1999 Volume 2 Issue 2

E-Commerce & Taxation

E-Commerce & Taxation

Three options offered for gathering billions in tax revenues from Internet sales.

Equity and efficiency in preparing for the end of the Internet tax moratorium will benefit all parties concerned.

The Inaugural Class of the School of Public Policy at Pepperdine University chose to do its capstone policy seminar project on “E-Commerce and Taxation: A Plan for California.” The report was specifically written as a policy recommendation for the state of California with California’s Electronic Commerce Advisory Council as the major client. It seeks to provide realistic recommendations for a complicated world that take into account the interests of different levels of government, private industry and consumers.

The following article presents some background information on the issues involved in electronic commerce and outlines the three basic options available for consideration. The July issue of the Graziadio Business Review will identify the option that the class is recommending as in the best interests of the state of California, along with their rationale. It will also include some of the issues raised by people actually involved in the policy process when the recommendations were presented to a panel of experts in April, 1999.

The class wishes to present its findings and recommendations in the hope that they will stimulate discussion and debate on this very critical and timely topic.


Like most fast-moving revolutions, the whirlwind development of e-commerce has inspired both hope and fear. In the space of only three years, less time than it takes to plan and build one suburban mega-mall, almost 13 million additional consumers will have become electronic shoppers. Another 21 million are projected to join them by 2002.

Indicators and analysts both suggest that this is only the infancy of a rapidly-growing form of commerce. One leading research firm forecasts business-to-consumer online spending to reach $41.1 billion by 2002[1], a potentially devastating trend for traditional retailers. Another forecast predicts business-to-business e-commerce in excess of $350 billion by 2002[2].

U.S. Online Shopping Forecast

Such escalating numbers heighten debate about the future of e-commerce taxation. In general, e-commerce sales are not currently taxable under the rules of the Internet Tax Freedom Act which provides for a moratorium on such taxes until October 21, 2001 unless company has “nexus” — a substantial physical presence in the state where the consumer resides. In that circumstance, the company must collect and remit taxes. This is consistent with the Supreme Court’s ruling on taxing mail-order sales.

Opponents of Internet regulation and taxation argue that Internet commerce must be allowed to grow unfettered, increasing the odds that an industry now bringing value to consumers will flourish and ultimately provide even greater economic gains

Proponents of Internet taxation – including state and local government officials – counter that taxing online sales is a mater of fairness to traditional brick-and-mortar merchants. It is also a matter of survival for many government entities, particularly local governments that depend on sales tax revenues to fund basic services such as fire and police protection.

The benefits of electronic shopping to consumers are significant and continue to expand. Wider selection, always-open stores, deeper discounts, and extensive product information are all available in the comfort of one’s own home. As columnist Norman Ornstein puts it,

“Internet shopping has accelerated astonishingly, and it’s not hard to understand why. You don’t have to look for a parking space, look all over a store, deal with surly or ignorant clerks, or wait in long checkout lines. And one other big plus: you don’t have to pay any sales taxes.”[3]

It is this last “big plus” that is keeping state and local treasurers awake at night. It also gives rise to a major question. If, or when, taxes are imposed, which state government should be able to tax an electronic purchase when the purchaser is in New York, the company is based in Seattle, Washington, and the commerce server (the computer that completes the transaction) is in San Jose, California? Even if the jurisdiction is determined, how can tax collectors grab their piece when digital money is so craftily elusive? The answer to these questions will affect the allocation of billions of tax revenue dollars.

In Quill Corp. v. North Dakota, prior to the advent of e-commerce on the Internet, the United States Supreme Court established that an out-of-state seller has nexus (and therefore the requirement to collect sales and use taxes for the consumer’s home state) only if the seller has substantial physical presence in that state. Legal battles loom over the definition of the terms “nexus” and “physical presence.”

Currently it is difficult to determine what percentage of e-commerce sales both originate and terminate within any one state. This factor is important when trying to estimate the amount of sales tax revenue that could be gained if e-commerce was to be taxed. In a related vein, there is little information on how much of current e-commerce is already taxed since companies may not differentiate between sales made in physical stores and sales made online when remitting their sales tax to the state.

Due to the youth of e-commerce as a mode of selling, there is not a lot of historical data available with regard to any aspect of it. Forecasting for the growth in this “industry” is therefore very challenging and inexact. Moreover, it is assumed that there would be some effect on the amount purchased online overall if e-commerce were taxed. That is, there would be some price-elasticity effect, a change in the quantity of goods purchased relative to the change in the price level. A study by Professor Goolsbee at the University of Chicago estimates the number of e-commerce shoppers might drop by 25%, and the price-elasticity of demand would be 30% or higher, depending on the tax rate.[4]

Projections, and fears, are largely focused on the domestic market, but unlike brick–and-mortar retail, e-commerce sales taxation is a global concern. Electronic transactions erase the geographic borders that nations have long taken for granted. Many governments are beginning to address these questions both internally and with their trading partners.

Presenting the Alternatives

It is not realistic to think that a tax moratorium will continue forever, especially considering the amazing growth rate of electronic commerce. Therefore, a complete absence of all taxation on e-commerce is not really a viable alternative policy. With this in mind, three general policy alternatives are presented here, including a brief statement of some of the pros and cons for each. They are the National Sales Tax Policy, The Freedom of States Policy, and the Internet Tax Equity Policy.

Some assumptions have been made about the details of the policies for purposes of this discussion. It recognized that there may be other variations possible. Also, business-to-business sales are not discussed, even though they represent the greatest portion of online commerce. This is because they primarily represent purchases of intermediate goods, and intermediate goods are not subject to sales taxes.

The National Sales Tax — Alternative One

Under a national sales tax option the federal government would determine the rules and tax rates for all domestic electronic commerce. A uniform national e-commerce tax would apply to all domestic sales. It would be collected by the federal government, with the revenue then rebated to the states based on where the point of sale occurred. The point of sale would be defined as the state from which the seller receives the buyer’s order for the good/service. For purposes of this study, the national sales tax is figured at 4.765 percent, the average of the sales tax rates of all 50 states combined.

There would be three categories of sales and purchases: (1) regular goods and services such as books and travel, (2) intermediary goods, and (3) international sales and purchases. Regular goods are defined as moveable things, other than documents, money or monetary instruments. Services are mental or physical labor or help purchased by consumers. Intermediary goods are components that are used to make a final product.

Regular goods and services that are bought and sold within the territorial boundaries of the United States would be subject only to the 4.765 percent sales tax. Intermediary goods that are bought and sold within the territorial boundaries of the United States would continue to be free of sales tax.

International e-commerce purchases (imports) that are bought in the United States from a foreign country would be charged only a three percent infrastructure fee in order to encourage other nations to trade with the United States. The infrastructure fee is remitted to the federal government for purposes of infrastructure maintenance only, including transportation facilities such as the federal interstate highway system, airports, and ports. Exported goods and services from the United States would be charged the three-percent infrastructure fee and the 4.765 percent national sales tax. The national sales tax is added to exported goods/services because of their use of state resources in production.

All other import/export duties would be waived for goods and services bought through e-commerce. This is consistent with free trade agreements such as NAFTA. However, the United States would reserve the right to add “special fees” on goods from nations that threaten U.S. political/economic interests in order to secure to the U.S. government the ability to respond to discriminatory trade policies when vital interests are being threatened from abroad.

Inevitably, some individuals or states would be disadvantaged under this policy relative to other options. For example, a customer from a state with a lower sales tax rate than the national average would pay more tax to purchase something over the Internet than if he or she purchased the good via more traditional means. States with higher sales tax rates than the national average could lose tax revenues relative to the other options. Cities and states might perceive this policy as a limitation on their liberty because it requires sole reliance on the federal and state to set tax rates and remit taxes owed to the city.

The proposed national sales tax policy will create efficiency in tax collection by creating a tax system with only three categories. The point of sale is automatically defined. States will be able to regain revenues now lost through the use-tax system. The major inefficiency of the national sales tax policy is that there is bound to be some administrative drain on revenues as they are collected at the federal level and then make their way to the lower levels of government.

Freedom of States — Alternative Two

The “Freedom of States” policy would give taxing authority, and the right to regulate e-commerce, to the individual states. The federal government would continue to determine import and export fees and taxes. Each state would be able to adopt whatever policies it deemed appropriate, at whatever rates it felt were appropriate.

This is similar to the current sales tax system for taxes on goods physically sold in the state. It therefore might seem a natural fit for e-commerce taxation since both are taxes on consumption. However, the unique nature of e-commerce makes this a problematic approach. In all research done on this subject, there were two principles that were demanded by consumers, private industry, and government: uniformity and non-duplication. The very fact that 50 states could enact 50 different tax policies with 50 different definitions of nexus violates both of these tenets. Under this scenario it is quite possible that a consumer living in California, purchasing a good in Nevada, with a server based in Texas might have to pay three different taxes on the transaction.

States would enact policies that maximized their advantages. States with low populations that use tax incentives to attract businesses would define nexus by the presence of the seller. High population states with a low concentration of technology companies would define nexus by the address of the consumer. With large volumes of transactions occurring across state lines, there would be duplication of taxes and confusion. Businesses would have to keep track of 50 different sets of tax policies and allocate sales tax receipts to each state based on its own rules. States could have difficulty collecting their taxes if the businesses collecting them were located in another state.

Internet Tax Equity Policy — Alternative Three

The third option proposed would involve allowing the states to collect taxes on all goods, regardless of the method of transaction, under a federally-regulated tax policy. The strategy behind this federal basis of regulation is to avoid the dilemma of double taxation that threatens when different states have not only different tax rates, but completely different policies in general. Congress would allow each state to tax its constituency on all taxable commerce, including goods bought and sold on the Internet, through catalog sales, or from television shopping channels. It would promote equity of commercial enterprises regardless of the mode of transaction. Nexus would be determined by the consumer’s billing address. In redefining the nexus from the traditional physical presence requirement, Congress would free the states to collect taxes from all types of sales based on a standard sales tax rate. This probably would require new federal legislation given the current court rulings.

In this option no state would have to fear placing itself at a unique competitive disadvantage with other states due to vastly differing e-commerce tax policies. The federal government would still remain responsible for regulations and taxes on imports and exports.


To reiterate, it can be assumed that the current tax moratorium will not be extended ad infinitum. When the moratorium finally ends, there will be a need for an e-commerce tax policy that promotes equity in its effects upon the concerned parties, efficiency in both its initial implementation and long term application, and the maximum amount of liberty of economic choices consistent with the other two options. Three years is a very short period of time to come to agreement on this issue. This paper is presented in the hope of stimulating that important debate.

Inaugural Class of the School of Public Policy

Pepperdine University

Project President
Pete Montgomery

Policy Team
John Michael – Leader
Robert Brunner
Natasha Milasinovic
Jason Pates
Keri Hetherington

Communications Team
Heather Barbour – Leader
Eryn Witcher
Ryan Storm
Shawn Lewis
Ashley Maples

Federal Government Group Anthony Scardino – Leader
David Watson
Derke Roeder
Elena Kozlova

International Group
Lulzime Elmazi – Leader
Julia Thomsen
Kathryn Kingsbury
Soo Bin Shin

Quantitative Analysis
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Aaron Pankratz
Ramin Razaghi
Joe Pohlot

Private Industry Group
Doug Morrison – Leader
Ross Neading
Cathy Karothers

State/Local Group
Colin McLean – Leader
Justin Powers
Jeremy Stewart
Thomas Hoover

Director of Resource Information
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Webmaster/Head Compiler
Bryndyn Crutcher

[1] Jupiter Communications, proprietary report issued in 1998.

[2] Forrester Ranch, proprietary report issued in 1998.

[3] Ornstein, Norman, “Tax the Internet before it’s too late,” USA TODAY, March 1, 1999.

[4] “Don’t single out the Internet for taxation, AEI panelists say,” Communications Daily. March 22, 1999.

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Authors of the article
Philip Romero
Philip Romero
James Wilburn, PhD
James Wilburn, PhD
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