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Hello, Internet; goodbye, revenue

As Orange County, Calif., goes bankrupt and cities and towns from Los Angeles to New York teeter on the edge of financial chaos, local governments crave some good financial news. This article can't deliver it.

This is the story of how the Internet may deal the final body blow to the financial security of local governments.

Governments could once count on local economic development to produce local jobs where local employees would spend money in local stores, thereby generating local tax revenue for further development.

This virtuous cycle has been fatally undermined by the new technology of cyberspace.

One great promise of the Internet is that it will not only supply amusement and information but also serve as a marketplace. Advocates paint happy pictures of consumers shopping through the ultimate collection of catalogs _ giving them access to a nationwide and worldwide marketplace _ and ordering and paying for goods from their computers.

Often overlooked is the fact that little of this buying and selling will be subject to state and local sales taxes.

That's good news for the consumer _ but a potential catastrophe for the state and local governments that have come to rely on sales-tax revenues.

States already lose at least $3.3-billion each year because of retail sales that have migrated to mail-order businesses, estimates the U.S. Advisory Commission on Intergovernmental Relations.

This is, roughly $3.3-billion worth of tax revenue would have flowed to state governments if goods had been purchased in stores rather than through mail order.

The Internet's impact has yet to be fully felt. Total retail sales transacted on the Net added up to only about $200-million in 1994, according to CommerceNet, a consortium of businesses exploring use of the Internet _ less than one-tenth of 1 percent of what was spent on mail-order shopping.

But corporate America is turning to the Internet at a dizzying pace. Companies are establishing sites on the Net at a rate of about 120 per day, according to Anthony Rutkowski, vice-president of the Internet Society, an organization that oversees standards-setting on the Net.

The number of World Wide Web pages advertising businesses and products is growing at about 12 percent a month, say industry analysts. Many of these pages make it easy for Net surfers to purchase goods by typing in a credit-card number and mailing address.

In an ominous collision of trends, this growth coincides with the emergence of sales taxes as a major revenue source for state governments.

Beginning in the early 1980s, broad cutbacks in federal funding forced states to pay for more and more services out of their own budgets. With voters typically unwilling to approve higher income taxes, sales taxes often became the only politically feasible way to make up for lost federal revenues.

Only Delaware, Montana, New Hampshire and Oregon now collect no state or local sales taxes; altogether, a quarter of all tax revenues that states collect stems from sales tax. In Florida, which has no state income tax, the sales tax is largest source of state tax revenue.

Ironically, the state most severely hit by the move to catalog and online shopping is California _ home to many of the companies and universities that invented the technology that makes the Internet possible. Because of Proposition 13, which limits California's ability to raise money through property taxes, towns and cities are dependent on sales taxes.

Right now, local governments that rely heavily on sales tax naturally have an incentive to encourage large retailers to move within their borders by granting them large subsides _ typically in the form of property-tax exemptions. But the competition for retail has distorted economic development.

Cities are vying against one another to attract discount "big box" retailers _ such as Home Depot and Toys "R" Us _ that suck in business from a whole region, often devastating the more dispersed retail establishments that local governments, especially in the West, depend on for financing their budgets.

Direct marketing through telephone or the Internet takes this economic cannibalism to a new level. Cities and states are competing with a vengeance to attract order-processing "call centers" to service direct marketing companies.

Oklahoma, for example, has worked hard to replace disappearing oil-patch jobs with the data entry, computer programing, and accounting employment that these call centers provide.

The state excuses direct marketing companies from having to pay sales tax on 800 numbers, WATS, and private-line services _ the essential tools of the mail-order trade _ and grants data-processing firms that move to the state a five-year exemption from property taxes.

In the end, however, such policies merely reward the flight of local retail to tax-exempt mail order.

Each individual state or municipality is betting that jobs from such call centers will endure and that the gain in long-term jobs will offset the cost of the subsides. But as the Internet blossoms, even that hope may wither.

People will be able to "window shop" the Web the way they do in malls and downtowns _ comparing product features and prices, seeing demonstrations, and making purchases.

As such online activity becomes more common, the whole job classification of entry-level data clerks at call centers may melt away, leaving only a much smaller set of more specialized, and skilled, troubleshooters.

"You'll still need some people to deal with hysterical customers, but that's about it," says Bruce Lowenthal, Tandem Corporation's program manager for Internet commerce.

There is one obvious response to this problem: Allow states to tax mail-order and Internet sales. But the courts have said no. The U.S. Supreme Court, in its 1967 National Bell Hess, Inc. vs. Department of Revenue decision, prohibited states from taxing out-of-state sales. The court based its ruling on the Constitution's "commerce clause," which restricts the federal governments's power over commerce between states and that prevents states from imposing tariffs on one another.

The court has held that for a state to collect taxes on sales, the vendor must have significant sales operations _ such as personnel, inventory, or showrooms _ within the state.

If no such "nexus" exists between the seller and the state in which the purchase originates, then the transaction must be regarded as interstate commerce and is constitutionally out of reach of a state sales tax.

Already, direct marketing companies have used toll-free numbers, computers, and faxes to dispense with the need to place operations within a sales-tax-collecting state.

As World Wide Web pages begin to eclipse printed catalogs, the physical connection between mail-order retailers and states trying to tax them will recede even farther.

The loss of local sales taxes owing to mail-order and online commerce should be treated as an opportunity to look more closely at how technology is changing the burdens we put on local and state governments.

We should question whether such burdens make sense in a world where multinational corporations often outpower whole states in total assets and can pit such local governments against each other in competition for jobs and local revenue.

Faced with such a disparity in power, local governments can hardly be expected to devise fair and efficient systems of taxation or make informed economic development decisions. The rise of national and global commerce calls for national and even global solutions, regulations and revenue sources.

Technology Review