Should World Wide Web be a tax-free zone?

With Americans buying billions of dollars worth of goods online with the click of a mouse, one of the hottest topics in Washington today is whether to tax Internet purchases.

On one side, Internet boosters such as online retailers and Republican presidential candidate Sen. John McCain are calling for a permanent ban on all Internet taxes, saying a ban is essential to free e-commerce to serve as the engine of US economic growth.

Many of the nation's governors, however, oppose a ban. They worry that the expansion of online retailing could eat into traditional bricks-and-mortar sales and erode vital state tax revenues.

Implications of the politically prickly debate go well beyond the issue of Internet taxation, forcing questions such as how to bring the nation's antiquated tax systems into alignment with the cyberage economy.

That is leading to some stunning arguments, from a proposal to have e-businesses "voluntarily collect" taxes to a bill in at least one state that would abolish sales taxes outright.

The debate also has raised thorny ideological trade-offs, especially for the Republicans who lead Congress and most states. It forces a choice between two core GOP goals: lowering taxes and shifting power from Washington to state and local governments. In terms of dollars, the stakes in the debate are potentially high - although still uncertain due to the newness of e-commerce.

Senator McCain, who vows to make the Internet a "tax-free zone," has sponsored a bill that would wall off the Internet from state and local sales levies. Similar legislation in the House has the backing of Budget Committee Chairman John Kasich (R) of Ohio.

Banning taxes on e-commerce would be nothing more than "government-sponsored favoritism" that would unfairly harm Main Street retailers, said Michigan Gov. John Engler, testifying before Congress for the National Governors' Association this month. "It is, in essence, a two-tiered system: good for clicks, bad for bricks," he said.

The result, Governor Engler stressed, would be "an unprecedented infringement upon the states' ability to raise ... revenues."

The governors' association, now meeting in Washington, has at the top of its agenda a plan to encourage firms to voluntarily collect levies on Internet sales under a simplified, streamlined sales-tax system. Today and tomorrow, the governors will be pitching their plan in meetings at the White House and on Capitol Hill.

Some in Congress and state legislatures say that if Internet taxes should be banned, so should all sales taxes - which would increase the tax burden on income and property ownership. In Virginia, state lawmakers this month are debating bills that would abolish the state's 4.5 percent sales tax in order to help traditional retailers vie with digital competitors.

"In the long term, the vitality of the sales tax depends on being able to collect on all forms of sales, whether Internet, over-the-counter or phone," says Harley Duncan, executive director of the Federation of Tax Administrators.

Internet retail sales, now at more than $20 billion, are expected to climb to between $130 billion and $180 billion by 2004, according to projections by Forrester Research in Cambridge, Mass. Business-to-business online commerce is far greater, totaling $176 billion in 1999 and estimated to rise to $1.3 trillion by 2003.

Meanwhile, states relied on sales taxes for about one-third of their total revenue, or $156 billion, in 1998. By 2003, state and local governments could lose an estimated $3.5 billion to $10 billion a year in revenues as a result of the failure to collect taxes on Internet sales, according to academic studies. "Is it going to devastate them? No. Is it a problem? Absolutely," says William Fox, an economist at the University of Tennessee at Knoxville who authored one study.

Under current law, states are in theory owed taxes on sales by Internet retailers, mail-order businesses, and other "remote" vendors. But states can only require remote vendors that have a physical presence, such as an office, in the state to collect the sales taxes. If there is no physical presence by the seller, the tax is supposed to be paid voluntarily by the buyer. But while firms often do so out of concern over a possible tax audit, individuals rarely do - and states have no easy way to force compliance.

Unlike states, Congress under a 1992 Supreme Court decision has the constitutional authority as regulator of interstate commerce to require Internet retailers to recoup the unpaid state sales taxes. Yet Congress has not used its authority, leaving states only the option of asking out-of-state retailers to collect taxes voluntarily.

A congressional panel set up in 1998 to study the tax treatment of Internet sales is scheduled to report to lawmakers in April. But the 19-member panel is divided over several proposals, and is expected to lack the two-thirds majority it needs to formally recommend a solution.

The panel could, however, agree to recommend that Congress take smaller, specific steps to simplify existing taxes and eliminate Internet access fees, taxes on digitized goods, and a 3 percent telecommunications tax, says commission executive director Heather Rosenker. Business representatives on the panel are pushing for a streamlining of sales-tax laws. "We shouldn't take the Internet and drag it into this morass of complicated tax laws," says former Rep. Rick White (R) of Washington, a Seattle lawyer whose firm represents Amazon.com and other e-commerce companies.

The same law that created the commission, the Internet Tax Freedom Act, also imposed a three-year moratorium on new Internet access fees and new state and local taxes that specifically target the Internet. The moratorium, set to expire in October 2001, does not cover existing federal, state, and local taxes.

If the political deadlock over the tax question continues, Congress may do nothing but pass a bipartisan bill to extend the current moratorium by two or more years. Indeed, some experts say Congress' wisest choice may be to simply postpone acting until the economic impact of e-commerce becomes clearer.

"A lack of consensus in which they kind of fumble toward a nonsolution is perhaps the best thing that could happen," says Austan Goolsbee of the University of Chicago business school, who researches the impact of taxes on Internet commerce. "Leave it be for a few years and revisit it when and if it becomes a revenue issue," he says.

(c) Copyright 2000. The Christian Science Publishing Society