But one of the attractive aspects of the Internet is that it allows small start-up companies to reach out to the world and this potential tax filing burden could crush a small company."

Smith has equally direct, if more prosaic, concerns. "If there's just a 2 percent drop in sales tax revenue, it means I have to lay off three of my 53 police officers."

"There's too many things left open to interpretation" in the bill, he said.

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