International Tax and Public Finance, 10, 79–97, 2003©C 2003 Kluwer Academic Publishers. Printed in The Netherlands.

Network Externalities and Indirect Tax Preferencesfor Electronic Commerce

GEORGE R. ZODROW zodrow@rice.eduEconomics Department, Baker Institute for Public Policy, Rice University, 6100 Main Street, Houston,TX 77005, USA

Abstract

Although most arguments supporting preferential tax treatment of electronic commerce are suspect, the existenceof network externalities provides one potentially defensible rationale. This paper considers (1) direct networkexternalities, which arise in communications networks like the Internet, (2) indirect network externalities, whicharise in computer hardware/software systems in imperfectly competitive markets, and (3) learning network ex-ternalities, which arise when existing network participants assist new users. It concludes the case for preferentialtreatment is weak, and that proposed blanket sales tax exemptions of remote (or all) e-commerce are especiallyinappropriate. Finally, the paper comments briefly on US sales tax reform efforts.

Keywords: network externalities, taxation of electronic commerce, Internet taxation, sales tax reform

JEL Code: H20, H21, H23, H25, H71, L86

1. Introduction

Much attention has been focused recently on the taxation of electronic commerce, especiallythe indirect taxation under a sales tax or a value-added tax (VAT) of purchases from remotevendors (those located outside the taxing jurisdiction). Many observers have noted thecomplex tax administration issues raised by this relatively new form of commerce, especiallythose associated with the sale of digitized content and the use of “electronic cash” as a formof anonymous payment.1 However, discussions about indirect taxation of e-commerce havetaken distinctly different tones in Europe and the United States.

In Europe, the consensus is that the VAT should be uniform or neutral between elec-tronic commerce and all other forms of commerce. For example, the OECD (1998, 3–4),while stressing that “Governments must provide a fiscal framework within which electroniccommerce can flourish,” concludes that “Taxation should seek to be neutral and equitablebetween . . . conventional and electronic forms of commerce.” Similarly, the EuropeanCommission (1998, 2) emphasizes that, “The EU VAT system should therefore providethe legal certainty, simplicity and neutrality required for the full development of electroniccommerce,” and that any legislated changes in the tax system “should neither advantagenor disadvantage electronic commerce compared with other forms of commerce.”

Moreover, the system of indirect taxation of remote commerce—at least for trade intangible goods—is well developed in the EU (Cnossen, 2001; McLure, 2001, forthcoming(a)). Imports into the EU are taxed at the border or post office, and sales between EUmembers are also generally taxed in the state of destination. In the latter case, registered

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traders are required to self-assess the VAT (“reverse charge”) on their imports, and EU firmswith sufficiently large sales to unregistered businesses and/or consumers within any stateare required to register and pay the VAT in that state. There are, however, two exceptions todestination-based taxation under the VAT in the EU. First, sales by an EU firm to unregisteredbusinesses and/or consumers within a state below a threshold are taxed in the state of origin.Second, services (other than telecommunications) are taxed in the state of origin—and arethus untaxed if provided by a firm outside the EU.

The VAT policy debate in the EU has focused on how best to extend the existing tax systemto e-commerce in the form of digitized products. As described by McLure (2001) and Weiner(2001), this process has been difficult, since the current system combines elements of bothdestination-based and origin-based taxation. Nevertheless, the focus of the debate has beenon adapting the current VAT system to deal with e-commerce, especially in intangibles,and there has been virtually no discussion of tax exemptions for e-commerce (McLure,forthcoming (a)).

By comparison, much of the US debate has focused on the extent to which e-commerce,especially sales by remote vendors, should in fact be subject to indirect taxation underthe system of state sales taxes. In particular, the recent recommendations of the AdvisoryCommission on Electronic Commerce (2000) would, if adopted, virtually eliminate thesales taxation of remote e-commerce and reduce the taxation of local e-commerce (sales byvendors located within the taxing jurisdiction). These recommendations would (1) exemptall sales of digitized content, as well as all competing non-digitized products, and (2) allowout-of-state on-line retailers to have conventional “bricks and mortar” affiliates in a statewithout triggering sales tax liability, even if the affiliate accepts refunds and performswarranty work. By comparison, most state and local government officials, as well as mosteconomic and legal tax scholars, argue for the opposite approach—uniform sales taxation ofe-commerce, other forms of remote commerce such as mail-order sales, and all sales fromconventional “Main Street” vendors.2 In addition, and in marked contrast to the situationin Europe, the current de facto tax exempt status of mail-order sales in the US has createda presumption that remote e-commerce will also be free of sales tax.

Numerous arguments have been made in support of preferential tax treatment of electroniccommerce. Many of these are of insufficient merit to justify over-riding the traditionalpresumption for uniform sales taxation of all consumption expenditures.3 In particular, thefact that Internet sales are likely to be responsive to preferential tax treatment (Goolsbee,2000) does not imply that preferential tax treatment is warranted. Indeed, it creates theopposite presumption, as a high degree of tax sensitivity implies that the economic efficiencycosts of diverting sales from Main Street retailers to online sellers for purely tax reasonscould be quite large.4 More generally, such preferential treatment represents a governmentalattempt to fashion an “industrial policy” through the tax system—by picking “winners”and then granting them tax preferences—and is thus inconsistent with the free marketprinciples generally supported by the business and academic communities.5 It is also clearthat preferential treatment of e-commerce results in inequitable treatment of existing “MainStreet” retailers and their consumers.6 Together, these arguments make a persuasive casefor taxing e-commerce under a sales tax base that is as comprehensive as possible, whichin turn implies that supporters of preferential tax treatment for e-commerce must providecompelling arguments to support their position.7

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One often-cited candidate for such an argument is that important network externalitiesexist for the network of computers that form and provide access to the Internet. Economides(1996, p. 682) makes the general argument that private markets will tend to under-providegoods characterized by network externalities, as “competition will provide a smaller networkthan is socially optimal, and for some relatively high marginal costs perfect competitionwill not provide the good while it is socially optimal to provide it.”8 Following the standardprescription for adjusting market prices to reflect external effects, such under-provisioncould be remedied with the appropriate governmental subsidy. This argument has beenapplied to the issue of preferential taxation of e-commerce. For example, Goolsbee andZittrain (1999, p. 422) note that the existence of various network externalities (includingall three types to be discussed below) may imply a “significant social cost” if computernetworks are inefficiently small; in this case, preferential tax treatment of e-commerce mightbe desirable to encourage expansion of the network to its efficient size, at least in the shortrun.9 Similarly, Goolsbee and Klenow (2000) argue that learning network externalities areempirically significant and thus may provide a rationale for preferential treatment. Networkexternalities thus potentially supply an economically defensible rationale for preferentialtax treatment of e-commerce.

This contention is evaluated in this paper, which is organized as follows. The followingsection contains a brief overview of the theories underlying the three types of networkexternalities considered in the paper: (1) direct network externalities, which arise in thecontext of communications networks such as the Internet, (2) indirect network externalities,which arise in computer hardware/software systems when markets are characterized byimperfect competition, and (3) learning network externalities, which arise when the existingparticipants in a network assist new users in learning the operation of the system and thushasten expansion of the system. Section 3 considers the case for preferential treatment ofe-commerce in light of these network externalities, considering first some general issuesand then issues specific to each type of externality. It concludes that preferential treatmentis generally unwarranted, and even if desirable would not take the form of the blanketexemptions of remote or even all e-commerce that are often advocated. Section 4 considersthe currently highly topical issue of how uniform treatment of e-commerce (and other formsof remote commerce) might be achieved under the sales tax system in the US, while thefinal section offers some conclusions.

2. A Review of the Theory of Network Externalities

2.1. Direct Network Externalities

The classic case of a “direct” network externality occurs when the direct benefits consumersor firms receive from participating in a communications network increase with the number ofcommunication points or “nodes” in the network.10 For example, the value to an individualof a fax machine increases with the number of individuals or firms who also have faxmachines and are thus potential exchangers of fax messages. An externality arises becausewhen individuals purchase fax machines, they ignore the direct benefits to others from theassociated expansion in network size, and thus purchase a quantity of fax machines that is

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suboptimal from a social standpoint. An appropriately designed subsidy (or tax preference,relative to existing levels of taxation) will increase private consumption to the optimallevel.11 In the case of computer networks, the external benefit of adding another computer tothe network is the gain to all existing members of the network from having another computeruser with whom to communicate (exchanging e-mails and files, engaging in commercialtransactions, obtaining information, exchanging views, playing computer games, etc.).

The case of direct network externalities is fairly complex because both private demandand the size of the network externality are a function of the expected size of the network.Consider first the private demand for the network. For any given expected network size, thedemand for network nodes is a standard downward sloping demand curve. However, as thesize of the expected network increases, the larger number of potential communication linksimplies that the marginal benefits to an individual or firm from participating in the networkincrease, which in turn implies that the demand curve shifts outward. Moreover, as thenumber of network participants increases, the marginal external benefits increase as well.Indeed, in the simplest (but unrealistic) models, there is a tendency for the absolute size of themarginal external benefit to increase without bound as the size of the network increases.12

However, this result is misleading, as both private demand and the size of the marginalnetwork externality will eventually decline with network size. This is shown by Economides(1996), who notes that the key concept in determining demand for a network good is the“fulfilled expectations” demand curve—the locus of equilibria obtained by finding, for anygiven expected network size, the price at which actual demand for the network good equalsthe expected size of the network. Economides shows that under plausible assumptions thefulfilled expectations demand curve is “humped-shaped.” That is, the fulfilled expectationsdemand curve is upward sloping at low levels of network participation because new partici-pants are relatively high demanders, who value highly the benefits from network expansionand who also tend to generate similarly large benefits to other network participants. How-ever, as the size of the network increases, increasingly low demanders, who place a lowervalue on the benefits from network expansion and also generate ever-smaller benefits to theother participants, are the marginal joiners of the network. In addition, congestion costs maycreate negative externalities—permanently or perhaps only in the short run until the networkinfrastructure expands—as the network expands (Mackie-Mason and Varian, 1996). The“low demander effect,” perhaps augmented by congestion costs, eventually becomes suffi-ciently important that the fulfilled expectations demand curve becomes downward sloping,thus yielding a hump-shaped curve. Similarly, the marginal external benefits of adding addi-tional users decline as relatively low demanders are added to the network (and if congestionoccurs). Thus, marginal network externalities also decline with network size.

This humped demand curve also implies that markets with network externalities haveunusual dynamics (Economides and Himmelberg, 1995a). Initially, if costs are relativelyhigh, very little of the network good is produced. However, if costs decline sufficiently, dueto improving technology or other factors, the market attains critical mass and then enters aperiod of explosive growth until, for any given price, it reaches the quantity demanded on thedownward sloping portion of the fulfilled expectations demand curve. That is, for any givenprice, the market “zooms” past the “small network equilibrium” (the quantity demanded onthe upward sloping portion of the hump-shaped fulfilled expectations demand curve13) andcontinues to expand rapidly until it reaches the “large network equilibrium” (the quantity at

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the same price on the downward sloping portion of the curve). Beyond that point, the marketexpands more gradually as further price reductions induce some more “low demanders”to join the network. At this point, however, the demand for network expansion—and themarginal network externalities generated by such expansion—are relatively low.14

The rationale for a subsidy (or a tax preference) in markets with such network external-ities is that an appropriately designed subsidy, reflecting the marginal external benefit ofexpansion of the network at the socially optimal network size, will effectively lower theprice of the network good and induce an increase in the size of the network to the efficientlevel. In addition, a temporary but perhaps much larger subsidy may be desirable to increasethe likelihood that the network enters its rapid growth phase and reaches the efficient “largenetwork equilibrium.”

Note, however, that government intervention on network externality grounds is unneces-sary and indeed undesirable if private firms are able to capture (and charge for) all or muchof the external benefits of a network. If a single firm or a small group of firms own all ormost of the nodes in a network, they will be able to both recoup the private benefits receivedby the purchaser of the marginal node and also increase the price they charge to the othermembers of the network to reflect at least some of the external benefits they receive fromnetwork expansion. In this case, firms may face approximately the correct incentives fornetwork expansion. At the same time, however, monopolistic or oligopolistic pricing andrestriction of output of the network good are likely to be significant problems in this case.

2.2. Indirect Network Externalities

Network externalities can also be indirect, in which case—in contrast to the direct networkexternalities paradigm—the size of the network does not appear in individual utility func-tions or firm production functions. Instead, in the case of indirect network externalities,the interactions between the individual decisions that determine the size of the networkand other consumers and/or firms occur through standard market mechanisms, as they arereflected in the effects of these decisions on either future prices or the variety of goodsproduced (Liebowitz and Margolis, 1994; Gandal, 1995). If all markets are perfectly com-petitive, such “pecuniary” indirect externalities, which are essential for markets to functionefficiently, require no government action. However, if one or more of the affected marketsis imperfectly competitive—e.g., characterized by significant economies of scale with onlyone or a small number of producers—then indirect network externalities can exacerbate theefficiency problems that already exist due to an imperfectly competitive market structure.

An example is the market for computer hardware and software systems, which is char-acterized by imperfect competition and tends to exhibit indirect network externalities.15

Software production is characterized by significant economies of scale, with large prod-uct development costs but low production costs. Although the computer industry is quitecompetitive, significant economies of scale and imperfect competition appear to exist incomputer chip production. Thus, the market for computer hardware/software systems ischaracterized by imperfect competition. In addition to the standard efficiency problems as-sociated with imperfect competition, outcomes in such markets may be inefficient dueto indirect network effects. For example, individuals or firms contemplating computer

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purchases must anticipate future prices, variety and availability of software. However, thesefactors will be determined by the current and future purchasing decisions of other agentsand, if software is subject to significant economies of scale, future software prices willbe significantly affected by these decisions. In particular, a larger base of hardware own-ers will imply larger future software sales, and thus lower prices and/or greater variety ofsoftware. However, current purchasers of hardware (adopters of the network) do not con-sider this indirect network effect in their purchasing decisions. Again, there is a tendencytoward under-utilization of the network—in this case, the hardware/software system—andpotentially a role for government subsidies or tax preferences to increase utilization of thenetwork to the efficient level (Katz and Shapiro, 1985).

2.3. Learning Network Externalities

The presence of learning effects in computer adoption may create another type of networkexternality. As the size of a computer network grows, the number of individuals with ex-pertise in both hardware and software applications increases; by making their knowledgeavailable to friends and neighbors, these “experts” may provide an impetus for their ac-quaintances to purchase computers and thus increase the size of the network more rapidly.The nature of the externality is that potential experts do not consider the benefits to others oftheir computer purchases and their resulting expertise and thus tend to underconsume bothcomputers and the development of their own expertise. As a result, the levels of computerpurchases, the rate of Internet adoption and the development of computer hardware/softwareexpertise may be inefficiently low. Again, there may be a role for a government subsidy toencourage network expansion to the socially efficient level.

3. Policy Implications of the Existence of Network Externalities

3.1. General Issues

Most importantly, tax preferences should be used only when the marginal external benefitis quantifiably large. Small preferences are not worth their administrative costs, and shouldbe avoided even if they could in theory correct the effects of a small network externality.The practical difficulties of structuring a subsidy of the appropriate size should also makeone wary of their use. For example, in the case of network externalities, a subsidy couldbe too large, resulting in an inefficiently large network and large revenue losses that wouldrequire increases in other distortionary taxes, or too broad in scope, causing allocativeinefficiencies as well as large revenue losses. Inappropriately designed subsidies might alsocause horizontal and vertical inequities.

Political considerations also argue for limited use of tax preferences. History suggeststhat, once enacted, even if supposedly on a temporary basis, tax preferences create strongvested interests that will forcefully oppose their elimination. Mazerov and Lav (1998) citePublic Law 86-272, which precludes state income taxation of corporations whose activitieswithin a state are limited to solicitation, as an excellent example. This provision was passed

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as a “temporary” measure in 1959 to give Congress time to determine how best to achievegreater uniformity in the taxation of multi-state corporations. However, the enactment ofPublic Law 86-272 created a strong corporate constituency that benefited from preferentialtax treatment, vigorously opposed its elimination, and indeed attempted (unsuccessfully)to expand it. The result is that the income tax treatment afforded out-of-state corporationsunder this “temporary” provision continues to this day.16 In addition, the enactment of taxpreferences begets additional preferences that are politically motivated; that is, once taxpreferences are granted, various special interests will inevitably argue that they are alsodeserving of advantageous tax treatment (and will buttress their case with economic studiesthat use the same rationales utilized to justify the existing preferences).

Finally, if a network externality is deemed to be sufficiently important that it merits atax preference, the preference should be carefully targeted to compensate for that specificexternality. Tax preferences that are only loosely linked to the activities generating anexternality can be costly in terms of both allocative efficiency and lost revenues.

3.2. Implications for the Taxation of Electronic Commerce—Direct Externalities

There are several reasons why preferential tax treatment of electronic commerce on directnetwork externality grounds is not likely to be desirable. Most important, although it isclear from a theoretical perspective that adding computers to the Internet generates net-work externalities, there currently is no empirical evidence that demonstrates convincinglythat these external effects are large at the current time.17,18 The most often-cited study isby Goolsbee and Zittrain (1999), who analyze a sample of Internet users and show thatthe probability of buying online increases with the share of one’s friends who buy online.However, they note that such network “spillovers” do not necessarily imply the existence ofnetwork externalities, and that their result could be due to common unobserved characteris-tics among friends. This result does not provide compelling evidence of significant networkexternalities at the current network size and, in the absence of such empirical evidence, theprinciple of uniform taxation should be followed.

Moreover, at current levels of computer usage, it seems likely that the marginal externalbenefits from increases in the number of computers connected to the Internet are fairlysmall—certainly relative to the size of the Internet or the number of transactions conductedover the Internet, and probably in an absolute sense. The rationale behind this argument isthe same as that underlying the derivation of the “humped-shaped” fulfilled expectationsprivate demand curve outlined above. That is, the marginal external benefit of adding anotheruser to the network may indeed be large at low and intermediate levels of network usage.Nevertheless, such benefits will eventually become small at a large enough network size,because the marginal joiners will be increasingly low demanders, who place a relativelysmall value on the benefits of joining the network and also generate small external benefitsbecause they participate less in network activities.

Although it would be difficult to prove that the marginal external benefits of adding anotheruser to the Internet are currently small, the size of the existing network suggests this is likelyto be the case. For example, MediaMark Research Inc. (1999) reports that early in 1999,83.7 million adults (or 55 percent of the population over 18) in the US had access to the

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Internet at home or work (an increase of 16.3 percent over the previous year), and that64.2 million adults (42 percent of the population) are regular Internet users (an increaseof 20 percent). Figures of this magnitude (especially if updated to reflect growth over theintervening two years) suggest that the period of explosive Internet growth is rapidly comingto a close, at least in the US. In particular, Juniper Communications (1999) reports that thenumber of online households was growing at an average annual rate of roughly 50 percent inthe mid-1990s—a growth rate that clearly has declined significantly and is likely to continueto do so, given current high levels of Internet connectivity. These figures suggest that theInternet is far beyond the initial “small network” stage in the US, and indeed likely alreadypast its “large network” period of explosive growth; that is, the current equilibrium is nowwell on the downward sloping portion of the fulfilled expectations demand curve, in whichcase marginal network externalities are likely to be relatively small.

This argument is not quite as compelling in Europe, where the network of computer usersis smaller than in the US and fewer computers are connected to the Internet (Coppel, 2000;Altig and Rupert, 1999).19 However, these differences seem to be only a matter of (a fairlyshort period of) time. In particular, Boston Consulting Group (2000) estimates that the lagbetween the development of the Internet in Europe and in the US is only about 1.5–2 years,with all EU countries falling within a range of 0.7–2.9 years behind the US. This is generallyconsistent with data provided by IDC Research (2002) which reports that by the beginningof 2002 nearly half of the European adult population was regular Internet users, a figurecomparable to that cited above for the US around 1999. Similarly, Boston Consulting Group(2000, 12–13) reports that the development of e-commerce in Europe has lagged that in theUS by roughly similar lengths of time (generally 1.5–2 years) in most categories.

Several factors have contributed to these lags. Most important is the significantly highercost of Internet access in Europe, which is roughly twice that in the US (Coppel, 2000; BostonConsulting Group, 2000); in particular, flat fee Internet service, which promotes heavyInternet use, is a nascent phenomenon in Europe. Boston Consulting Group (BCG) (2000,16–17) cites several other barriers to Internet growth in Europe. These include consumerconcerns about the safety of shopping online (especially the use of credit cards), uncertaintyabout the rules and regulations governing e-commerce, the inertia of traditional retailers,and relatively low amounts of venture capital available to finance Internet growth. However,BCG concludes that all of these barriers are beginning to crumble. Note in particular thatBCG does not cite the lack of a tax preference for e-commerce as a reason for the relativelyslow rate of growth of the Internet and electronic commerce in the EU; accordingly, it seemsunlikely that tax issues have played an important role, relative to the other factors describedabove. Given the relatively high growth rates of Internet use and e-commerce in Europe(Coppel, 2000), differences between the US and Europe will almost assuredly narrow overtime. Thus, the argument that the size of the computer network is already large enough sothat the marginal network externality is relatively small and subsidies on network externalitygrounds are undesirable is either already applicable in Europe—or in any event soon willbe. Thus, the lack of debate in Europe regarding preferential tax treatment of e-commerceseems entirely appropriate.

Also, as noted above, the network externalities argument for government intervention isappropriate only if private firms do not capture most of the benefits from network expansion.Recent years have seen vigorous competition among Internet service providers (ISPs),

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including discount packages for entrants who make a multi-year service commitment. Suchcustomers are valuable to the ISPs not only for their access fees but also because a largercustomer base allows higher advertising fees. However, the resulting increases in advertisingrevenues create a mechanism for ISPs to capture at least some of the external benefitsfrom expanding access to the Internet (Zimmerman, 2001), thus weakening any case forpreferential tax treatment.20

It should also be noted that, in the US, the case for preferential tax treatment of elec-tronic commerce on network externality grounds is even weaker when one considers thecurrent legal and political environment. Specifically, current law implies what is a de factomoratorium on sales taxation of most e-commerce (Nellen, 1999). The Supreme Court hasruled, first in National Bellas Hess in 1967 and more recently in Quill in 1992, that remotevendors without a physical presence (nexus) in a state cannot be required to collect usetax.21 Although initially litigated for mail order sales, these rulings also apply to sales ofphysical goods over the Internet and arguably to the sale of digital content as well. Moreover,current rulings imply that retail outlets in a state are not sufficient to establish nexus for aclosely affiliated online company. As a result, much e-commerce escapes state sales anduse taxes entirely. This situation is unlikely to change soon, as significant simplification ofstate sales and use taxes must be achieved before congressional or judicial action requiringremote vendors without nexus to collect use taxes will be a realistic possibility. Although,as will be discussed below, some progress is being made in this area, e-commerce in the USwill assuredly enjoy at least several more years of virtually tax-free growth. This expansionwill only strengthen the argument that the marginal external benefits of further expansionof the Internet are relatively small—and far too small to justify preferential tax treatment,especially the large subsidy implied by exemption of all remote e-commerce (or even allelectronic commerce) from sales taxation.22 Indeed, it is possible that the current de factoexemption of remote e-commerce is a more generous tax preference than could be justifiedon network externality grounds, and has thus already inefficiently stimulated the expansionof the Internet. In any case, continuation of preferential tax treatment if and when the currentde facto exemption of remote e-commerce is lifted seems like a very dubious proposition.

Finally, suppose one believes that direct network externalities are currently importantenough at the margin to justify a tax preference. What would be the nature of such a taxpreference? The policy goal is to increase the number of nodes on the network—to encour-age first-time computer buyers (or upgrades to machines with rapid Internet access) andconnection to the Internet. A sales tax exemption is an extremely blunt and thus very expen-sive means of achieving this goal, as it extends to all remote purchases (or to all electronicpurchases), including those by established users. An incentive more carefully targeted atsubsidizing connection to the network would be far more effective. A good candidate is taxexemption or even subsidization of Internet access fees, including fees paid to telephoneand cable companies for DSL and cable broadband access. Such a policy would facilitateInternet access while limiting windfalls to existing participants, especially those who arealready large purchasers of goods over the Internet. Tax exemption of Internet access feesis already a policy in many states, and new taxes on Internet access are precluded until 2003under the recent extension of the Internet Tax Freedom Act. Thus, preferential tax treatmentof Internet access already exists,23 which makes it even less plausible that further subsidiesare desirable. An important caveat, however, is that existing special excise taxes imposed by

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the national and state governments on telecommunications services result in a differentiallyhigh tax burden on Internet access. Elimination of these taxes, as recommended by theAdvisory Commission on Electronic Commerce in the US, would be entirely appropriate.

3.3. Indirect Externalities

As discussed above, indirect network externalities in the computer hardware/software sys-tems market might warrant a subsidy to software producers or an indirect subsidy to softwarein the form of a subsidy to hardware, its critical complementary good. This argument mighteven support a subsidy to chip manufacturing, to the extent it is characterized by economiesof scale.24

It is difficult, however, to make a compelling case for preferential tax treatment ofe-commerce based on indirect network externalities in the computer hardware/softwaremarket. As in the case of direct network externalities, there is no convincing empirical evi-dence that demonstrates the existence of large indirect network externalities in this market atcurrent levels of usage. In particular, as stressed by Liebowitz and Margolis (1994), softwareproducers are unlikely to enjoy infinite economies of scale as variable costs, especially themanagement costs associated with software distribution, meeting customer service needsand accommodating differences in consumer tastes, suggest that economies of scale mayeventually be exhausted even if the fixed development costs of the software product arefairly large. Accordingly, given current high levels of computer usage and software pur-chases, there is arguably a presumption that indirect network externalities are currentlyrelatively small. In addition, private firms may be able to capture much of the benefits fromexpanded utilization of computer hardware/software networks, rendering government inter-vention unnecessary. In particular, firms may join forces—through contracts, alliances andjoint ventures, or vertical integration—so that the combined entity can capture much of thebenefits of a larger network. Indeed, currently popular packages, which combine computerpurchases with multi-year contracts for Internet access, suggest that some such transactionsare already occurring. Moreover, in the case of the Internet, the relevant software—networkbrowsers—can already be downloaded at little or no cost; presumably, browser producersbelieve that the prospects for future revenues and profits from sales of Internet advertisingand other sources of income more than offset the costs of these promotions. In any case, suchpricing again suggests that the magnitude of the indirect network externalities associatedwith the Internet that are not captured privately is likely to be relatively small.

Most importantly, even if subsidies were deemed desirable due to indirect network exter-nalities, the appropriate remedy would be subsidies to software or hardware producers.25 Acase could perhaps be made for subsidies for Internet access but, as noted previously, thesealready exist. By comparison, sales tax exemption of either remote or all e-commerce isuntargeted and expensive, and thus an inappropriate means of providing such subsidies.

3.4. Learning Externalities

Goolsbee and Klenow (2000) investigate the importance of learning externalities. They usedata on the buying habits (including computer purchases) and demographic characteristics

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of 110,000 US households in 1997, and show that the probability of a first-time computerpurchase is significantly higher for individuals who live in cities with a relatively highproportion of computer users. They attribute this phenomenon to network learning effects—that is, individuals who live in cities with a relatively high degree of computer usage havemore friends and neighbors on whom they can rely for help and are thus more willingto adopt new technology. Indeed, their estimates suggest that roughly half of first-timecomputer purchases may be attributable to these learning network externalities; they alsoshow that avid Internet participants and e-mail users are the most likely to generate learningnetwork externalities for their friends and neighbors. They note that learning externalitiesmay lead to suboptimally low levels of production, which could be increased toward efficientlevels with subsidies for computer use and Internet adoption.

However, it is questionable whether a subsidy is justifiable in this case. One can ofcourse quibble with the econometric results. The most important issue is that the positiverelationship between first-time computer purchases and the fraction of computer users ina city may simply reflect other unobserved common traits—that is, individuals who live in aparticular city may share some unobserved trait that makes them more likely to purchase acomputer, in which case the estimated effects of network learning externalities will be toolarge. Although Goolsbee and Klenow attempt to correct for this, it is inevitably difficultto do so completely. In addition, the Goolsbee-Klenow results examine the effects of theintensity of computer use by cities. However, the relevant group for an analysis of networklearning effects would be an individual’s circle of family and friends. To the extent that thefraction of computer usage, controlling for the other factors, is not constant across cities,the results of the Goolsbee-Klenow study may be inaccurate.

Moreover, even if one accepts the existence of significant learning network externalities,the case for government subsidies, especially in the form of a tax exemption of electroniccommerce, is quite weak. Learning effects are unlikely to lead to real externalities, as ex-changes of computer advice among neighbors and friends are likely to involve reciprocalactivities that amount to compensation (e.g., implicit or explicit payments, including assis-tance/favors in other areas, free meals, etc.). In this case, a market is effectively created forcomputer expertise and learning network externalities are not an issue. In addition, to theextent that individuals enjoy being “experts” and serving as consultants to their friends andneighbors, such benefits will be taken into account in their buying decisions, which willreduce the extent of any under-consumption of network goods. The marginal value of suchfree consulting services is also debatable, as (1) the problems addressed are presumablytroublesome but nevertheless often fairly easy to resolve, and (2) roughly comparable ser-vices from professionals in the form of technical support experts employed by computerhardware and software manufacturers or retail sales outlets (as well as information technol-ogy colleagues at work in some cases) are often available at little or no cost. Moreover, asstressed above, a large number of individuals already own computers and are online; it isthese individuals who, given their “early” interest in computers and the Internet, are mostlikely to develop into experts capable of generating significant learning network externali-ties. Accordingly, any network learning externalities associated with enticing “latecomers”to join the network will be small, as they are less likely to develop into such experts.

Finally, it is again the case that even if network learning externalities are important enoughto justify a preference, an appropriate subsidy should be carefully targeted. In this case,

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the best approach would be to encourage first-time computer purchasers and users of theInternet. Again, a reasonably (although not perfectly) targeted approach would be to providea tax preference for Internet access, and would be far preferable to any type of sales taxexemption for e-commerce.

4. Achieving Uniform Treatment under the Sales Tax

Even if one is convinced that arguments for preferential tax treatment of electronic com-merce based on the existence of network externalities are not compelling and that uniformtaxation should be the rule, one must still devise a method for implementing such an idealunder the state sales tax system in the US.26 Although many reforms would be requiredto achieve such an ideal sales tax system, the following discussion provides a necessarilybrief overview of the issue that is most critical to the taxation of electronic commerce—thedevelopment of a means of effectively taxing all remote sales, including those made overthe Internet.27

As noted above, the US Supreme Court has ruled that the existing system of state salestaxes is sufficiently complex that requiring remote vendors to collect use taxes for states inwhich they do not have a physical presence (nexus) would be an unconstitutional restrictionof interstate commerce. Accordingly, some simplification is essential if the states are to besuccessful in taxing such sales. The primary question is how extensive this simplificationshould be—both from an economic perspective and in terms of provoking either congres-sional or judicial action to require an expanded responsibility for use tax collection byremote vendors.

The past few years have seen a number of simplification proposals. At one end of thespectrum lies the “technological fix,” under which state tax systems would remain largelyunchanged but computer software programs would be utilized to determine sales tax lia-bilities on remote sales and thus simplify compliance for remote vendors. These programswould determine the total sales tax due (including local sales taxes) using product codesthat would identify the relevant sales tax jurisdiction(s) based on the location of the sale,determine whether the item was taxable, and apply the appropriate tax rate(s) to taxableitems. Moreover, under this approach, payments might be made in “real time” directly tostate and local governments by a “trusted third party.” Sullivan et al. (1999) argues thatelectronic calculation, reporting and payment of sales and use taxes by remote vendors isalready manageable, although it would be greatly facilitated by simplification of the stateand local sales tax system. In particular, he notes that the restructuring of zip code (orzip+4) boundaries to follow tax jurisdiction boundaries, creating uniform definitions ofexempt and taxable goods, and uniform electronic filing processes would greatly simplifyelectronic tax determination and payment. Such compliance software could be provided bythe states to all taxable remote vendors, that is, those with taxable remote sales in excess ofsome de minimis amount.28 This approach requires few changes to the current system, andwould preserve most of the independence of the state and local governments to set theirown tax policies. At the same time, it offers relatively little true simplification and resultsin relatively high overall compliance costs (even though these costs would be shifted fromvendors to state governments).

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At the other end of the spectrum, McLure (2000a) argues for a completely revamped“ideal retail sales tax” system, under which all states would agree on a common base thatwould include all consumption items including services used by individuals, and wouldthen be free to set their own rates. All businesses would be issued a uniform exemptioncertificate, and their purchases of all business inputs (defined as those deductible under thefederal income tax) would be tax exempt. The states would agree on common simplifiedadministrative procedures (registration, filing, tax payment, audit, appeals, etc.) and a uni-form legal framework (statutes, regulations and interpretations). McLure favors a single taxrate per state, but notes that local taxes might be accommodated if the uniform structure heproposes were adopted and compliance software of the type described above were madeavailable.

The two proposals reflect fundamental differences in intent and approach. The technolog-ical fix focuses on finding an administrable means of maintaining state revenues within thegeneral context of the current system. It places great weight on state and local autonomy insetting bases and rates, assumes that compliance software can be perfected to deal with ahighly complex system, and implicitly assumes that meaningful simplification will be verydifficult if not impossible to achieve from a political perspective. By comparison, McLureplaces great weight on the gains in simplicity, economic neutrality and equity that would beachieved with a comprehensive reform that would rationalize the sales tax system, seemsto hope that significant reforms can be achieved despite formidable political obstacles, andargues that state and especially local autonomy can be limited significantly in many areaswith little real cost, as long as states—and perhaps local governments—retain the essentialpower to set rates.

A wide variety of proposals fall in between these two points on the spectrum of potentialsolutions. Interestingly, early attempts at a compromise that would combine simplificationwith an expanded duty to collect use taxes tended to impose severe restrictions on rateflexibility, but were quite modest in terms of limiting base variations. For example, the“tentative and preliminary conclusions” of the National Tax Association (1999) projectincluded a single rate per state, which would eliminate all local rate flexibility, but did notinclude any base simplification beyond perhaps establishing a uniform “menu” of some10,000 potentially taxable items. Similarly, the National Governors Association (NGA)(1999) initially recommended a single rate per state, although only for remote sales, andcalled for uniform base definitions.

The most recent effort, however, has taken a somewhat different and more promisingapproach. Specifically, the Streamlined Sales Tax Project (SSTP), a joint endeavor by theNGA (which started the project), the Federation of State Tax Administrators, the Multi-state Tax Commission, and National Conference of State Legislatures (NCSL), representsan ongoing reform effort that involves 40 of the 45 states, plus the District of Columbia,that levy the sales tax, including 35 voting participants and 5 observer states (StreamlinedSales Tax Project, 2001; McLure, forthcoming (b)). The SSTP proposal would allow localrate differentials, but would require one rate per jurisdiction. Local bases would eventuallyhave to be identical to the state base, with a single rate at the state level. Zip codes wouldhave to be sufficient to determine both state and local tax liabilities. The SSTP establishescommon base definitions for taxable and non-taxable products, and uniform and simpli-fied administrative procedures, including rules for exempt purchases, sourcing rules, and

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registration and audit procedures. Collection procedures would be automated and stateswould be required to pay for the costs of implementing the system, which would be volun-tary. The SSTP model legislation was endorsed by the NCSL in January 2001, but subjectto several important revisions, including deletion of the uniform base definitions and theprohibitions of sales tax caps, thresholds and tax holidays (pending further review). As ofFebruary 2002, twenty-three states and the District of Columbia had enacted some formof the SSTP legislation, although many of these adopted the much less comprehensiveproposal endorsed by the NCSL or modified versions of that proposal.29

The SSTP approach, which corresponds to a “fallback” position discussed by McLure(2000a), maintains the autonomy of local governments to set their own tax rates andfinance their own marginal expenditures, which is consistent with facilitating the efficientoperation of the local public sector. At the same time, it requires state and local tax baseswithin a state to be identical (eventually) and attempts to limit the number of categoriesof items potentially in the base and define them uniformly across states. If successful, thisapproach will significantly facilitate the use of compliance software to determine the taxliabilities of remote vendors, especially if the number of taxable and non-taxable categoriescan ultimately be severely limited. Such an approach may be sufficient to prompt eithercongressional or judicial action to require remote vendors to collect use tax. Nevertheless,the SSTP approach falls far short of fundamental reform of the state sales tax system. Itsprimary weakness is that it does not really attempt to address the more fundamental issuesof sales tax reform—comprehensively taxing all consumption, including services providedto individuals, at a uniform rate under the sales tax and uniformly exempting all purchasesof all business inputs from tax—that are addressed in the McLure proposal and indeed areessential elements of any truly fundamental sales tax reform package. Nevertheless, theSSTP proposal provides an important step toward a workable and potentially politicallyfeasible means of equitable and neutral taxation of remote sales, including e-commerce.

5. Conclusion

The lessons of the above analysis are straightforward. Although one can in principle con-struct a case for tax preferences for e-commerce due to direct, indirect and/or learningnetwork externalities, the case for such intervention is weak in the current environment.Moreover, even if a preference were desirable, proposed sales tax exemptions of remote(or even all) e-commerce are poorly targeted and thus inappropriate; exemption of Internetaccess fees would be a preferable response to the existence of significant network exter-nalities, and indeed already occurs in many US states. Thus, the states in the US shouldadopt the EU goal of uniform taxation of electronic and other commerce, and focus on thedifficult task of devising means of achieving that goal.

Acknowledgments

I have benefited from comments on an earlier draft from Richard Bird, Charles McLure,Nicholas Economides, Austan Goolsbee, Hal Varian, an anonymous referee, and the

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participants of a conference on “The Debate on E-Commerce Taxation Issues” sponsored byCESTEC (Centro Europeo di Studi Tributari e sull’Electronic Commerce) in Stresa, Italy,December 3, 1999. I thank John Diamond for research assistance. A preliminary version ofthis paper was published in Italian as “Esternalita di rete e trattamento fiscale privilegiato delcommercio elettronico,” Fiscalia: Analisi e Commenti di Diritto Tributario Internazionale,Vol. 6 (Nov./Dec. 2000), pp. 577–594.

Notes

1. These issues will not be discussed here; for overviews see McLure (1997), Hellerstein (1997), Fox and Murray(1997), European Commission (1998), OECD (1998), and Bird (2001).

2. For example, see Mazerov and Lav (1998), National Governors Association (1999), and McLure (2000a).3. For more details on these arguments, see Zodrow (2000).4. Note that the standard optimal taxation prescription for lower taxes on relatively elastically demanded goods

is not likely to imply preferential tax treatment of e-commerce. It is not surprising that the elasticity ofsubstitution between the “Main Street retailer” and “e-tailer” versions of the same good is high, as they differonly in secondary factors such as ease of shopping, purchase and return, ability to “touch and feel” the good,delivery costs, times and uncertainties, etc. However, from an optimal taxation perspective, high substitutabilitybetween such goods implies that differential taxation of them should be relatively low to avoid causing largedistortions in demand patterns. With respect to other goods, the extent to which goods that can be purchasedfrom both standard retailers and over the Internet should be taxed more or less than other goods will in generaldepend on factors such as the extent to which the various goods are relatively complementary with untaxedleisure and the relative demand elasticities of the goods. The resulting pattern of optimal tax rates is far fromobvious, but unlikely to imply a blanket exemption of those goods that can be purchased over the Internet. Inaddition, any tendency toward preferential treatment of such goods—say, because they are less likely to benecessities—will be offset by distributional considerations which suggest that goods that tend to be purchasedby those with higher incomes, including those purchased over the Internet (Goolsbee and Zittrain, 1999), shouldbe taxed at relatively high rates. On balance, as concluded by Bruce, Fox and Murray (2001), the principles ofoptimal taxation are unlikely to imply preferential taxation of electronic commerce. More generally, uniformrate sales taxation is in practice likely to be desirable, given the often offsetting influences of efficiency andequity considerations in determining optimal tax rates, the practical difficulties of administering differentialrates, and the likelihood that “real world” tax differentials will reflect political factors rather than optimal taxconsiderations, even if enough information were available to determine the latter; see Harberger (1990) for adiscussion of the practical advantages of uniform taxation.

5. An attempt to eliminate the implementation of “industrial policy” through the tax system was one of thehallmarks of the Tax Reform Act of 1986 in the US; see McLure and Zodrow (1987).

6. Arguments that such retailers can negate a tax preference by establishing an online presence are not compelling.Although participation in e-commerce will inevitably be an appropriate business strategy for many retailers,it should occur for competitive reasons, and not to offset preferential tax treatment. Those firms for whichan online presence is inappropriate on economic grounds should not be placed at a competitive disadvantagesolely due to the tax system.

7. As discussed below, this issue is complicated considerably by the fact that most mail-order sales escape salestaxation under current law (McLure, 1999).

8. Economides (1996) also shows that under-provision of network goods occurs in markets characterized bymonopoly or imperfect competition.

9. They also qualify their argument by noting that network externalities justify government intervention only ifthey are not offset by congestion effects and create new trade rather than simply diverting trade from traditionalretailers.

10. See Shapiro and Varian (1999) for a recent discussion of the economics of networks.11. In a first-best world, the size of the subsidy equals the sum of the marginal external benefits at the efficient

level of output; Sandmo (1975) generalizes this result to include other distortionary taxes.12. Consider a network of size N , and assume that the benefit to an individual of participating in the network is

proportional to the number of potential communications links. The total number of potential communications

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links is N × (N −1). Increasing the size of the network to N +1 nodes thus increases the total number of linksby 2N [= (N +1)× N − N × (N −1)], but only N of these benefits—the links the marginal individual enjoyswith the other N members of the network—are captured privately. The absolute marginal external benefit fromexpanding the network equals N and thus increases without limit with the size of the network. Of course,relative to the size of the network, the marginal external benefit of expansion is constant, and, relative to totalbenefits of the network, it declines uniformly. The relevant concept of marginal external benefit depends onthe nature of the subsidy or tax preference being considered. If the subsidy were targeted toward the marginaluser—e.g., a subsidy for the purchase of a first computer or for the initial connection to the Internet—then theabsolute marginal external benefit would be the relevant concept. By comparison, if the subsidy were providedto all users—e.g., tax-free Internet access—then the marginal external benefit relative to the size of the networkwould be the relevant concept. Finally, if the subsidy were loosely based on the number of communicationslinks—which one might argue is the case for a subsidy based on transactions such as sales tax exemption ofremote electronic commerce or of all electronic commerce—then the marginal external benefit relative to thesize of the total benefits from network would be the relevant concept.

13. The “small network equilibrium” is unstable as demand exceeds supply for any upward perturbation in quantity.14. Economides and Himmelberg (1995b) shows that the market for fax machines demonstrated this pattern.15. See Katz and Shapiro (1994), who note that the hardware/software paradigm includes the markets for durable

goods and repair services, audio/video equipment and programming, and credit cards and merchant acceptance.16. As discussed below, the absence of a requirement for remote vendors to collect tax on sales to states in

which they do not have nexus also has a long history (Due and Mikesell, 1994), and has created a powerfulconstituency favoring continuation of this treatment. However, the political efforts of this constituency havebeen aided greatly by favorable court decisions and the unwillingness of states to simplify their tax systems(McLure, 1999).

17. Note, however, that the above analysis suggests that preferential treatment can be more easily justified in theearly stages of formation of a network. In the case of the Internet, the US government played a crucial role byfunding the formation of the initial network of supercomputers installed at various locations throughout thecountry.

18. This discussion refers primarily to business-to-consumer or consumer-to-consumer network links. Any externalbenefits from expansion of a business-to-business network are likely to be captured by the firms involved. Inaddition, most business-to-business commerce, including remote sales, is already subject to tax.

19. The Internet is of course a global phenomenon, and it is therefore somewhat artificial to discuss separatelyits development in the US and in Europe. Nevertheless, the sizes of regional networks are relevant in somecontexts. For example, advertising can be limited to regions or countries that speak a common language. Thedemand for certain products may be limited to certain regions or cultures. Shipping costs may make longdistance sales uneconomical in some cases. The demand for certain communication services may be greatestwithin a geographical region. Finally, regional growth may be tied to the fraction of the local population thatis online.

20. Note, however, that early predictions of Internet advertising revenues have recently been proved to be far toooptimistic. This suggests both that advertising has it limits as a mechanism for capturing external effects, andthat the external effects from expansion of the Internet may be smaller than previously thought.

21. The states in the US are constitutionally prohibited from imposing sales tax on remote sales, but can and doimpose use taxes on goods purchased in another state for use in the taxing state. Although use taxes complementsales taxes effectively for items that must be registered (e.g., cars) and for business purchases, they are seldompaid on other purchases (Due and Mikesell, 1994).

22. Revenue losses due to the de facto tax exemption of e-commerce under existing law are currently low and,although expected to increase rapidly, are projected to remain low relative to total sales tax revenues in thenear future. For example, Bruce and Fox (2000) project such revenue losses to be 1.5 percent of total sales taxrevenues in 2003. However, this figure is likely to grow rapidly in future years due to the growth of e-commerce.More importantly, current estimates may dramatically understate these revenue losses if firms become muchmore aggressive in setting up online versions of their enterprises which do not have nexus in most states.

23. In addition, many private firms offer incentives for first-time Internet purchases.24. Of course, current tax preferences, such as the expensing of R&D expenditures and the R&D credit—especially

when combined with favorable trade policies—may be more than generous enough to offset the need for anyadditional subsidies on network externality grounds.

25. In addition, in some cases, the appearance of providing subsidies to highly profitable firms to induce them toreduce monopolistic restriction of output would pose severe political problems.

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26. In the interest of brevity, this section focuses exclusively on state sales tax policy in the US. In Europe, asnoted above, preferential treatment of electronic commerce is not much of an issue, but the appropriate wayto implement uniform taxation under the VAT in the EU is very much a subject of debate. For extensivediscussions of this issue, see Cnossen (2001) and the three papers in a forum on this topic in a recent issueof International Tax and Public Finance—McLure (2000b), Keen and Smith (2000), and Bird and Gendron(2000).

27. In addition to devising a means for taxing remote sales (including the administrative issues raised in theintroduction), the most important of these reforms are in the areas of the taxation of services consumed byindividuals, the removal of tax from business inputs, and the treatment of goods that are consumed dispropor-tionately by the poor or are perceived to be merit goods; see Due and Mikesell (1994), McLure (2000a) andZodrow (1999).

28. Alternatively, Sullivan et al. (1999) notes that many software firms charge vendors based on their usage, andthat a typical charge for a small vendor operating at a low level in, say, two states, would be only $20 permonth per state.

29. For current information on participating states as well as the status of SSTP legislation in the various states,see http://www.nga.org/nga/salestax/1,1169,00.html.

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