A national debate is taking place that promises to intensify in coming months: Should government tax purchases made over the Internet? If not, why not? And if so, how? While the question of federal taxation is certainly alive, most of the focus to date has been on the question of state and local government taxation—specifically, should sales and use taxes apply to Internet purchases just as they do when, say, a consumer walks into a nearby department store and pays a sales tax when he buys a television set?

The best policy is one that leaves the modern technology of the Internet alone to develop its potential unhindered by ancient ways of exacting revenues for government.

In general, businesses are forced to collect sales taxes on many goods they sell and sometimes on services they provide within the state where they are based. Stipulations as to the tax rate and which goods and services are included in or exempted from the sales tax differ in each state. A Michigan book dealer, for example, collects a six-percent sales tax when he sells a book in his store to another Michigan citizen.

If the same citizen were to buy the same book from an Internet vendor such as Amazon.com, Amazon.com would not assess him a Michigan sales tax (or any sales tax for that matter) because Amazon.com is neither based in Michigan nor does it have a physical presence here. A Michiganian who buys his book this way is supposed to declare the purchase to the state and pay a six-percent "use tax." However, few citizens bother to do so. Because the state of Michigan cannot force out-of-state companies to charge the tax and remit the revenue, the use tax goes largely unpaid and unenforced.

Of the use tax revenue that is collected, two-thirds goes to General Fund/General Purpose and one-third goes to the School Aid Fund. A new effort this year by the state of Michigan to collect the use tax by asking citizens to declare their out-of-state Internet, catalog, and 1-800 number purchases on their state income tax forms may yield some additional revenue, but no one expects widespread compliance.

In fact, a large part of the reason "e-commerce" is enjoying robust growth is the fact that it is subject to little direct taxation. A congressionally mandated three-year moratorium on "multiple" and "discriminatory" Internet taxation is set to expire in October 2001 and a special federal commission, the Advisory Commission on Electronic Commerce (ACEC), will report soon on what it thinks Congress and the states should do after that.

Meanwhile, interest groups are weighing in with their own recommendations. The National Governors' Association, the National Association of Counties, and the U.S. Conference of Mayors all support devising some mechanism to extract revenue from Internet purchases—involving a new "third-party" entity that would collect and distribute sales taxes on those purchases. Perhaps the most extreme pro-tax view came recently from South Dakota Governor and ACEC member William Janklow. Janklow startled his audience when he announced that unless steps are taken to immediately tax online purchases, he may begin "sending out the highway patrol to start pulling over little brown trucks" delivering goods purchased via the Internet. He threatened to "disrupt interstate commerce" by sending out state highway-patrol officers to pull over delivery trucks, inspect packages for those originating out of state, and "following the packages" to their final destination to force his residents to pay the state's use tax.1

Other groups and policy makers including Americans for Tax Reform, the National Taxpayers Union, and several state chief executives including Virginia Governor James Gilmore argue against Internet taxation on the grounds that the benefits of leaving the Internet relatively tax-free far outweigh whatever "unfairness" may exist among states' current tax structures.

In our view, the best policy is one that leaves the modern technology of the Internet alone to develop its potential unhindered by ancient ways of exacting revenues for government. To understand why, it is necessary to explore the issue in detail. This report provides further background information on this controversial issue and deals with the relevant, and often thorny, aspects of Internet taxation in a separate question-and-answer section, followed by a section of specific policy recommendations.