Frank A. Schmid

Judith H. Hazen

English

Research Papers in Economics

NationalEconomicTrends
September 2000
Online Taxation
In a recent report, the Federal Trade Commission
analyzed the economic implications of the Internet.*  
A major issue is online taxation.  Currently, the Internet
allows out-of-state vendors who do not pay sales tax 
to compete with local brick-and-mortar stores that are
subject to sales taxes levied by local and state govern-
ments.  It seems natural to call for a level playing field
on equity and efficiency grounds.  However, in this
respect, it is not all that straightforward what a level
playing field means.
In the debate on online taxation, theoretical argu-
ments and empirical evidence are brought forward on
either side. The “infant industry” argument figures
prominently.  According to this reasoning, a develop-
ing industry should receive protection from competi-
tion until it is “mature” and able to compete on equal
footing; otherwise, a market failure may result with
the industry not being able to fully utilize its compar-
ative advantages.  E-commerce could be viewed as
such an industry.  Opponents of online taxation point
to network externalities that deserve to be subsidized
via tax exemption.  Generally, a good possesses net-
work externalities if it becomes more valuable to the
consumer as the number of users increases.  Thus, the
marginal consumer generates benefits for all the existing
consumers without being compensated.  If e-commerce
generates such an externality, a tax exemption on online
purchases is a way to correct for it.  Proponents of In-
ternet taxation, however, point out that “infant industry”
policies rarely produce the desired outcome. Once a
developing industry enjoys protection, it has little in-
centive to become competitive.
Empirical research in the area of e-commerce offers
some insights into the pros and cons of online taxation.
Current empirical evidence points out three key findings.
The first is that consumers who live in areas with high
sales taxes are more inclined to purchase online than
consumers in areas where sales taxes are low.  A sec-
ond finding is that governments do not lose a sizeable
portion of tax revenue through e-commerce due to the
still relatively low volume of business-to-consumer
Internet transactions.  For 1998, it is estimated that the
tax exemption amounted to $170-430 million based
on a business-to-consumer Internet sales volume of
$2.5-2.6 billion.  Even a projected loss in sales taxes
by the year 2002 of around $2.5 billion is less than
two percent of projected sales tax revenue.
The third finding concerns the burden that tax col-
lection would represent to online retailers.  Currently
46 states and almost 7,500 local governments impose
sales taxes of various forms, differing across goods and
jurisdictions.  With online taxation, Internet retailers
would have to determine which tax rate applies for every
good and destination, and would be responsible for tax
collection.  A field study conducted by the Washington
State Department of Revenue among brick-and-mortar
retailers in Washington and Oregon indicates that the
burden on online retailers for collecting and remitting
sales taxes would be significant.  This study estimated
that the cost of tax collection and processing to retailers
amounts to about 4.23% of total state and local sales
taxes.  Thus, the cost of compliance already is high,
even though brick-and-mortar retailers only deal with
one set of tax codes pertaining to their place of business.
In summary, Internet taxation remains a challenging
issue.  Given the small volume of business-to-consumer
transactions, the government is in no hurry to act.  As
the Internet grows in importance, however, the tax issue
will not remain in the background.  A uniform tax rate
for online sales would help minimize the cost of com-
pliance, but it might prove difficult for state and local
governments to coordinate on this solution.
* Alan E. Wiseman, July 2000, Economic Perspectives on the Internet, 
Federal Trade Commission.
—Judith H. Hazen
—Frank A. Schmid
Views expressed do not necessarily reflect official positions of the Federal Reserve System

Online taxation

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Online taxation

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