Invited TESTIMONY of
Sonia Arrison
Director of Technology Studies
Pacific Research Institute

Before the California Senate's Revenue and Tax Committee

First, I would like to thank you for the opportunity to testify today. The Internet economy is changing the way we live and work, and is of particular importance to California, home of the legendary ‘silicon valley.’

There are a couple of points I’d like to make today regarding the Internet and sales tax in the new economy, but before I do, I would like to read you some statistics to give you a feel for what the Internet economy has accomplished so far.

In 1998, the "Internet economy generated an estimated $301 billion U.S. dollars in total revenue and was responsible for 1.203 million jobs." As of October of 1999, the Internet economy was credited with providing 2.3 million jobs and was expected to have generated $507 billion dollars in revenue by year’s end. By 2003, it’s estimated that business-to-consumer sales will reach $108 billion dollars and business-to-business sales will reach 1.3 trillion.

Those are large and impressive numbers. But it’s important to remember that the growth has taken place in an environment where there were federal and California state moratoriums on new Internet taxes, accompanied by a sales tax regime similar to that of the mail order industry – that is, because of Supreme Court decisions Bellas Hess (1967) and Quill (1992), states have been barred from collecting sales taxes from out-of-state sellers with no physical presence in the state. What does all that mean? It means that many sales over the Internet have gone untaxed and that has led to the creation of a relatively unburdened sector of the economy which in turn has been responsible for much of America’s recent economic growth.

And that leads me to my first main point. I assert to you today that it is extremely important for California’s future growth that the Internet remain as unburdened as possible.

This means:

• that no new taxes should be applied to this medium
• that some old taxes should be eliminated.

Currently, California is in the position of deciding what to do with a $5 billion dollar surplus. Like many states, we are awash in cash. That’s a good position to be in, but if governments allow their tendency to tax and spend to take over, that surplus could all but disappear. Why is that? The reason is simple. Taxation limits the growth of the economy.

A study by Dean Stansel and Stephen Moore at the Cato Institute demonstrates how taxation affects the economy. They found that following California’s $7 billion tax hike in 1991, "actual revenue growth came in below projections in each of the next three years." Alternatively, when California cut taxes between 1995 and 1998, income tax revenues rose 48 percent. What that just goes to show is that sometimes cutting taxes can lead to higher revenues for governments because it allows for greater growth of the economy.

Consider also the competitive position that California would acquire if it were to exempt the Internet from sales and use taxes. As Pete du Pont said in his testimony for the last meeting of the Advisory Commission on Electronic Commerce "those states quickest to embrace a sales taxless future will gain at the expense of those that continue to cling to the outmoded sales tax." Granted, Pete du Pont is from Delaware – a state that has never had a sales tax. But that just goes to show two things: a) that a state can exist and provide education and shiny red fire trucks even without an Internet sales tax, and b) that he really does know what he’s talking about when he notes the impressive advantage gained by those living in a freer economy.

Now, consider the alternative to allowing for a tax free Internet. In a study published by the National Bureau of Economic research, Austan Goolsbee found that applying sales taxes on-line would reduce the number of on-line buyers by 24%. That means that approximately 1 in 4 customers that are currently on-line would disappear. This shrinkage would result in less demand for everything on-line from books to software to routers and ISPs, and other products and services that power the technology industry.

That would mean a loss of high tech jobs and companies that provide tax revenues for governments in the form of income tax receipts, business license taxes, utility taxes, excise taxes, and property taxes.

So briefly, lets compare the two alternatives: to tax or not to tax sales over the Internet. According to California’s Board of Equalization (BOE), allowing for the exemption of the Internet from sales and use taxes would amount to a loss of less than 1% of the state’s total sales tax revenue (or 177.7 million dollars). That’s in comparison to the loss of 24% or more of California’s Internet market. One percent of total sales tax revenue is hardly worth giving up 24% or more of California’s Internet economy and all the revenues that go along with it.

A second point I have to make on taxing the Internet is the fact that doing so brings up some serious privacy issues. In order to collect a tax from a California consumer, the government first needs to determine where that consumer actually lives, and then second what product they are buying and in what quantity. What that amounts to is a government-mandated list of all consumers’ shopping habits – a situation over which consumers have repeatedly voiced concerns.

A mini experiment of this sort has already occurred in the case of cigarette taxes, with the Board of Equalization forcing businesses selling supposed "tax free" cigarettes over the Internet to hand over information about their customers such as names and addresses as well as the cigarette brands that the consumers preferred and how much of each was purchased.

Clearly, this is not a situation that many would choose, and if the government were to try to implement it, it would lead to two potential outcomes. First, in order to avoid these privacy violations, consumers may simply decide to stop shopping on-line. In this case, sales taxes over the Internet are made irrelevant for the government and the economy is harmed beyond anyone’s imagination. Second, consumers could begin shopping using on-line technologies that protect their identities and location from the taxman’s prying eyes. Again, sales taxes would likely not be collected as consumers could simply say they live in a state with no sales tax. Both scenarios show the government running into collection problems, leading me to conclude that the BOE would eventually decide that collecting less than 1% of their sales tax revenue is not worth the PR damage done and effort required to collect it.

So, given these facts, what is the best course of action for California? The best-case scenario would be for California to embrace the new economy and exempt the Internet from taxes that hinder its progress and the prosperity of Californians.

Thank-you.

Sonia Arrison is the Director of Technology Studies at the Pacific Research Institute, a California-based think tank. She can be reached via email at sarrison@pacificresearch.org.