Policymakers should resist intervention. It wasn’t that long ago that many proclaimed “hands off the Internet!” Where government intervenes in the high-tech economy and the Internet, there will be unintended consequences. Lawmakers should exercise patience and humility in the face of ongoing change, and encourage industry to employ self-regulatory solutions instead of assuming Washington has the answers. Unfortunately, however, the impulse to intervene remains strong for many policymakers.
Online Marketing and Privacy
As if it needed another headache after the dot-com and telecom crashes, the technology industry is facing a renewed push to regulate in the name of privacy.
Web sites, as is well known, frequently collect information about visitors, and they often sell it. Some legislators want to require online and even main street firms to reveal what information they collect and share, and allow customers to “opt out.” Others would require a much more restrictive opt-in standard for “sensitive” consumer information like religion and financial information, whereby no information may be used until a consumer grants permission.
But is all this fuss over information-age marketing justified? Some surely are bothered. Yet as author Michael Lewis put it, when it comes to companies trafficking in personal information to better target what they try to sell, most people don’t care. They’re “willing to feign outrage on command, until they see the benefits of relinquishing their privacy,” says Lewis. Free-flowing information means more stuff more cheaply. The concept of privacy encompasses varying relationships between consumers and businesses. Some people are secretive. Others post all on personal Web sites.
Business use of personal information to move merchandise may sometimes be irritating, federal regulation, which will hurt e‑commerce and consumers, isn’t the answer. Small businesses will suffer more than larger companies that have already assembled databases.
Moreover, Washington itself can be the leading privacy offender, not just with regard to such things as driver’s licenses and Social Security numbers. Post-September 11 has brought renewed government surveillance, such as pushes for mandatory national ID cards, escalated monitoring of emails facilitated by the USA Patriot Act, and ubiquitous surveillance cameras. These incursions raise serious constitutional issues and should be the focus of any serious congressional privacy debate. We don’t get to “opt out” of government information collection. Washington does not have a track record that inspires confidence as a protector of personal information.
As businesses respond to consumer preferences, more stringent privacy protections are emerging. The notice and choice sought in privacy legislation already exist. Most highly trafficked sites already feature privacy policies. Users can set their Web browser to reject information gathering. Software tools that provide for anonymous surfing or warn when information is being collected further empower consumers. The marketplace increasingly forces sites to develop online privacy policies knowing that ever-more-efficient browser technology will alert users about the level of security.
Unsolicited E‑Mail (“Spam”) Policy
The purpose of limited government is to stop force and fraud. That extends to fraudulent email solicitations, the prosecution of which is the job of the Federal Trade Commission.
It is certainly easy to see why spam is widely used by the unscrupulous. It’s as easy to send a million emails as it is to send one, and the spammer passes the costs on to ISPs and users. Spam is a relentless pain, and ISPs have every right to block it ruthlessly — their servers are their own property.
Peddling fraudulent merchandise or impersonating somebody else in the email’s header information should be punished, as should breaking a contract made with an Internet Service Provider that prohibits bulk mailing. But in the debate over this outpouring of spam, it’s important to avoid unintentionally stifling beneficial e‑commerce. Setting aside the most egregious and offensive solicitations, the optimal amount of unsolicited commercial email isn’t necessarily zero for everybody, at every point in time. Sometimes, commercial email, even if unsolicited, might be welcome if the sender is a business selling legal and legitimate products in a non-abusive manner.
Increasingly, legitimate companies are embracing permission-based, “opt-in” email standards, enabling people to get email only from senders they have chosen. If legislation merely sends the most egregious offenders offshore, it may simply create legal and regulatory hassles for small businesses trying to make a go of legitimate e‑commerce, or for mainstream companies that are not spammers. Likewise, unwise legislation could create headaches for non-commercial emailers.
A smarter approach is email filtering , such as setting one’s system to receive only from recognized and approved addresses. That standard is particularly appropriate for children’s email accounts. In this vein, emerging “handshake” or “challenge and response” systems capable of totally blocking spam show promise: Since the most offensive spam is sent by automatic bulk mailing programs that aren’t capable of a reply, spam no longer appears in the inbox. Identifiers or “seals” for trusted commercial email that certify the sender could be another means of helping ISPs block non-certified mail.
As the market works to shift costs of commercial email back to the sender, we must be on guard against legislative confusion: How might the definition of spam expand beyond “unsolicited” and “commercial” email, and would such expansion be a good thing? What about unsolicited political or non-profit bulk emailings, or press releases, resume blasts, and charitable solicitations? What about newsletters that contain embedded ads or link back to for-profit websites. Would pop-up ads become suspect in the aftermath of spam legislation: they’re not email but they are unsolicited and commercial.
Another issue with some proposed legislation is that it would grant ISPs powers to decide what is spam and to unilaterally block it with “good faith” immunity and sue the spammer. It is appropriate for consumers and ISPs to effect complete blackouts from spammers if they like; computers, wires, servers and routers are private property. But it’s not necessary to federalize such contracts. (Some ISPs are actually spam-friendly.) Relationships between companies, users, and well over 5,000 ISPs are complex. And legislation could unintentionally block legitimate commercial transactions consumers want — some of which will resemble spam. Furthermore, government-set, per-violation financial penalties that exceed the actual harm done by the typical spam would create incentives to go on “spam hunts,” looking for “technically illegal” commercial solicitations embedded within every email. That will keep many businesses out of Internet marketing altogether, fearful of the risks. Finally, legislative bans on false email return addresses, as well as bans on software capable of hiding such information, have worrisome implications for free speech and anonymity for individuals — not just misbehaving businesses. “Spamware” is a means by which individuals can create contemporary versions of the anonymous flyers that have played such an important role in our history. Individuals must retain the ability to safeguard their anonymity even in (or perhaps especially in) a mass-communications tool like email. In an era in which so many are concerned about online privacy, legislation that impedes a technology that can protect privacy would be a puzzling move.
In the perfectly understandable desire to stop unsolicited mail, it is all too easy for Congress to undermine legitimate commerce, communications and free speech. And crippling Internet commerce would be especially pointless if spam continues pouring in from overseas.
Protecting Kids Online
The Communications Decency Act, passed to ban pornography on the Internet, was struck down by the Supreme Court in 1997. But Washington continues efforts to regulate Internet content. A prime example is the Supreme Court’s upholding in 2002 of a portion of the Child Online Protection Act (COPA), passed by Congress in 1998 to shield children from online pornography by requiring that Web site operators verify the age of visitors (such as by requiring a credit card). The Court held that free speech is not necessarily violated by the imposition of community standards on a national scale.
Congressional efforts to regulate content on the Internet can create a false sense of security. There’s a simple reason why such regulation won’t help kids: The Web isn’t the Internet. Consider: the trading of mp3 music files was largely stopped long ago on Web sites by a determined music industry tired of piracy. But the trade in pirated music files continues through other, non-Web avenues on the Internet that are just as user-friendly: peer-to-peer networks and email. The same will be the case for pornography, much of which is already traded through file-sharing that bypasses altogether the Web sites that would be targeted by COPA.
While the Supreme Court does not reject the notion of “contemporary community standards,” the lower court got it right when it noted that the community standard notion lets the most squeamish dictate what all others on the Web see. In the name of protecting children, the law interferes with content that adults should have the right to see under the First Amendment.
Nor is it fair to single out the Internet for content regulation, given front-page newspaper stories about Monica Lewinsky and abusive priests. On an Internet that is increasingly capable of direct peer-to-peer communication and broadcast, individual choices and behaviors replace “community standards.” And laws like COPA can have unintended consequences: barriers to those who seek porn voluntarily will likely increase email solicitations for porn (spam), which COPA wouldn’t regulate.
The best and least restrictive defense is parental supervision. If parents provide their children with Internet access, they have no choice but to supervise. All manner of seedy stuff is on the Web: dirty jokes, violent content, totalitarian racist ideas. Sometimes, youngsters themselves misbehave on the Web and actively seek out porn, or even create viruses or hack other computers.
Parents must do their job. Filtering — not just filtering software but filtered online services apart from the broader Internet that might be appropriate for the very young — is available. Filtered online services also can limit the receipt of unwanted salacious email, for which COPA is no use. Another tool at parents’ disposal is tracking software that lets them monitor everything a child does or has done on the Internet. Some might call that “spying” but it is less restrictive than Congress regulating content on the entire Internet. Parents, not government, can protect their children.
The Internet and Anonymity
Anonymous speech is as old as America. Gentlemen calling themselves “Publius” wrote the Federalist Papers. Thomas Paine’s Common Sense was signed by “An Englishman.” Today, email encryption represents an important example of the tradition of speaking freely and anonymously.
But encryption technology in the hands of people bent on destruction can be deadly. Some believe the terrorists who attacked America communicated via encrypted messages. Fear of this indisputable threat led to renewed proposals to give government a “back door key” to encryption products. Similarly, calls for a national ID card exemplify new urges to shine a federal light on individuals. But calls for prohibitions on encryption products are a non-starter in the sense that trying to prohibit bad actors from acquiring hardware or software is futile in today’s global, integrated marketplace.
Government’s job is to restrict the liberty of dangerous criminals and enemies — not that of innocent citizens, or to treat everyone like a suspect. The USA Patriot Act has set up a new law enforcement infrastructure that can easily increase surveillance of non-terrorists. For example, the perpetrators of victimless crimes — the pot smoker or gambler — may find themselves under renewed scrutiny, but such is clearly beyond the stated intent of combating terrorism. New powers should apply only to terrorism, not to routine criminal investigations. While surveillance can and likely will be enhanced to account for the new realities of instant electronic communications, the Fourth Amendment’s protections against unreasonable and warrantless searches must not suffer.
Proposals to re-regulate encryption are the digital equivalent of seizing grandma’s nail clippers at the airport — in the sense that terrorists would simply resort to illegal encryption. Congress decided in the mid-1990s that the benefits of readily available access to the technology are significant. Like proposals to mandate that everyone carry a national ID card, it’s a needless undermining of anonymity and privacy.
It’s important to remember that the root of the terrorist threat America faces does not lie entirely in cyberspace. In that light, fighting encryption is a misplaced priority. Despite the intense Internet privacy debate of recent years, the real dispute isn’t whether privacy is achievable — it’s whether government will allow it where the capability finally exists. Encryption is essential not just for keeping intact a pure version of the principle of free speech, but for such “mundane” needs as private communication, secure online commerce and business-to-business exchanges. Restrictions would damage the security of America’s financial systems, making it easier for the everyday hacker, let alone terrorist, to invade personal information and tinker with the financial infrastructure. One of the imperatives in combating terrorism is to secure sensitive and critical systems from attack. Since encryption happens to be essential for companies and individuals to protect themselves, misguided legislation undermining it hampers sensible, private security measures.
The encryption genie is out of the bottle. Not only can malevolent programmers create their own strings of ones and zeros capable of encrypting communications, so can legitimate companies overseas. And requiring the deposit of an encryption “key” at a central governmental location creates a “honey pot” for hackers to attack, reducing our security. Encryption legislation to deliberately reduce our privacy would have been unthinkable only recently given widespread concerns over privacy. As Rep. Bob Goodlatte (R‑Va.) has pointed out, we need more encryption, not less. New encryption techniques are critical to the protection of intellectual property, such as digital distribution of books, movies and music, upon which a rising share of America’s wealth creation depends.
Moreover, encryption plays a key role in the struggle for human liberty itself. It has aided political dissidents shielding themselves from brutal governments, helping democracy and individual liberty flourish overseas. Regulating encryption could encumber us far more than the terrorists, who can still encrypt as well as use other means of communication. Terrorists can use face-to-face contact, human messengers, compose messages in free email accounts (perhaps sharing a password), or conceal messages in images. As one researcher noted, “From a terrorist point of view, the fact that you are using encryption at all will draw attention.” Encryption may not be essential for terror, but it is essential for our advanced economy.
Internet Gambling
Some in Congress want to stop online gambling by banning the acceptance of credit cards or other instruments to process gambling transactions. It’s understandable that politicians would be concerned about gambling operations being used as a tool for terrorist money laundering post-September 11
But in this privacy-sensitive era, the question arises: if you were gambling on the Internet, how would the government ever know about it? For the government to know about such personal, consensual behavior requires spying. But to impose federal surveillance on consumer financial transactions before consumers have even universally embraced Internet banking and commerce as such has serious implications for people’s willingness to welcome online finance.
Banks and Internet Service Providers would be drafted into the role of snooper, sifting all financial transactions. And not surprisingly, credit card companies don’t want to be held responsible for assuring that companies for which they process card services are not involved in gambling operations.
Another rationale for gambling restrictions is to target, not the gamblers, but shady dealers who run phony, fraudulent operations — or to protect people from gambling addiction. This is paternalism: consumers should screen any gambling operations with which they transact, and avoid fly-by-night operators. Beyond that, most people realize that gambling is a pastime in which the house usually wins. While gambling is a problem for some who have trouble controlling themselves, others enjoy the challenge or just think it’s fun, and are able to contain their addictive impulses.
What constitutes “gambling” is often in the eye of the legislator. Fantasy sports get a limited exemption in proposed legislation, as do horseracing and jai alai. And investing in stocks can be a “gamble” in the sense that “the opportunity to win is predominantly subject to chance” — as proposed legislation defines gambling. Yet the anti-gambling proposals exempt “any over-the-counter derivative instrument,” though these clearly are not for the squeamish.
It’s not the job of politicians to hector constituents about morality or finances. Rep. Ron Paul (R‑Tex.) summed up the matter. “[T]he overriding freedom issue [with respect to gambling] is whether or not government should be involved in trying to improve personal behavior by an authoritarian approach by the use of law. This really falls into the category of legislating morality. I don’t happen to like gambling, and I think it is rather dumb, to tell you the truth, but in a free society, people should have the right to do dumb things.”
Once we travel down the road of regulating behavior on the Internet, there’s basically no limit to government’s ability to regulate voluntary speech and interaction and to substitute its moral vision for those of individuals.
Protecting an Internet “Commons”
Some scholars and organizations are clamoring for the creation of “public spaces” on the Internet. For example, University of Chicago law professor Cass Sunstein worries that the individual’s habits of personalizing or filtering his Web experiences thwarts the “unanticipated encounters” and “common experiences” that should unite us as a democracy. Where the private sector doesn’t come through, he wants the government to “pick up the slack,” requiring sites to disclose their biases and link to opposing views. And he wants popular sites to act as a “public sidewalk,” providing links “designed to ensure more exposure to substantive questions.” Presumably the government would decide if a site is guilty of “failure to attend to public issues.,” In this view, free speech doesn’t mean saying what you want, but providing a platform for other views.
Acting on similar beliefs, former leaders of the Public Broadcasting System (PBS) and the Federal Communications Commission set up the Digital Promise project to “halt the encroachment of purely market values” on the Internet. They propose the establishment of a Digital Opportunity Investment Trust fund program, or “DO IT,” to fund “the development of online courses, training materials, archives, software, civic information, quality arts and cultural programs, and other digital resources and services of the highest standards to meet the needs of all citizens and help them gain access to the best minds and talents in our society.”
DO IT might best be thought of as a sort of Ministry of Cyber Culture; the fusion of the National Endowment for the Arts, PBS, and the “E‑Rate” program (or “Gore Tax”). The $18 billion program would be funded by wireless spectrum auction revenues. Legislation has already been introduced to make DO IT a reality.
Despite these worries, a torrent of “shared experiences” bombards us despite personalization and filtering. As one critic put it, given Sunstein’s view, “these sort[s] of chance encounters should be happening to me less and less on the Internet. Instead, they seem to be happening more and more.” Sources of exposure have ranged from the early bulletin boards of the 1980s to the peer-to-peer networks of today. And in between they encompass Web pages, search engines, chat rooms, email, auctions, Internet phones, instant messaging, and more.
The Internet’s attraction is the fact that it already is a public space, in the proper sense of the term. Besides, to the extent “public space” means non-profit, advocates are getting greedy. Non-profit interests already dominate the .org and .edu domains. There is even a movement afoot to assure that the .us domain is largely ceded to non-commercial interests. Governmental information is widely available given that an entire top-level domain, .gov, is devoted to governmental goings-on.
The public shouldn’t be compelled to subsidize content deemed appropriate for cyber-citizenship. Aside from news with common sources, vast online libraries are being developed. But such efforts are undoubtedly polluted in public-space parlance because they are profit-seeking ventures. Nothing in government’s legitimate scope qualifies it as a fountain of superior, purer information or a source of social cohesion. Governments are well known for censorship and control, like the mandating of library filters and ratings for movies, music and videogames.
Most fundamentally, the “public spaces” premise fails because it rests on the notion that capitalism and freedom are inimical to civil society and the diffusion of ideas rather than the prerequisites. We cherish a free press, dissent, and debate because governments can threaten these values. We need markets to maximize output, including that of true and useful “public” information. The inclination of some academics and policymakers to despise the commercial Internet grows tiresome, not just because they often occupy a stance parasitic with respect to the commerce they denounce, but because their notion of public spaces would enshrine a political rather than civil view of social interactions.
In practice, a “public spaces” regime would simply deteriorate into congressional mandates and funding of “approved” sites. But funding is the role of venture capitalists, who have learned that not every Internet venture makes sense. Government programs would be failure-proof in the sense that politics rather than competition for eyeballs would matter. While the unalloyed Internet constitutes a real free press, a potpourri of information people seek (or that the unpopular post on their own dime), public spaces will consist of “worthy” things people are forced to pay for or link to.
Online Free Speech and the Rising Threat of Global Internet Regulation
As countries across the globe become more aware of the power of the Internet as a communications medium and channel for global commerce, they also grow more interested in regulating what takes place online.
The most prominent example of such international regulatory mischief so far has been the efforts by the French courts to force the American-based web portal company Yahoo! to remove, or at least block from the view of French citizens, those portions of its website where Nazi memorabilia was for sale. Although a lower district court in California held in November 2001 that the French ruling could not be extraterritorially enforced here in America, former Yahoo! CEO Timothy Koogle, who resides in the United States, could still be convicted, fined $40,000, and face up to five years in prison if he ever sets foot in France. Declining to dismiss the charges against Koogle and Yahoo! the Paris Criminal Court held in February 2002 that the case could go forward and noted that “the French judge is free to adopt his own principles of international criminal jurisdiction to sanction offenses that are completely or partially committed abroad and are likely to threaten national interests” to the extent that “the website’s message or contents are made accessible, through the Internet, within French territory.”
Under that standard, anything posted anywhere else in the world that was potentially offensive to French “national interests” might be subject to regulation or even criminal penalties by French officials. If such parochial speech controls were enforceable across the globe it would obviously force content providers and network operators to restrict their speech so as to avoid potential liability or penalties. And many other examples of such extraterritorial speech regulation already exist. Evidently, everyone wants to have a say regarding what can be seen or said on the Internet.
But can parochial standards really be applied to the web? Or is the web truly a borderless medium that cannot be regulated in any workable sense by local authorities? Many important legal issues are at play, especially when you expand the discussion beyond free speech to include commercial regulation of the Internet. Some scholars have suggested that international treaties could be the answer. Others are calling for a “U.N. for the Internet,” or some sort of global regulatory body to resolve such questions. Still others suggest that the best answer is to do nothing, since anarchy, at least so far, has the advantages in terms of broadening the range of free speech globally. What should American policymakers do? As Cato adjunct scholar Robert Corn-Revere properly warns: “Other nations may treat their citizens as fragile children if they wish, or worse, as enemies of the state. But U.S. courts should not permit the seeds of foreign censorship to be planted on U.S. soil by finding that such restrictions are enforceable here.” While Americans have good reason to ignore the French ruling in the Yahoo! case, however, the question remains: how will these disputes be decided in the future? As Net connectivity across the globe grows, and human communication and interaction bridges the geographic divides between countries and continents, governments will attempt to pigeonhole this new technology into old regulatory paradigms. Defenders of free speech would be wise to start thinking about ways to convince them to do otherwise.
State and Local Restraints of Electronic Trade
New York Times reporter John Markoff noted in a December 2000 column that, “In a remarkably short period, the World Wide Web has touched or has promised to alter — some would say threaten — virtually every aspect of modern life.” Of course, not everyone has enthusiastically embraced the changes the Internet has brought, especially those who feel threatened by it.
This is particularly true in the business marketplace where many well-established industries and older institutions fear that the Net is displacing their business or perhaps entire industry sector by bringing consumers and producers closer together. For example, in recent years, the following industries or interests have decried the rise of the Net and e‑commerce:
- car dealerships who fear direct-to-driveway vehicle delivery by auto manufacturers;
- wine and beer wholesalers concerned about mail order shipping;
- travel agents fearing online airline reservation systems;
- optometrists warning of Internet sale of glasses or contact lenses; and
- lawyers claiming free online legal advice by certain websites was illegal since it is not licensed by states.
Older industries fearing newer ones is nothing new, of course. Any new and disruptive technology will attract its fair share of skeptics and opponents. Steamboat operators feared the railroads; railroaders feared truckers; truckers feared air shippers. Likewise, horse and buggy drivers probably sneered at the first automobiles that crossed their path.
But while fear of technological change is to be expected, the problem is that older industries often have significantly more clout in the political marketplace and can convince policymakers to act on these fears. State licensing or franchising laws are often the favored club of choice for entrenched industries that are looking for a way to beat back their new competitors. Demanding that producers comply with a crazy-quilt of state and local regulations will often be enough to foreclose new market entry altogether.
Various industry watchers have labeled this phenomenon, “revenge of the middleman” or “revenge of the disintermediated.” More simply, these pleas can be thought of as old-fashion industrial protectionism. But requiring national or even global commercial vendors — as is clearly the case with e‑commerce and Internet sellers — to comply with such parochial laws and regulations is antithetical to the interests of consumers and the economy in general. Consumers clearly benefit from the development of online commercial websites and value the flexibility such sites give them to do business directly with producers and distributors. More importantly, the development of a vibrant online commercial sector provides important benefits for the economy as a whole in terms of increased productivity. The Progressive Policy Institute has estimated that such protectionist laws and regulations could cost consumers over $15 billion in the aggregate.
Lawmakers must be flexible in crafting public policies so as to not upset the vibrant, dynamic nature of this marketplace and be willing to change existing structures, laws, or political norms to accommodate or foster the expansion of new technologies and industry sectors. Just because some Old Economy / Manufacturing Age interests may not like the emergence of these New Economy / Information Age sectors and technologies, it does not mean policy makers should seek to accommodate older interests by stifling the development of the cyber-sector. Such a Luddite solution will hurt consumers and further set back the development of the online marketplace. Finally, Congress must exercise its powers under the Commerce Clause of the Constitution to protect interstate electronic commerce when it is seriously threatened by state and local meddling.
Internet Taxation
A remarkably contentious battle has taken place in recent years over the Internet Tax Freedom Act (ITFA) of 1998 and the federally imposed moratorium on state and local taxation of the Internet. But this measure certainly stands as one of the most misunderstood or misinterpreted bills of recent memory. The ITFA moratorium does not prohibit states or localities from attempting to collect sales or use taxes on goods purchased over the Internet. Instead, the moratorium merely prohibits state and local government from imposing “multiple or discriminatory” taxation of the Internet or special taxes on Internet access.
What pro-tax state and local officials are really at war with, therefore, is not the ITFA but 30 years of Supreme Court jurisprudence that has not come down in their favor. The ultimate goal of the pro-tax crowd is to overturn cases such as National Bellas Hess v. Illinois (1967) and Quill v. North Dakota (1992), in which the Supreme Court ruled that states could require only firms with a physical presence, or “nexus,” in their states to collect taxes on their behalf. State and local tax officials have worked tirelessly to eliminate or at least water down these legal guidelines, largely in an effort to tax catalog or mail order sales. Luckily for companies and consumers, Congress has so far not allowed the states to set their own ground rules for the taxation of interstate commerce, which would upset the delicate constitutional balance by giving the states too much authority over the interstate marketplace.
But what this effort to tax the Internet really comes down to is a classic case of misplaced blame. In their zeal to find a way to collect taxes on electronic transactions to supposedly “level the (sales tax) playing field,” most state and local officials conveniently ignore the fact that current sales tax system is perhaps the most unlevel playing field anyone could possibly have designed. Several politically favored industries and politically sensitive products receive generous exemptions from sales tax collection obligations or the taxes themselves. Food and groceries, agricultural products and production, and clothing all receive sales tax exemptions in most states and localities. That creates massive confusion in defining the sales tax base in some states.
Despite the definitional quibbles and the problems brought on by the growing number of exemptions, sales tax collection remained fairly effective in the post-World War II period since a sizable portion of the American economy was still subjected to the tax. When the sales tax was first being formulated during the 1930s to supplement income and property taxes, which was less effective during the Depression, tracing and taxing the sale of commodities were a far more rudimentary undertaking, because the Industrial Age economy of the time was primarily goods based. In other words, most commodities were tangible goods that typically were sold over the counter in most business establishments. That made sales tax collection fairly routine.
But as America began a gradual shift to a service-based economy in subsequent decades, serious strains were placed the sales tax system since sales taxes had traditionally been collected on goods, not services. Therefore, the vast majority of “service-sector” industries and professions receive a blanket exemption from sales tax obligations. A partial list of the professions exempted from the sales tax in most jurisdictions includes business services, banking and financial services, construction and contracting, health services, media services and advertising, and transportation as well as a wide variety of other personal and professional services.
The sales tax was not designed to capture those activities and, therefore, as the service sector became a larger portion of the American economy, the overall tax base shrank accordingly. Limited efforts have been made by some states to expand sales tax coverage to include services, but those efforts have met with staunch corporate and consumer opposition. Regardless, the combined effect of the service-sector exemptions and exemptions for “special” goods-producing industries such as agriculture and clothing, has been the gradual diminution of the sales tax base in America.
In fact, in a December 2000 study in the National Tax Journal, economists Donald Bruce and William F. Fox of the University of Tennessee Center for Business and Economic Research estimated that the sales tax base as a percentage of personal income has fallen from roughly 52 percent in the late 1970s to less than 42 percent today. That is just a complicated way of saying that the current sales tax system hits only about 40 percent of all individual consumption. In other words, America’s primary method of taxing consumption — the sales tax — doesn’t hit even half the consumption activity in the economy. Worse yet, as the sales tax base has been gradually eroding in recent decades, evidence suggests that average sales tax rates have been going up. In other words, we now have a rising average tax rate over a shrinking tax base. That is the textbook definition of an inefficient tax. Optimally, economists want a low tax rate over a very broad tax base.
Does this mean that state and local policymakers should scrap the sales tax system entirely and learn to rely on other tax bases such as property and income? Not necessarily. It is just to say that citizens should be cognizant of the deficiencies of the current system and not allow state and local policymakers to trick them into thinking that the Internet is to blame for the holes in their sales tax bases. Electronic commerce sales constituted a surprisingly low 1.1 percent of aggregate retail sales in 2001 according to U.S. Department of Commerce data. In light of this, it’s hard to see how the Internet is to blame for the declining sales tax base.
So before state or local officials plead for Congress to save them from the massive sales tax drain brought on by the Internet, they first need to be told to clean up the existing mess they’ve created. And if they really want to find a way to “level the playing field” and tax Internet transactions, an origin-based sales tax system would allow them to do so in an economically efficient and constitutionally sensible way. In the meantime, however, Congress would be wise to permanently extend the existing ITFA moratorium on multiple and discriminatory taxes, as well as Internet access taxes, and let beneficial Supreme Court precedents continue to govern the interstate marketplace for electronic commerce transactions.
