INTERNET TAXATION

AS and A Level Media Studies

Keller Graduate School of Management

IS535

INTERNET TAXATION

June 20, 2007

IS535

Managerial Applications of Information Technology

Submitted by

Haci Fehmi Ozgun

Opal Shelton

Background to the Problem

Turquoise Incorporated is a web-based startup that is a reseller of electronics. The company is a pure click commerce site. It acts as an intermediary between larger electronic companies and reatail consumer. The company uses a drop shipping method of delivery and orders are taken via their website. They also have a presence on Amazon.com Marketplace and Ebay.com

The Company has had moderate success and is thinking of investing more capital into the business and acquiring warehousing facilities. The company has proposed California as a probable location for its new warehouse.

However, with the proposed changes to Internet taxation the company is hesitant to pump capital into a business that may lose its competitive advantage to Traditional Brick and mortar business that would severely compromise Turquoise’s future profitability.

The Board of Directors has retained the services of our group to analyze the impact that the proposed Internet taxation law will have on E-Commerce and its potential impact on the future of the business.

History of Internet Taxation

The Internet taxation issues stems primarily from the fact that the Internet was not designed for E-Business. The Internet was designed in part to provide a communications network that would work even if some of the sites were destroyed by nuclear attack.

Initially primarily academics, engineers, scientists, and librarians used the Internet. (Howe,2006)

However with the advent of the Personal Computer, the general public had access to the Internet. In 1996 “approximately 45 million people used the Internet, with roughly 30 million of those in North America (United States and Canada), 9 million in Europe, and 6 million in Asia/Pacific (Australia, Japan, etc.). 43.2 million (44%) U.S. households own a personal computer and 14 million of them are online.”(Howe, 2006)

This surge in popularity opened new channels for business.
The number of Internet users worldwide reaches 150 million by the beginning of 1999. More than 50% are from the United States.
“E-commerce” becomes the new buzzword as Internet shopping rapidly spreads. (Howe, 2006)

Many Brick and Mortar companies revamped their business models and became Brick and Click operations. These companies saw the Internet as a way to extend their business. There was also a rise in the number of pure click companies that did not have a store front location.

The phenomenal growth of the Internet has provided a unique change with the issue of taxation. The Internet allows the world to be a marketplace without geographic borders. The challenge with Internet taxation involves jurisdiction.

The Current Situation

“One of the apparent attractions of Internet shopping is the absence of sales tax collection: according to a recent survey, 46 percent of online buyers said they have never paid sales tax on an Internet purchase and 75 percent said they would buy less on the Internet if a sales tax were imposed.2 State officials, alarmed by the rapid growth of Internet commerce and the potential of lost sales tax revenue, have called for the legislation allowing them to collect sales taxes on Internet transactions. Others have argued that the de facto tax-free status of online shopping has provided an important stimulus to electronic commerce. In 1998, Congress passed the Internet Tax Freedom Act, which placed a three-year moratorium on new Internet taxes. In 1999 Congress created the Advisory Commission on Electronic Commerce, a 19-member panel of representatives from government and the high-tech industry to study online taxation and related issues. The Commission is scheduled to release its report in April 2000. The purpose of this briefing is to lay out the relevant issues and consider some of the proposed solutions. My conclusion: The current system of state taxes is overly complex and poorly designed. No matter what one thinks will happen with online purchases it stands in need of serious reform. (Varian, 2000)

Currently, the obligation to pay sales tax is determined by the location of the buyer, not the seller. If a business does not have a physical presence in a particular state, such as a store or warehouse, it is not required to collect sales tax for sales from customers in that state. The connection between sales and location is called nexus. The concept of Nexus is complex.

If a consumer in California purchases good in Nevada e.g. books, then a sales tax cannot be imposed also if a Nevada based company hosts his site on a California based computer, there ...

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If a consumer in California purchases good in Nevada e.g. books, then a sales tax cannot be imposed also if a Nevada based company hosts his site on a California based computer, there is no nexus if a California resident purchases a product.

Consequently, pure Internet retailers, those without a store front location or those in states that do not levy taxes definitely have a competitive advantage. However this advantage at same level is balanced with the shipping cost that incurs because of remote sales nature of the internet.

Many States are concerned that they are losing taxes that should be used for vital services such as education and healthcare. Many Companies such as Staples have sided with the states to call for Internet taxation.

Consequently, the states have been working on a simplified tax system, and 40 have signed on to the Streamlined Sales and Use Tax Agreement.

The effected parties of the taxation of e-commerce is the internet commerce that has touched all aspects of business technology infrastructure, business-to-business commerce, business-to-consumer commerce, business portals, new business models, the growth, and decline of tech stocks, new marketing and advertising strategies, and interesting strategic alliances and partnerships.

The consequence, that if electronic commerce should be completely tax-free then it is often the interpretation given to parts of the White House paper, "A Framework for Global Electronic Commerce." But, it is a misinterpretation, failing to distinguish the United States' views on tariffs from those on taxes. The United States has made it clear that it does not oppose existing taxes being applied to electronic commerce in a neutral manner. In fact, former President Clinton, at a technology conference in San Francisco, indicated that the United States was working with the Organization For Economic Cooperation and Development (OECD) on the taxation issues to achieve this neutrality and to ensure that taxation will not become a barrier to the development of electronic commerce. Although tax-free e-commerce might assist the sector to grow more rapidly, it also would create an uneven playing field, which would discriminate against conventional commerce. Not only would such an approach be unfair, it would create serious economic distortions in the market place.

“The agreement establishes one tax rate for each state and one rate for each ZIP code, as well as uniform audit procedures and other methods to simplify tax collection. The belief is that with new technology, merchants know which goods are taxed and at which rate, regardless of where the sale is completed. This is viewed as a signal that it is time to introduce the Internet Sales Tax” (Gordon ,2002)

Disadvantages of Internet Taxation for businesses

Many E-Commerce businesses strongly oppose the introduction of Internet Taxation. Several factors have been cited that show that this will have an adverse impact on E-Businesses.

Consumers use E-Commerce because of the absence of a Sales Tax and if the tax is introduced, the consumer will revert to Brick and Mortar stores. . Hal R. Varian1Dean, School of Information Systems and ManagementUniversity of California at Berkeley explains

Economists argue that taxing business purchases is not wise since these taxes end up being passed along to consumers in the form of higher prices, which distorts both consumer purchases and business structure. Suppose that firm A sells a product to firm B for $1 plus a 5 percent sales tax. Firm B then sells the same product to a consumer for $2 plus another 5 percent sales tax. If these taxes are fully passed along to the consumer, he or she ends up paying 15 cents tax on a $2 purchase. The increase in the final tax paid by the consumer due to the taxation of business inputs is known as "pyramiding" or "cascading." This pyramiding of taxes will cause consumers to consume less of the good than they would have otherwise and may cause firms to change their behavior simply to reduce their tax burden. For example, firms may choose to vertically integrate solely to avoid taxation on purchases of intermediate products.(Varian, 2000)

An Internet retailer, or any direct marketer, would have to file dozens of sales-tax returns monthly and could be audited any time. It is argued that

“the fact that the Internet is inherently non-geographic. As Representative Chris Cox, author and sponsor of the Internet Tax Freedom Act said: "The decentralized nature if the Internet makes it impossible to establish the precise geographic route or endpoints taken by any single transmission. This makes every Internet transmission vulnerable to multiple taxation that could stop this rapidly growing medium in its tracks." Although state and local governments enjoy a significant amount of freedom in determining their tax policies, their tax discretion does not extend beyond their geographic boundaries. Taxing the Internet may also drive away the dot.coms to locations that do not tax them, if we impose taxes that reduce their business. Many of the companies that engage in commerce over the Internet do not have to be physically located in the United States. An exodus of e-commerce companies could impact the growth of Internet-related jobs, a loss that could hurt the economy. Other opponents argue that compliance with the thousands of differing local tax rates, would be unduly burdensome on out-of-state companies, especially for small businesses or for sellers of information goods that are delivered online and often do not even have a customers mailing address. Some argue that the Internet stimulates purchases at retail stores and through catalogs. One study found that consumers spent $3.3 billion on Internet retail sales in 1997. But they spent more -- $4.2 billion - buying goods and services elsewhere after getting product information online. (Isidro, 2006)

It is believed that E-Commerce Taxation would inhibit the growth of Online business and online innovation. Isidoro in analyzing this claim states “Opponents fear that the imposition of taxes would slow the growth and opportunity of e-commerce, just before it fully gains a foothold among consumers. They fear that introducing taxes now might seriously impede the Internet?s growth at a critical stage of early development. Extending the moratorium will enable e-commerce, which is relatively new and emerging industry, a chance to develop without the market distortions caused by a haphazard tax structure. The anti-tax camp argues that the Internet, by its very nature, cannot be regulated or controlled. Policymakers and businesses opposed to Internet taxes argue that the Internet should remain a "global free trade zone," unencumbered by overlapping and discriminatory taxes imposed by the country's 30,000 taxing jurisdictions. However, if taxes are imposed on Internet commerce, this zone of freedom and opportunity will become enmeshed in government bureaucracies. According to research by Austan Goolsbee, an economics professor at the University of Chicago Graduate School of Business, sales of merchandise on the Web could plummet if consumers were forced to pay sales taxes. After examining the purchasing habits of 25,000 online users, Goolsbee estimated that one in four would stop buying on the Web if the sales were taxes in a way similar to those in conventional retail settings, resulting in a 30% drop in online spending. Online buyers are "highly sensitive" to taxes, says Goolsbee, with many of them residing in high-tax areas of the country." A similar study by the National Bureau of Economic Research in 1999 concluded that applying existing sales taxes to the Internet would slash the number of online buyers by 25 percent and reduce online purchases by 30 percent or more, thereby damaging one of the leading sectors of today's booming economy. A December 1999 study by BizRate.com also showed that nearly 60 percent of consumers would make fewer purchases if they had to pay a sales tax on all Internet purchases. The tax issue, according to the BizRate.com?s Flash Survey study, would have a greater negative impact on foreign merchants, as 30 percent of the respondents indicated that they would never buy from an online foreign merchant if they had to pay tariffs on online purchases.(Isidro, 2006)

4 Accoring to State of California Board of Equalization Sales and Use Tax regulations, a drop shipment generally involves two separate sales. The true retailer contracts to sell tangible personal property to a consumer. The true retailer then contracts to purchase that property from a supplier and instructs that supplier to ship the property directly to the consumer. The supplier is a drop shipper. A drop shipper that is a retailer engaged in business in this state is reclassified as the retailer and is liable for tax as provided in this regulation. When more than two separate sales are involved, the person liable for the applicable tax as the drop shipper is the first person who is a retailer engaged in business in this state in the series of transactions beginning with the purchase by the true retailer.

Recommendations for the Business

One very important finding was that the impact of taxes on consumer demand was not that significant for low cost items. The item may even cost more if the shipping cost is a significant part of the total sum. E-commerce makes more sense for the consumer when the product is highly standardized and has a high price tag such as a notebook computer.

Another intriguing result is that taxes, while important, are less important to consumers than the before-tax price. When separately estimating the impact on demand of before-tax price and sales tax, the authors find that a one dollar increase in taxes reduces demand less than a one dollar price increase. This seemingly puzzling result provides good evidence that it is difficult and costly for consumers to gather and process information about after-tax price structure, since a fully informed (or fully rational) consumer would only consider the after-tax price and would be indifferent to the source of its increase.(Smart Economist, 2006)

The conclusion is that “On the whole the results suggest that while online retailing owes much of its success to tax avoidance motives, there are still certain dimensions in which online and offline retailers may compete” (Smart Economist, 2006)

Because of such a challenge, nowadays most of the vertical price comparison sites has a handy option to calculate the “bottomline price” of the item based on the consumer’s ZIP code. is one of the typical examples of this application.

With the information gleaned from our analysis, we advise the company to inject the capital into the business.

Taxation gives a competitive advantage for highly price sensitive items as well as high price tag. Otherwise shipping cost may neutralize the taxation advantage.

It makes more sense to use other advantages that internet can provide. One example of this can be focusing on “niche products”. Niche products target a very narrow consumer segment. Because of that it’s not feasible for a brick-and-mortar business to offes such products. Since it’s very easy to reach a very wide array of consumer segments via internet; such products and services offer a great opportinuity for click-and-mortar businesses.

Regarding the drop shipping opportinuities In dropshipping, since we don’t actually stock the products, we have limited control over inventory management, product availability, order fulfillment, shipping processes, etc.

Therefore success of the business heavily relies on the reliability of the drop shipping company. It’s imperative that working with reputable and reliable drop shipping companies are vital for the success of the business.

References

Isidro, Isabella, 2006 ,What Will Guarantee Your Success Online Starting Your Online Business E-Commerce: The World at Your Fingertips Speed Kills on the Web Maximizing the Potential of Your Internet-Based Activities , Retrieved June 10, 2007

Gordon-Murnane, Laura, 2002, E-Commerce and Internet Taxation: Issues, Organizations, and Findings. Searcher; Jun2000, Vol. 8 Issue 6,

Howe, Walt, 2007, A Brief History of the Internet , 2007