Should state and local sales taxes apply equally to e-commerce? The debate over whether the Internet should remain a tax-free zone is creating divisions among governors of both parties, but especially between moderate Republican governors and conservative anti-tax activists.

The Advisory Commission on Electronic Commerce, appointed by Congress to recommend a solution by next month, is not even close to a consensus on how, or even whether, to create a national system to collect sales taxes on items purchased over the Internet.

A crack in the GOP

The commission's chairman, Gov. James Gilmore (R-VA), is urging a permanent ban on Internet sales or use taxes. Those supporting a permanent exemption, including presidential candidate John McCain (R-AZ), argue that the extra cost and burden of collecting taxes on behalf of some 6,000 jurisdictions with different rates and exemptions would stifle e-commerce.

Meanwhile, a silent majority of Republican governors is looking for a compromise that prevents the Internet from tearing a hole in state and local budgets. Since 46 states collect between one-third and one-half of total revenues from sales taxes, they know that replacing lost revenue with higher income or property taxes would induce howls of protest from their core upper-income constituencies.

Led by Utah Gov. Mike Leavitt (R), chairman of the National Governors Association, the NGA has proposed a privately managed clearinghouse that would use sophisticated software to impose a tax on all purchasers depending on where they live. "It boils down to a question of whether sales taxes are viable in the 21st century," Leavitt says

Whether or not sales taxes remain viable, the intra-Republican debate over e-taxes is an opportunity for progressive reformers to question the fairness of relying so heavily on sales taxes at all

Who pays for state government

Overlooked in this debate is the unfair impact of sales and excise taxes in general. As the bar chart shows, state and local taxes fall most heavily on middle- and low-income households, and the primary reason is sales and excise taxes. Unlike federal income taxes, which apply graduated rates based on ability to pay, sales taxes take a larger share of income from families that earn the least.

A 1996 study of the 50 state tax systems by Citizens for Tax Justice, a nonpartisan research group in Washington, found that while the best-off 1% of families paid, on average, 8% of their income in state and local taxes, the poor paid 12.5%. Families in the middle-income quintile paid nearly 10%.

Of course, there is tremendous variation between the states. CTJ found that in 10 states, the poorest 20% pay between two and four times as much of their earnings in taxes (ranging from 12% of income in South Dakota, to 17% in Amazon.com's home state of Washington) as the wealthiest 1%. Middle-income families paid as much as three times as high a share as the wealthiest families.

Not surprisingly, seven of the 10 most regressive state taxing systems -- Texas, Florida, Louisiana, Alabama, Washington, Tennessee and South Dakota -- have high rates of sales taxes and little or no income taxes. In contrast, the least regressive states -- California, Delaware, Montana and Vermont -- collect most revenue with a graduated income tax.

While a flat-rate sales tax appears fair on its face, in practice it is inherently regressive. Liberal critics of the e-commerce exemption focus on the fact that affluent families are much more likely to shop online. But this "digital divide" is a small and hopefully transitory problem. The greater inequity occurs because high-wage taxpayers allocate a far larger share of their income to investments and to services, which are generally exempted. CTJ reports that 10 of the 12 states with the most regressive sales taxes apply them to groceries, a necessity exempt in most states.

A pox on both their houses

From this broader perspective, liberal and conservative reformers should embrace an opportunity to use the e-commerce debate to question the viability of sales taxes in general. If so, then what now appears to be a marginal debate about e-commerce could become a transforming debate over tax fairness.

At least the conservative cause is clear. Gary Becker, the Nobel Prize-winning economist and conservative pundit, explained in his Feb. 28 Business Week column that promoting e-commerce is not the main motive behind the Internet tax ban.

"If Internet sales are permitted to be taxed at a lower rate than brick-and-mortar retailers, these retailers are likely to put strong pressure on politicians to greatly lower, perhaps even eliminate, taxes on their sales as well," Becker wrote. "If they are politically successful, it should slow the increase in overall taxation and also slow government spending."

This potential constraint on state and local budgets is precisely the short-term disruption that most governors -- as well as knee-jerk defenders of public-spending-at-any-price -- most fear. But progressive advocates should remember that some of their most damning defeats occurred when liberals chose to soak the middle class for easy revenue rather than stand and fight for tax equity.

For example, President Reagan's supply-side tax cuts of 1981 resulted in part because Democrats in Congress allowed "bracket creep" to squeeze working families between steadily higher income taxes, rising payroll tax rates and stagnant wages. It took Reagan, a conservative populist, to index tax brackets even as he made the overall tax structure less progressive and triggered a decade of record deficits. And California's Proposition 13, the radical slashing of local property taxes in 1978 that torpedoed the quality of California education, resulted when Democrats (led by then-Gov. Jerry Brown) stood by and watched housing inflation ratchet middle-class property tax bills to painful levels.

Outflanked again by "conservative populism"?

In both cases, an unfair tax burden stoked a backlash in support of lower but ultimately more regressive taxes. Progressives were outflanked by the same sort of "conservative populism" now articulated by the most visible critic of Internet sales taxes: John McCain. McCain is also peddling the regressive flat tax by shrewdly taking the populist approach of cutting rates from the bottom up.

To be sure, the lack of a level playing field between competing retail stores based on bricks vs. clicks is unsustainable. Favorable treatment for e-commerce is also the worst sort of "industrial policy" -- the kind of "corporate welfare" subsidy that true conservatives like McCain normally condemn.

So long as the anti-tax crusaders use this issue to tap popular resentment against sales taxes, progressives have a choice. They can either allow conservatives to portray them as defenders of unpopular taxes -- and in this case as enemies of e-commerce -- or they can call their bluff by opening up a larger debate about the fairness of sales taxes in general.