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Taxing the Internet

“Tax free Internet!” is becoming the new rallying cry of computer users
everywhere. HR 1054 has been dubbed the Internet Tax Freedom Act and is
gaining support in the House and Senate and seems to be supported by the
president. But are there any good economic reasons behind treating the
Internet as a special good?

This feature takes a brief look at optimal commodity tax design, and
how the Internet may fit into the tax bundle.

To head off a couple of criticisms at the start and to get a discussion
going, I am going to ask you to assume that 1) we need to raise some money
via sales taxes, and 2) we should do so in the most efficient way possible.1
I hope to thus head off the argument that goes something like: taxes are
evil; therefore, taxes on the Internet are evil. Once we get beyond this
we can have a real discussion on the merits of taxes on the Internet vs.
taxes on other products.

The General Problem: Coffee and M&M’s

Lets start from scratch with a simple hypothetical situation in order
to get a better idea about how and why the Internet should or should not
be taxed. 

Consider a problem that a company, let’s call it the Ramsey Corp., is
facing. The corporation needs to raise 10$ per person to pay for a new
water cooler for their break room. They decide to use a “sales tax” on
the coffee and M&M’s sold through the vending machines to do this.

Say that all the employees earn the same income, and consume only M&M’s
and coffee at work. The employees are not known for being morning people,
and so need to drink 2 cups of coffee every morning, almost regardless
of the price. The M&M’s provide a nice sugar high in the afternoon,
but the amount the employees buy depends a lot on the price — mmm, M&M’s,
I’ll be right back…

The president of the company, Dr. Ramsey, wishes to raise the money
so as to keep his employees as happy as possible. How should he set the
tax rates on coffee and M&M’s?

If he mostly taxes the coffee, the employees will grumble and end up
paying the 10$ per person when getting their morning coffee, but their
consumption of coffee and M&M’s will remain mostly unchanged.

If he mostly taxes the M&M’s, the employees will again grumble as
they end up cutting back on their M&M consumption and up paying the
10$ during their afternoon sugar fix. In this case, the employees not only
pay the 10$, but they also experience a greater “distortion” in their
when they cut back on their usual afternoon chocolate.

The employees are better off in the first case when the coffee is taxed,
and their routine is not disturbed. Mr. Ramsey being a nice boss, should
decide to tax the coffee.

More generally, imposing a tax usually involves some amount of “distortion”
to behavior, and the less the distortion the better. This solution is what
economists call an “inverse elasticity” rule. Those goods that are most
sensitive to prices (demand elastic) should be taxed least.2

FYI, here is the Ramsey rule for n commodities in all its glory:


Taxing Internet Service

From the example above, we see that if the Internet were just an ordinary
commodity, we would not necessarily like to tax it at the same rate as
other goods. If Internet access is very price sensitive, then we would
want to tax it less than other goods. On the other hand, we should tax
it more heavily if consumer demand does not vary too much with prices.

I am unaware of any studies looking at the price sensitivity of Internet
usage – but at this level of analysis, there should at least be some positive
level of taxation.

“But”, you say, “the Internet is not just an ordinary commodity”.
As I see it, the Internet is different from a standard commodity in (at
least) two fundamental ways. First, the Internet can be thought of as a
“market” – a place where buyers and sellers can meet, exchange information,
and trade. Taxing the Internet or Internet access can be thought as a hindrance
to the formation of an relatively more efficient market and thus not desirable.

Second, the Internet contains significant Network
— where the addition of another Internet user increases
the value of the Internet for all current users — in which case it may
be desirable to actually subsidize Internet access rather than to tax it.

These arguments seem to me to be sufficient to keep the tax collectors
away – at least for the time being.

Internet Commerce

Another related taxation issue is whether Internet Commerce should be
taxed. This seems like a rather clear situation. From a sales tax perspective,
I see no real difference between ordering something from a catalogue or
from a company over the phone, and ordering something via the Internet.
It seems reasonable to use the same taxation laws that currently exist
for Internet commerce.

If the two systems were to differ, then there would be an added incentive
to move commerce onto the Internet, even if it is not efficient otherwise.
There would also be an incentive to dodge taxes by simply moving current
commerce to the Internet.

This isn’t to say sales taxes for catalogue or phone ordering is the
best or even a good system3 
– it’s just that the two should be the same. If the debate over Internet
commerce prompts a (good) revision in the relevant taxes for other sales
mediums, then this is to be commended.

On the other hand, if the Internet were in the situation in which it
lacked a critical mass of both buyers and sellers to really get the Internet
marketplace going then there might be a good argument for no taxes – or
even subsidies to get the “infant industry” off the ground.

This seems to be president Clinton’s attitude: “We can’t allow unfair
taxation to weigh [the Net] down and stunt the development of the most
promising new economic opportunity in decades”.


Other links

1I will confine the discussion to optimal
commodity taxes. Experienced economists will be groaning about now – “oh
no, he’s going to try to explain the Ramsey rule in plain english”. As
much as I’d love to tackle the Ramsey general optimal commodity taxation
problem and the Diamond-Mirlees multiple household and production elaboration
– that’ll have to wait for another time. 
2The “Ramsey rule” is considerably more
complicated with many more subtleties than the simple story told here.
Cross price elasticities, multiple households, etc., are important when
deriving the optimal tax – but the insight is roughly the same as presented
here. Strictly speaking the inverse elasticity rule is only valid if the
cross elasticities are constrained to zero. 
3In particular, since sales taxes are
levied at the state levels, there is substantial competition among states
to attract companies. This means that firms have incentives to locate in
places that they would choose in absence of the tax system. Dealing with
sales taxes in 50 states may also be a significant burden.


Filed under: Microeconomics

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