Contemporary Economic Policy (ISSN 1074-3529) Vol. 21, No. 1, January 2003, 25–40 © Western Economic Association International TO TAX OR NOT TO TAX? THE CASE OF ELECTRONIC COMMERCE DONALD BRUCE, WILLIAM FOX, and MATTHEW MURRAY* Despite the intensifying debate over the taxation of Internet commerce, the relevant issues have not been given a systematic treatment in the context of the literature on optimal taxation. This article presents such an analysis and investigates separately the taxation of business purchases of intermediate goods, the taxation of consumer purchases of final goods and services, and the various issues of administration and compliance costs as they apply to the development of e-commerce. The authors conclude that generally the optimal tax literature cannot be used in support of a blanket tax exemption for Internet purchases. Certain conditions could lead to the optimality of an exemption, but those conditions are not likely to be met in practice. (JEL H21, H71) I. INTRODUCTION The sales tax treatment of goods and ser- vices purchased via the Internet has attracted attention far beyond that normally afforded to issues of state and local taxation. The discussion is motivated by widely different objectives, with some seeing the issue as how to create the best tax structure, some as a means to reduce the size of government, and others as a way to give preferential tax treat- ment to a particular industry. A number of the participants in the debate have made claims, apparently based on opti- mal tax theory, about the appropriateness of taxing transactions through e-commerce. It is somewhat surprising, then, that the question of Internet taxation has not received a thor- ough and systematic treatment in the context of the diverse body of optimal tax literature. * The authors thank James Alm, Gary Anders, Austan Goolsbee, the editor, and one anonymous referee for insightful comments on an earlier draft. Bruce: Research Assistant Professor, Center for Business and Economic Research, University of Tennessee, 100 Glocker Building, Knoxville, TN 37996-4170. Phone 1-865-974-5441 ext. 6088, Fax 1-865-974-3100, E-mail dbruce@utk.edu Fox: Director, Center for Business and Economic Re- search, University of Tennessee, 100 Glocker Build- ing, Knoxville, TN 37996-4170. Phone 1-865-974- 6112, Fax 1-865-974-3100, E-mail billfox@utk.edu Murray: Associate Director, Center for Business and Economic Research, University of Tennessee, 100 Glocker Building, Knoxville, TN 37996-4170. Phone 1-865-974-6084, Fax 1-865-974-3100, E-mail mmurray1@utk.edu This article seeks to add to the discussion by examining what contributions the optimal tax literature provides for design of sales taxes on electronic commerce. The authors note which arguments are and are not supported by opti- mal tax theory and the rather unlikely condi- tions under which an exemption for Internet commerce might be warranted. Following a brief overview of the current sales and use tax system and a summary of the Internet Tax Freedom Act (ITFA), the article addresses the following questions: • Should local and remote purchases of final goods and services be taxed differently on efficiency grounds? • Should local and remote purchases of final goods and services be taxed differently on equity grounds? • How should intermediate transactions be taxed? • How do administrative and compliance costs affect optimal tax considerations? • How does uncertainty affect optimal tax considerations? • Are there nonoptimal tax considera- tions? ABBREVIATIONS B2B: Business-to-Business B2C: Business-to-Consumer ITFA: Internet Tax Freedom Act 25