1999 Volume 2 Issue 3

E-Commerce & Taxation

E-Commerce & Taxation

Three options offered 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.

Based on the work of the Inaugural Class of the Pepperdine University School of Public Policy.*

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 class constituted itself as a consulting firm named MPP for purposes of this project and will be referred to as MPP within the body of the report. 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’s recommendations may be less appropriate for some other states. It does seek to provide realistic recommendations for a complicated world that take into account the interests of different levels of government, private industry and consumers.

The Spring Issue of the Graziadio Business Review included an article summarizing three basic policy options available regarding taxation of e-commerce. The following article focuses on recommendations for the state of California, but the class wishes to stress that this is not a final version. Some issues raised by policy experts from government, business, and academia are summarized following the article. It is the intention of the class to respond to these comments in a final version of their report. Readers are encouraged to respond as well.

The previous article is available at: https://gbr.pepperdine.edu/2010/08/e-commerce-taxation-2/

The rapid growth of electronic commerce has led to increased interest and debate on whether, and how, e-commerce should be taxed. Opponents of Internet regulation and taxation argue that if Internet commerce is allowed to grow untaxed, it will bring even greater economic benefit in the end. Proponents of e-commerce taxation argue that it is unfair to traditional brick-and-mortar merchants for e-commerce not to be taxed. It is also viewed as a matter of survival for state and local governments, many of which depend on sales tax revenues for basic operating income. As more people rely on the Internet for shopping, these entities would stand to lose millions of dollars in sales tax revenues if e-commerce is not taxed, or if those tax dollars are diverted to some other governmental agency. This is of particular concern to local governments in the state of California that have had to rely heavily on sales tax revenues since the passage of Proposition 13.

While there is currently a moratorium on e-commerce taxes except for those companies that have a “substantial physical presence” or “nexus” in the state where the customer lives, that moratorium is scheduled to end in October 2001. To reach some consensus and pass necessary legislation before then requires that serious debate be undertaken immediately.

Three Basic Options

It seems very clear that the moratorium will not last indefinitely. Some form of taxation of e-commerce will be imposed shortly after the moratorium is ended. Given that assumption, there are three basic options.

The National Sales Tax Option (NST): The federal government would impose a uniform tax on all domestic e-commerce, collect the tax electronically, and then remit the proceeds to the states based on some standard definition of nexus. From California’s perspective it would be preferable to have that be the billing address of the consumer.The Freedom of States Option (FS): All states would be free to impose whatever tax they wished and define what constitutes “nexus” for tax purposes. Businesses would be required to keep records and respond separately to each state’s requirementsThe Internet Tax Equity Option (ITE): The federal government would define nexus and create some uniform regulations but would give states the freedom to determine their own tax rates and exemptions. Tax receipts would be transmitted electronically directly to the appropriate state through the use of standardized accounting software. The tax policy would be expanded to include mail order catalogs, television shopping channels, and any comparable new venues that may be developed in the future.

(See the Spring 1999 GBR for an expanded discussion of these options.)

Recommendations for California

First, MPP strongly recommends that California not act ahead of its competitors – the other 49 states — in order not to put itself at a competitive disadvantage in terms of business growth, job retention, and consumer transactions. Second, MPP recommends that the state lobby for a two-year extension of the moratorium in order to ensure sufficient time for studies to be done and appropriate legislation to be thoughtfully considered and passed before the tax-free period is over. If an extension is not politically feasible, and many argue that it is not, then it is imperative that the state begin immediately working with the Congress to pass necessary legislation to ensure a smooth transition when the moratorium does end.

At this time MPP recommends that California support the third option mentioned above, the Internet Tax Equity Option (ITE). California should take the lead in supporting a federally-regulated tax policy that would resolve the nexus question by allocating taxes to states based on the consumer’s billing address. Each state would tax its constituents equally, regardless of the method of transaction, i.e., physical retail stores, catalog sales, television shopping, or e-commerce. Additionally, the state should encourage Congress to support a uniform electronic means of tax collection.

This proposal is recommended over the other alternatives because it demonstrates superior results in MPP’s analysis of efficiency, equality, and liberty. It also provides for greater state revenue than the NST option. The following sections examine each option in terms of these three criteria and in terms of its impact on the key players involved — the State of California, consumers, and private industry.

MPP has estimated the e-commerce sales tax revenues California would receive in the years 2002 – 2003 under three different combinations of price elasticity and three assumptions about the percentage of e-commerce taxes already collected. ( . . . Link to an explanation of methodology and assumptions.) The amounts are calculated both at the current state tax rate of 7.25%, which it is assumed would be applied under the ITE option, and at 4.77%. The latter is the average of all current state tax rates and is used in this analysis as the best estimate of the tax rate under the NST option. These figures are presented in Table 1.


For the State of California – 2002 – 2003

(Figures Reported in Millions of Dollars)

Lowest Range

30% Elasticity

15% already taxed

Most Likely Range

20% elasticity

10% already taxed

Highest Range

0% Elasticity

0% already taxed

At 7.25% tax rate

$530 – $770

$640 – $930

$890 – $1,300

At 4.77 % tax rate

$350 – $510

$420 – $610

$590 – $850

Based on this analysis, California clearly gains more revenue if it applies the current tax rate than if it is restricted to the estimated national sales tax rate. However there are other factors to be considered in making a recommendation. The three options were evaluated for their impact on the state of California, on consumers, and on private industry according to the following criteria:

Liberty – Allowing maximum choice and sovereignty for those affected.

Efficiency – Achieving both immediate and long-term objectives with the least effort and expense.

Equality – Affecting all individuals and groups in the same manner.


State of California – If liberty is defined as maximum choice and sovereignty for those affected, then the moratorium limits the freedom of all states. None are permitted to tax e-commerce while the moratorium is in effect. However, MPP assumes that the moratorium will not continue, so that is not a long-term concern. Under the National Sales Tax option (NST) states would not be free to set their own sales tax rates or determine exemptions. The Freedom of States option (FS) provides the maximum amount of liberty to the states, but it does so at a very high cost to efficiency and equality. These points will be explained later.

The Internet Tax Equity or ITE option, which MPP recommends, restricts all states, including California, by having Congress establish the uniform definition of nexus as the billing address of the consumer, and possibly by requiring standardized software for recording and transmitting taxes. While this does limit liberty somewhat, there is more freedom than exists under the moratorium or the national tax option. On balance these limits on freedom are a benefit. They bring order out of a potentially chaotic situation. California, with its large population, also should fare well under this definition of nexus.

Consumers – Virtually any sales tax limits the liberty of consumers. None of the three options being considered provides an exception to that rule. However the consumer’s liberty is not compromised any more under the ITE option than it is in the traditional venues of commercial transaction. California residents might pay less tax on e-commerce transactions under the NST option, but that gain could be offset by higher taxes of some other type to maintain local services, or a loss of those services. Consumers in many other states would pay more under NST than they do in traditional retail. The recommended policy merely maintains consistency of taxation for all types of commerce within the state’s jurisdiction.

Private Industry – The national tax policy would limit the liberty of at least some businesses by eliminating the benefit of moving from one state to another to take advantage of more favorable e-commerce tax policies. Under the Freedom of States (FS) option, there might be opportunities for businesses to find better tax opportunities by moving, but flux in state policies and evolving definitions of nexus might make such moves problematic. Under the recommended ITE policy, the tax rate would be determined by where the purchaser resides, not the location of the business. This reduces the effectiveness of moving for a tax advantage in e-commerce. However this policy does not impose any new restrictions on liberty that do not currently exist.


State of California – Both the national policy and the tax extension policy could be efficiently administered through a uniform software program used by all e-commerce merchants. This program would automatically calculate the appropriate tax and transmit it electronically directly to the taxing authority. In the case of a national sales tax, it would be remitted to the federal government, while under the recommended policy, it would be remitted directly to the states. The automated system would be efficient for both merchant and California’s State Board of Equalization. In addition to lower payroll expense, the timeliness of the tax potentially gives greater sense of flexibility to the state in its budgeting process. The state would not have to wait for quarterly or annual receipts for a significant portion of its income and could track projections more efficiently. Automatic electronic transmission could also prevent much of the “leakage” from occurring in e-commerce that is typical in the cash underground economy.

The FS option is by far less efficient. It would violate the two principles most demanded by all groups in research done of this topic: uniformity and non-duplication. Under this policy all 50 states could enact different definitions of nexus and set different tax rates and reporting requirements. Each state would likely enact laws that would maximize its own advantage in determining nexus. Transactions that cross state lines could be taxed by each state, depending on its laws. A customer in New York that orders a product from a company based in Seattle, Washington, with a server based in California could be subject to three different taxes on the transaction. States would be unlikely to receive all revenues. Because of the complications involved, it would be expected that businesses would not transmit all taxes the state claims – either because of confusion or because it would be too hard for the state to monitor all transactions.

California could also see a drain on its business base. Businesses would go to the states that can afford to minimize taxes on electronic commerce. California, with its high infrastructure costs and large population could be at a disadvantage.

Consumers – The FS option is also detrimental for consumers. Depending on where the customer lived, where the e-commerce merchant was incorporated, and what servers were used — and therefore what states were involved — taxes on a given item could vary significantly. In some cases, two or three different taxes could be imposed if the transaction involved entities in that many states. Consumers would have to be very vigilant to avoid being taxed more than necessary. Both of the other two options are much more efficient for consumers. Either the National Sales Tax or the Internet Equity option would be preferable for consumers from an efficiency perspective.

Private Industry – This same analysis basically holds true for business. Businesses would have to spend a great deal of money and effort tracking and responding to all of the different regulations and rates. They could also be a target for customer complaints over confusing tax issues.


There is no concern for equality in the Freedom of States option, and therefore the following comparisons deal only with the National Sales Tax and Internet Tax Equity Options.

State of California – The NST option would maximize some forms of equality nationally. Although the Internet Tax Equity (ITE) option has less uniformity than does NST, it provides equality of a crucial kind – a standardized definition of nexus for all states, and common regulations to help all states keep track of taxes due.

Consumers – NST treats e-commerce consumers equally across political jurisdictions, but the policy as stated does not directly address equality between e-commerce and other types of shopping such as catalog sales, and traditional retail. In that respect, consumers are not necessarily treated equally. Under the ITE option, e-commerce shoppers and catalog and television shoppers will all be subject to the same sales taxes as shoppers at traditional retail outlets.

The tax moratorium gives tax advantages to those who have computers and Internet access. The ITE option, and in some cases the NST option, eliminate the bias against consumers who do not have access to Internet shopping or do not have credit cards. Many of these are lower-income people for whom taxes represent a disproportionate share of income. Therefore the ITE option promotes equality among consumers.

Private Industry – Since the sales tax of each state would be applied to all forms of commerce engaged in by that state’s consumers, traditional retailers will no longer be disadvantaged by the tax structure relative to e-commerce or even catalog sales.

California Urged to Promote Internet Equity Tax Policy

MPP recommends that the state of California take the lead in promoting the Internet Equity Tax Policy which would have the federal government define nexus for all forms of non-traditional consumer retail purchases as the purchaser’s billing. There may also be other regulations regarding reporting and remitting taxes where uniform policies would be useful. Beyond that, each state would be allowed to set its own tax rate that would apply to all consumer purchases. Each state could also determine any exemptions from sales taxes, such as food or medicine, and each state would determine the distribution of its tax revenues as it now determines them. The taxes would be collected and electronically transmitted automatically at the time of purchase in the case of e-commerce. This policy will apply only to tangible goods since under California law [Public Law 1502(f)(1)] intangible goods, including software, are non-taxable. In keeping with this law, neither will Internet access be taxed.

When measured by the criteria of liberty, efficiency, and equality, this option provides for more liberty and more equality for consumers and private businesses than does the National Sales Tax Option. It also would generate more revenue for the state than would the NST option. While the Freedom of States Option would grant even more liberty, it lacks efficiency and is not equitable. That option would result in a very chaotic environment and cannot be recommended.

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
John Workman – Leader
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
Alan Beard

Webmaster/Head Compiler
Bryndyn Crutcher


Methodology and Assumptions Used for this Study

Because e-commerce is a very new sales channel, there is little historical data. Forecasting is therefore inexact. However, conscientious examination of trends can provide a useful basis for policy recommendations. The sales projections used here are provided by Jupiter Communications, one of the leading analysts of e-commerce trends.

If Internet sales are taxed, it is assumed there would be an effect on the level of purchases made online. Professor Goolsbee at the University of Chicago has estimated the price elasticity of demand at 30% or higher, depending on the tax rate. California has one of the highest sales tax rates, so this effect may be even higher. For the analysis here, however, we have accepted a more cautious elasticity of 20%.

Another factor to be considered is the percentage of current e-commerce sales that are currently taxed. Businesses with a substantial physical presence in the state are required to collect and remit taxes from e-commerce sales to citizens of that state as they do with sales from their traditional outlets. Most businesses do not differentiate between taxes collected from one source or the other when remitting state taxes, so the actual number is not known. For purposes of this study, MPP has estimated that 10% of current e-commerce is already taxed.

MPP conducted a sensitivity analysis to determine the range of estimated revenues that would be generated for California under the recommended policy. The results are seen in Table 1, above. The analysis was conducted with various levels of elasticity and current percentages of taxed items, and encompasses the high and low estimates for revenue generation.

To compare the results of this analysis with the outcome under a national sales tax policy, MPP assumed that a national tax would be the average of the current state taxes, or 4.77%. Using the same price elasticity and current taxation assumptions, the amount of sales taxes generated for California under a national sales tax were also calculated. No allowance was made for transaction costs at the federal level in the collection and distribution of the taxes under this policy.

Expert Response to E-Commerce Proposal

The Panel of Exerts assembled to respond to the policy proposal represented all points on the political scale and several different organizational entities. There were representatives from government, academia and the private sector. As would be expected with such a panel, their concerns were different, the points they chose to emphasize were different, and their action recommendations were sometimes contradictory. All did agree that the topic is critical and that building public awareness of the issues, the options, and the consequences is necessary.

Following is a brief summary of some of the points raised. They have been consolidated into two major categories: Issues about the policy itself, and issues related to implementation of the suggestions, including political considerations. Because of the panelists’ differing approaches, the comments do not necessarily “flow” from one to the other. Some are even contradictory.

Issues Related to the Policy Choices

Electronic commerce has contributed significantly to job growth and the increase in productivity that has contributed to economic expansion. Imposing taxes on e-commerce would slow growth.

There is a very real issue of fairness involved when people who operate traditional retail establishments must charge sales tax as well as pay property taxes and often special assessments, while electronic competitors do not have those burdens. The taxation of e-commerce would not be a “new” tax. It is the same tax that would otherwise be paid at the local establishment.

Conversely, using the billing address of the credit card as the situs for the tax may place an unfair burden on the e-commerce business since that business will have the responsibility to determine where that card is registered – while the local merchant does not have that responsibility. Additionally, it is conceivable that someone would establish a business that would register electronic commerce cards in a low-tax state and forward the bills to the buyer’s home address. Perhaps the shipping address is a better choice since people would be less apt to find it worth while to pay for, and wait for, goods to be reshipped.

For local communities, the move to e-commerce means more than the loss of sales tax revenue. The local community also loses property taxes, jobs and the multiplier effect of those wages. If buildings are not being utilized anymore, there is the risk of blight. It is at the local level that we pay for the services about which people really care: police, fire, and paramedic services. Thanks to Proposition 13, California now has some of the lowest property tax rates in the nation, and they cannot be raised more than a minimal amount each year. Where will the money come from for local services? All of these factors need to be worked into the calculations when one attempts to determine the impact of any policy suggestion.

The policy accepts the sales tax as an appropriate tax. It is, however, a regressive tax. Perhaps there are better options. Yet, on a macro-level, it can also be argued that consumption taxes are preferable to taxes on capital and savings if the concern is to keep the economy growing.

The discussion of e-commerce taxation policy provides an opportunity to focus on the broader picture. If the policy were to be enacted as proposed, how would tax revenue be distributed? Would it all go to the state to be disbursed at the state’s discretion? Would a percentage be returned to the buyer’s local community?

Some of the issues raised by e-commerce taxation are variants of other issues that have been under discussion for several years but still need resolution. The discussion should be at that broader level. These issues include:

  • The need to rationalize the distribution of tax receipts between levels of government and between different local communities;
  • The question of fairness in taxation of goods purchased from shopping channels and catalogs;
  • The issue of the taxation of services as well as tangible goods.

New technologies are challenging the definitions about what is a taxable good. Is a book that is sent as a file over the Internet rather than as a print edition a tangible good? What about music that is downloaded from the Net and saved to a disk? Is that a taxable tangible good?

Using software that would capture tax revenue automatically and remit it would be a major step toward tax equity. There is a great deal of “leakage” in traditional retail and a very large underground economy that currently does not pay tax at all.

The benefits of competition among states to attract businesses should not be underestimated. Policies that discourage competition, including a uniform national sales tax, should be avoided.

Using the consumer’s address as the determination of taxation means that you permit people from outside the United States to purchase goods tax-free while citizens pay taxes. Is that appropriate?

The international aspects of the policy need to be addressed in more detail, including trade treaties.


The difficulty of collecting tax revenues automatically is underestimated. Encryption is liberating for those who want to avoid taxation. The algorithms are widely known and trying to outlaw them is not realistic.

If you leave it to the federal government to write the uniform regulations, there is a chance that the federal government will also decide to take a “cut” of the taxes collected.

If automatically collecting taxes eliminates the “leakage” that now occurs with the underground economy, then a lower tax rate could generate as much tax revenue as is taken in with the current system. A lower tax rate could be an incentive to help gain political support for passage of legislation taxing e-commerce. Downward pressure on income taxes or capital formation taxes (as proposed in the policy statement) is likely to generate less support for the policy than lowering the sales tax rate.

Politically it will be very difficult to get a proposal that favors large population states such as California through the U.S. Senate, where each state has an equal vote. Some compromises with low-population states that have adopted a policy of attracting business with low tax rates will be necessary.

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