Revised December 23, 1999

Should the Internet Remain a Sales Tax Haven?
by Michael Mazerov

Sales taxes account for one quarter of all tax revenues raised by states and localities to fund education, public safety, health, and many other essential services. The sales tax is a tax on the purchaser of goods and services, whether that purchaser is an individual or a business. In the case of purchases in a retail store, the sales tax is collected from the purchaser by the seller at the time of sale and periodically remitted by the seller to the state in which the sale occurred.


Who Will Remit Sales Taxes on Internet and Mail-Order Sales?

The vitality of the sales tax as a critical state and local government revenue source has been eroded in recent years by the rapid growth in mail-order and Internet sales. Sales taxes are due on mail-order and Internet purchases just as they are on purchases in stores.(1) But a large majority of the sales taxes due on mail-order and Internet purchases made by individual consumers and a significant share of the taxes due on purchases made by businesses are effectively uncollectible. States and localities are unable to collect these taxes because the Supreme Court has prohibited states from requiring mail-order and Internet merchants to charge the customer for the tax and remit it to the customer's state unless the merchant has a physical presence or "nexus" within the state's borders. This means that although an Internet merchant like presumably has customers in every or nearly every state, it can only be required to collect sales tax from customers in its home state of Washington and a handful of other states in which it has built warehouses or stationed personnel.

If the seller does not charge and remit the tax, laws require customers of Internet and mail-order companies to pay the state and local sales tax directly to their home states. However, compliance with this self-remittance requirement is almost non-existent in the case of individual consumers and is spotty in the case of businesses that make purchases from Internet, mail-order, and other "remote" sellers. The combination of weak tax compliance by purchasers and a sharply limited tax collection obligation on the part of remote sellers is eroding the sales tax base of state and local governments.

The requirement that a business be physically present in a state before it is obligated to collect and remit sales tax stems from a 1967 Supreme Court ruling. At the time, the Court expressed concern that collecting sales tax on behalf of 45 states and several thousand localities that impose such taxes would be excessively burdensome for remote sellers under the diverse sales tax rules then in effect. The Court wished to carve out a "safe harbor" from these burdens for companies that were willing to avoid establishing a physical presence in states where their customers were located. Nonetheless, in its 1992 Quill decision, the Court made clear that Congress could authorize states to require remote sellers to charge sales taxes just as Main Street businesses are obligated to do. The Court held that it would be entirely fair for a state to require remote sellers to charge sales taxes provided that Congress first set ground rules aimed at reducing the burdens of sales tax collection.


The Search for a Solution to the Remote Sales Problem

Since the Quill decision, state and local government representatives have actively sought a deal with the "direct marketing" industry in which governments would agree to simplify and reduce compliance burdens arising from their sales tax laws in exchange for the sellers' agreement to collect and remit sales taxes on all of their sales.(2) The explosive growth of Internet commerce during the past few years and the projections of rapid ongoing growth have heightened the urgency of achieving an agreement along these lines.

The forum in which state and local governments currently are making their case for sales tax authority over remote sellers is the Advisory Commission on Electronic Commerce (ACEC). The ACEC was established by the Internet Tax Freedom Act (ITFA) signed into law by President Clinton in October 1998. ITFA imposed a temporary, three-year moratorium on the imposition of new state and local taxes on Internet sales and Internet businesses to allow ACEC time to conduct a thorough study of the remote sales taxation issue and prepare recommendations to Congress on whether and what type of federal legislation might be warranted to resolve it. Major elements of the direct marketing industry heavily lobbied Congress to deny ACEC the authority to recommend federal legislation addressing the remote sales issue, but Congress rejected that plea and authorized ACEC's consideration of the need for federal legislation.(3) The ACEC is to report to Congress by April 2000.


Simplified Taxation or No Taxation?

Until quite recently, it appeared that ACEC would choose between two positions in making its recommendations to Congress. It could recommend that Congress accept the Supreme Court's invitation to set ground rules under which remote sellers could be required to collect state and local sales taxes. Alternatively, ACEC could recommend that Congress do nothing and preserve the current physical presence nexus requirement that protects sellers from sales tax collection obligations in most states.

As ACEC got down to serious work, however, it put out a formal request for written proposals on whether and how Internet and other remote sales should be taxed by states and localities. The responses it received went beyond these two basic positions. On the one side, a sophisticated proposal for collecting and remitting taxes through a private, commercial entity was put forth. At the other extreme, a number of proposals calling for additional restrictions on the taxation of remote commerce were submitted.

The National Governors' Association Proposal

In one camp stand the organizations representing state and local governments and representatives of traditional retailing interests, who continue to explore options for achieving collection of sales taxes on Internet and other remote sales. In mid-November, under the leadership of Utah Governor (and ACEC member) Michael Leavitt, the National Governors' Association and the other major state and local government organizations made their most far-reaching proposal yet. These organizations made a public commitment to develop and implement a "Streamlined Sales Tax System for the 21st Century."(4) State and local government organizations intend to issue a Request for Proposals to the private sector for the development of an entirely privatized sales tax collection system. Under such a system, one or more organizations (such as existing credit card networks) would become intermediaries between remote sellers and state tax authorities and, using software the firms would develop, would collect tax from customers at the time the sale occurs and immediately remit it electronically to the states. The intermediaries would be compensated for this service through a small per-transaction fee. To make this work, remote sellers would install on their computer systems software that would be furnished by the intermediary and that would pass to the intermediary sufficient information to ensure that the proper sales tax could be collected from the customer. The state and local government organizations have committed to developing this system on their own and piloting it with remote sellers that they expect will volunteer to test it. They believe that in the long run the system will be attractive enough to remote sellers that the vast majority will voluntarily adopt it and that no federal legislation to compel adoption would be needed.

Anti-Tax Proposals

By contrast, the anti-tax camp has submitted to ACEC a variety of proposals for additional, statutory restrictions on the ability of states and localities to collect sales taxes on Internet and (in some cases) other remote sales. Virginia Governor James Gilmore, ACEC's Chair, and California Board of Equalization and ACEC member Dean Andal have made such proposals. Representatives John Kasich and John Boehner have introduced legislation to that effect, the Internet Tax Elimination Act, H.R. 3252, and have pushed for ACEC's endorsement of the legislation. The "e-Freedom Coalition," which includes Americans for Tax Reform (headed by another ACEC member, Grover Norquist), the National Taxpayers Union, Citizens for a Sound Economy, the Heritage Foundation, and a score of other conservative advocacy groups and think tanks, has put forth a similar position.(5)

Each of these proposals would further constrain state and local taxation of Internet and mail-order sales. The Andal proposal (which has also been endorsed by Governor Gilmore and the e-Freedom Coalition) would strip from state and local governments the authority they currently have to require some remote sellers that do have a physical presence within their borders to charge sales tax. For example, remote sellers that regularly deliver goods to customers in their own vehicles or send in sales people to make sales calls to major customers are currently obligated to charge sales tax in many states where they engage in such activities. The Andal proposal would permit remote sellers conducting such activities to stop collecting and remitting the tax.

The Gilmore and Kasich/Boehner proposals are more far-reaching. These proposals would deprive states of the power they now have to require consumers to pay sales tax on their Internet purchases themselves.(6) Currently, for example, states can effectively collect sales taxes on cars purchased out of state, because registering the vehicle notifies tax authorities that a taxable purchase has been made. Under the Gilmore and Kasich/Boehner proposals, however, states would be prohibited from requiring purchasers to pay sales taxes on cars purchased out of state over the Internet. Indeed, under the Kasich/Boehner proposal, states would be prohibited from collecting sales tax in connection with the Internet purchase of a car from a dealer in the customer's own state. So a person in the market for a new car who does comparison shopping and test driving at the showroom but places the actual order over the Internet could completely avoid taxation under these proposals.

The type of blanket prohibition on taxation of Internet purchases proposed by Governor Gilmore and Representatives Kasich and Boehner would affect all types of Internet purchases. Many large brick-and-mortar retail chains could easily restructure their operations to re-characterize their in-store sales as Internet sales. All that would be required would be an Internet-linked computer in the store that customers could use to place orders that would be delivered locally to their homes.(7) Over time, the state and local revenue losses resulting from these types of sales could be very large.


The Long-Term Consequences of Making the Internet a Sales Tax Haven

Even if state and local authority to tax Internet and mail-order sales were not further constrained as Governor Gilmore and others propose, failure to eliminate the de facto tax exempt status of most such sales that results from the inability of states to compel remote sellers to collect sales taxes would have an adverse impact on the quality of state and local services, the tax burdens shouldered by lower-income Americans, and the future economic vitality of Main Street businesses:


Critical Decisions Ahead

The written proposals on electronic commerce taxation submitted to the Advisory Commission by the National Governors' Association, Governor Gilmore, Commissioner Andal, the e-Freedom Coalition and Representatives Kasich and Boehner were formally presented and intensely debated at ACEC's December 1999 meeting in San Francisco. No consensus among the Advisory Commission members concerning any of the proposals emerged during the meeting.

A final meeting of the Advisory Commission on Electronic Commerce is scheduled for March 20-21, 2000 in Dallas. It is likely that the Commission will try to make final decisions at that time concerning its recommendations to Congress. The decisions ACEC makes could help determine whether the adverse trends affecting state and local services, low-income consumers, and Main Street businesses discussed above will deepen or will be fairly and effectively addressed. Enacting new federal restrictions on state and local sales tax authority would impair the ability of state and local governments to improve education and other services that are an important underpinning of an increasingly technology-based economy. Endorsing the principle of equal tax treatment of Main Street businesses and remote sellers, on the other hand, could encourage the electronic commerce and mail order industries to work constructively with state and local governments toward a workable compromise. Such a compromise could achieve a reduction in sales tax compliance costs for many businesses, while ensuring both that no business or individual avoids paying a fair share of sales tax and that state and local governments remain capable of financing necessary services.

End Notes:

1. Technically, the tax that is due on a purchase from a merchant in another state is a "use tax" rather than a sales tax. See: "Sales Taxes, 'Use Taxes,' and 'Nexus' — A Primer," Appendix A of A Federal "Moratorium" on Internet Commerce Taxes Would Erode State and Local Revenues and Shift Burdens to Lower-Income Households, Center on Budget and Policy Priorities, May 1998,

2. State and local governments and traditional retailing interests pursued such a deal in Congress, supporting legislation sponsored by former Senator Dale Bumpers that would have granted states sales tax jurisdiction over large remote sellers if the states essentially eliminated the responsibility of remote sellers to comply with city and county sales taxes. Next, state and local governments engaged in two separate rounds of private negotiations with the direct marketing industry in which they sought voluntary compliance by large direct marketers with a substantially simplified sales tax system. State and local governments then participated in a 2 ½-year-long project sponsored by the National Tax Association (a professional association of tax economists and attorneys) focusing on the particular tax issues raised by sales over the Internet and aimed at engineering a similar trade of sales tax simplification for abandonment of the "physical presence" tax collection requirement.

In each instance, state and local government efforts to stop the erosion of their sales tax base by remote sales were thwarted by industry opposition or foot-dragging. The direct marketing industry successfully lobbied against enactment of the Bumpers legislation and walked away from the negotiations for the voluntary collection agreement days before it was to have been signed. The National Tax Association Project was suspended after it became clear that the electronic commerce industry was not prepared to use that forum to negotiate the actual terms of federal legislation that would have traded an "expanded duty to collect" on the part of Internet and other remote sellers for simplification and interstate standardization of sales tax rules on the part of state and local governments.

3. See: Michael Mazerov, The Internet Tax Freedom Act's "Advisory Commission on Electronic Commerce": Preserving Flexibility to Consider All Options, Center on Budget and Policy Priorities, October 2, 1998.

4. The proposal is available at

5. All of these proposals may be accessed at

6. Governor Gilmore proposes to compensate state and local governments for the loss of revenue attributable to his proposal by dedicating the revenue raised by one percentage point of the three-percent federal telecommunications excise tax to a fund that would be divided among the states. By his estimates, this would provide $3.4 billion in new revenues to state and local governments 10 years from now. As will be discussed below, state and local governments could be losing as much as $15 billion annually from untaxed mail-order and Internet sales by 2003; given projections for Internet commerce growth, the losses are likely to be far greater than that 10 years from now.

7. Indeed, if a Borders bookstore in the District of Columbia placed in the store a computer linked to the Internet, someone working in the District but living in suburban Rockville could use it to place an order to a Web site of Border's Rockville store and pick up the purchase on her way home in the evening. Under the Kasich/Boehner proposal (and perhaps under the Gilmore proposal, depending upon how "remote sale" was defined in the statute implementing the proposal), such a purchase would be exempt from state sales tax by federal law.

8. Harley Duncan, Executive Director of the Federation of [state] Tax Administrators, has taken projections of consumer Internet purchases in 2003 prepared by Forrester Research, Inc. and shown that they imply as much as $4 billion in lost state and local sales tax revenues in that year. (See: "State Revenue Losses from E-Commerce Underestimated," State Tax Notes, July 26, 1999, p. 245.)   Like most industry analysts, Forrester expects business-to-business sales over the Internet to remain many times larger than consumer purchases. Forrester currently projects $1.3 trillion in U.S. business-to-business Internet sales in 2003. (See: "The Online Revolution," Wall Street Journal, July 12, 1999, p. R6.) If just one-third of these sales represent items that would be subject to state and local sales taxes, and if it is assumed that just one-third of the taxes due on this one-third of sales would go uncollected, then the 2003 revenue loss from untaxed business-to-business Internet sales (at the average 6.5 percent tax rate used by Duncan) would be $9.6 billion. (Assuming that one-third of the $1.3 trillion would be subject to sales tax seems reasonable. Computers, industrial equipment, office supplies, and shipping supplies alone account for 40 percent of the total; such items generally do not qualify for sales tax exemptions). Combining the $9.6 billion in lost revenues on business-to-business sales with the $4 billion in lost revenues on consumer purchases estimated by Duncan yields $13.6 billion. Thus, an estimated $10 billion total revenue loss from untaxed Internet sales in 2003 appears reasonable, if not conservative.

9. Forrester Research, Inc.'s updated September 1999 forecast of consumer Internet purchases projects $143 billion of such purchases in 2003 and $184 billion in 2004.

10. Some argue that the "digital divide" will disappear over time, but the disappearance of the divide may not be as likely as many assume. Failure to take advantage of the Internet is closely associated with low educational attainment — which in turn is associated with low income — and there is some indication that the gap in Internet use between highly- and less-educated individuals may be getting wider rather than narrower. The distributional consequences of perpetuating the de facto sales tax exemption for Internet purchases are discussed extensively in the Center's September 1999 submission to ACEC, available at

11. Austan Goolsbee, In a World Without Borders: The Impact of Taxes on Internet Commerce, June 1999. Available at