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by Andrew Starling

Governments may find themselves losing tax income because of e-commerce. They won't like it. The current situation is that tangible goods sold over the Internet are generally taxed. Intangible goods like software downloads are more difficult to tax, but ultimately most governments will find a way of getting revenue from these too.
February 9, 2000

He takes one look at the car and his eyes light up. "Wow! What an invention! Look at the potential. We can tax all the people making it and all the component makers, then put a big slice of tax on the selling price. We can have a tax for driving it on the road and a local authority charge for parking it, a revenue stream for driving licenses, and as for petrol…"

The rest is history. And yet there are still Internet pundits out there who think that for some reason society's latest invention, the Web, won't be taxed. Why? Where's the precedent?

Sure, data transfer is a bit intangible, and there are all the complications of globalisation and international movements of e-commerce goods. But ultimately these problems will be overcome. I bet back in the 1890s there were people who thought the car would be difficult to tax too. Somebody at that first car showing probably sneered at the tax inspector and said, "Don't be stupid. How the hell are you going to tax something that's so mobile?"

Boston Tea Party

A problem now faced by governments around the developed world is the threat of the Internet reducing their tax revenues. The big areas of concern are local sales tax, VAT (Value Added Tax) and betting tax. And as the players at the Boston Tea Party knew, if there's one thing guaranteed to irritate a government, it's meddling with its income.

If you believe that the Internet and e-commerce transactions will never be taxed, you're effectively saying that national and local governments around the world will sit back and watch their income go down.

You may even see this as politically desirable, an easy way for society to move into an era of minimal-tax government. If everybody simply sits on their backsides and does nothing, a global philosophy of lower taxation will quietly sneak in.

I'm not going to argue for or against that opinion. It's a matter for political debate and for democracy to deal with. But I'm betting (online of course) that governments won't allow this new philosophy to sneak in by default. They'll notice their income slipping, and do something to correct it.

You can already see the debate in full flow in the US, where the counties and individual states get around one third of their income from sales tax. As a general rule, they collect sales tax from companies that have a nexus in their area, meaning a physical presence. Mail order firms have exploited loopholes in the nexus system for a long time, but it's e-commerce that's really got these local authorities scared.

In 1998, the Clinton Administration applied a three year monatorium on e-commerce taxation and created an Advisory Commission of 19 members to work out what to do next. These include three federal representatives, eight from state or local government and seven from business, plus one representing consumers. A report from the panel is due this summer, but already it looks likely that widely differing views within the panel about the local/federal power balance and the desirability of any kind of tax in general will make the commission less than effective.

Not that they've got an easy task. As well as trying to reconcile their own differences and still come up with something simple and workable, they've got the big complication of intangibles to deal with. How do you deal with the sale of ones and zeros, of software and data down the line?

This is more important than it looks, because in the future it seems likely that a lot of music and video will be sold on the Internet. Not, as it is now, in physical packages like CDs and DVDs, which are ultimately posted in the mail, but as strings of data transferred from one computer to another.

Currently the separate US states agree on how to deal with tangibles such as CDs. They all agree that tangibles sold over the Net should be subject to sales tax, they just have a fair amount of difficulty collecting those taxes. And of course there are states such as Delaware that complicated matters by having no sales tax at all, and attracting plenty of e-commerce companies as a result.

But on intangibles they're split: 19 impose tax across the board, 16 exempt information and software, 10 exempt information only. There's no consensus about how to deal with sales of data down the line.

European Angle

Over in Europe, the problems are similar but not quite the same. The main issue for European governments is VAT, a tax that's imposed at each stage of the manufacture of an item according to how much value has been added. Although this tax is unfamiliar in the US, it's common around the world. Of the 29 countries in the OECD, 27 use VAT taxation. The other exception is Australia.

In Europe, VAT rates vary from country to country and item to item, but are often high, around 17-20 %. If VAT is applicable to an item, it's applied whether the sale is over the Internet or not. There's a parallel here with the US for tangibles. The difference is that in Europe, intangibles definitely come under the same rule. Most software, for example, is subject to VAT, and that VAT is applied whether it's bought on disk from a brick and mortar shop or downloaded from the Internet.

Because the amounts involved are so large, Internet VAT avoidance on both tangibles and intangibles is a big deal for European consumers and their governments.

People in the UK, for example, have found they can buy their CDs from a US store over the Internet with no VAT. An instant 17.5% saving. FedEx then ships the discs into the country, acting as an unwitting smuggler, and because transatlantic transport is so efficient, there's barely any delay and just a small shipping charge and all in all it's a better deal than buying from a UK Internet retailer.

Business is brisk and everybody's happy. Everybody apart from UK Customs and Excise, who keep losing their 17.5% cut.

Recently the UK authorities started to wake up to this little scheme. Music-lovers are now finding that FedEx and the other carriers turn up at their door with not just the CDs but also a VAT bill imposed as the goods passed through customs. The catch rate is well short of 100%, but it's growing.

Let the Carrier Beware

A key element here is that the carrier actually pays the VAT at the border to get the goods inside, and then the customer reimburses the carrier. This is a clever method of collecting cross-border taxation.

It doesn't take much imagination to see that the UK authorities will soon recognise that anything sent from address X in New York and transported by carrier Y is almost certainly a batch of CDs and should have a VAT bill slapped on it.

There's potential for this system to become standard for goods sold over the Internet and crossing international boundaries - a system of Charge the Carrier. The main issue is how to recognize goods that are eligible for taxation.

Well, why not get the carrier to sort that out too? Ask the carrier to apply a little yellow "W" sticker to everything that's been bought on the Web and is eligible for tax. At first this may sound ridiculous, but a similar system is already in place for transporting that most precious of commodities, people.

If an airline rolls up at a border carrying an immigrant who is then refused entry, most countries in the world oblige them to carry that person out again, and to pay the cost of the flight out if necessary. With this threat hanging over their heads, the airlines make damn sure they don't carry that kind of passenger in the first place. They weed them out at the check-in desk, making sure everybody's passports and visas are in order before the flight begins. Effectively, airline check-in desks have become extensions of immigration departments.

It's only a small step for goods carriers to become extensions of Customs departments. I bet (again online) that the little yellow sticker idea is being discussed in a taxation department somewhere in the world.

I digress, but in doing so I've shown there are methods of dealing with taxing international imports of tangible e-commerce goods. To a greater or lesser extent, Europe will tackle the potential loss of VAT on e-commerce goods entering its borders. VAT problems on trade within Europe are less likely to be a major issue because the system is so thoroughly enforced internally.

But European problems when dealing with intangibles are greater than in the US. Many people in Europe download software from the US and don't pay VAT. On professional software this can mean a big saving. When they start doing the same with digital video and music, the tax loss for European governments will be significant.

There's no easy solution to this. At one point Europe toyed with the idea of a "bit tax" charged on data transfers, and the same idea has been voiced within the UN, but so far it hasn't amounted to anything. Nor does it look imminent. Apart from its many other downsides, a general per-bit tax would surely kill any new high-bandwidth multimedia applications.

Bet It Will Happen

The same problems that local US governments and European governments face over taxing intangibles apply to another area of Internet trade - gambling. Online betting is booming, because it helps punters avoid strict laws in the US and high betting taxes in Europe. Simply set up your casino or run your book from a Web site in the sunny Caribbean and you'll soon be a very moderately-taxed millionaire. A lot of your transactions will be illegal in your clients' countries, but as long as you don't keep many records at your end you won't have much to fear.

This wouldn't be a big deal if the gambling industry were small. It's not. At more than $500 billion a year in the US alone, it's bigger than the music and movie industries combined. It's also a significant source of tax revenue, a source that's under threat. In the UK, loss of tax revenue due to online betting is already a real issue, way before e-commerce losses have made any impact.

Getting There

So what conclusions can we draw from all this? That tangible e-commerce goods are already taxed like any other merchandise. That intangibles including wagers will be taxed if governments can find a way of doing so. Except in the US where there's no consensus and nobody's sure which way it will go. That muddle looks set to last a while unless Clinton's panel of 19 does better than expected.

But this is all very short-sighted analysis, peering into the immediate future, wondering how current tax mechanisms can cope with a new technology. Let's remember that this is a gargantuan new technology, one destined to drive the world economy, be the backbone of business and trade, more important than the TV or telephone ever were.

Then let's go back to the vision of a major invention being unveiled, only this time it's the Internet, not the car.

Our tax inspector is there again. He's a bit older now. He says: "Wow! What an invention! Look at the potential. We can add a few ones and zeros to all this data for tax purposes. The tiny tax file we add will be able to work out what's being carried, whether it's software, video, money, or correspondence. It'll know where the data originated and where it's going, what the tax rate is for that kind of transfer and where the revenue should go. And it'll automatically send it there. All without any kind of administrative cost. Perfect!"

The question is not whether the Internet will be taxed, but how clumsy and drawn-out the process will be of getting there.