Culled from the ``Opinion'' section of the December 2, 1996, internet edition of The Times.
The man with the laptop cannot be traced and taxed, so governments will have to cut spending
Let us start with the facts in the Piedras Negras Broadcasting case; I will then explain why it is of central importance to the future of the world. The Piedras Negras Broadcasting Company was an American equivalent to the old Radio Luxembourg. In 1941 it was broadcasting programmes including advertisements across the border from Mexico to Texas. The American tax commissioners argued that this constituted ``engaging in a trade or business'' in the United States and claimed the right to tax the company.
Piedras Negras appealed to the Board of Tax Appeals, which found in favour of the company; the tax commissioners then appealed to the Fifth Circuit Court of Appeals, which upheld the finding. The actual words of the Court of Appeal were: ``If income is produced by the transmission of electromagnetic waves that cover a radius of several thousand miles, free of control of regulation by the sender from the moment of generation, the source of that income is the act of transmission.''
``Piedras Negras'', as Mr Michael Karlin of the American lawyers Morgan, Lewis & Bockius observed in his recent UCLA lecture, ``continues to be good law, and should apply to Internet advertising as it does to other broadcast income.'' In terms of regulation, the European Union has followed the Piedras Negras principle. In European law, which has been much complained about in Britain, the regulation of satellite broadcasting is the responsibility of the transmitting and not of the receiving country; in the case of the Astra satellite, that is Luxembourg, which does in fact regulate, through the terms of the basic contract between the Luxembourg Government and Astra.
Mr Karlin's lecture was entitled ``Cybertax: The Impact of the Internet on International Taxation and Vice Versa''. Although the Internet is still in its infancy, it is already clear that it is going to alter the whole tax structure of the advanced countries. To start with, international taxation is growing in importance. We are entering the age of the global economy, and leaving the age of separate national economies. International taxation is based on the concept of residence and source. As Mr Karlin comments: ``The Internet and other technological developments will tend to undermine the administrability of a tax system based on these concepts.''
As Piedras Negras determined and it is hard to see how that could be reversed the taxable source of an electronic communication is the point of origin, not the point of receipt. On the Internet this source may be unknowable, and even when it is knowable it may be located in a jurisdiction where no tax is levied. Many tax systems depend on the customer reporting the source from which he is provided; that cannot be required of Internet transactions because the customer does not necessarily know who or where the provider is.
Mr Karlin also points to the disintermediation which is already one of the Internet's most striking characteristics. Instead of people dealing with each other through an intermediary, they are able to deal direct; they no longer need the distributors, brokers, bankers and so on who put them in touch with each other in terrestrial business, because the Internet lets them do that for themselves. But these intermediaries are the people who report taxable transactions to the authorities, and they are essential to the tax system. No intermediary, no reporting.
Substantial taxable revenues will therefore just disappear, either because the activity is taxable only in another jurisdiction, or because the source of activity is not traceable, or because the activity will no longer be reported to the tax authorities. These legal and administrative problems arise even before one looks at encryption. Cheap and readily available software for encoding Internet messages is already on the market, at a cost of £100 or so. In theory, some of these codes could be broken, but if one considers that there will be billions of messages running through billions of alternative routes and using billions of coding possibilities, the tax authorities will not in practice be able to decipher them. In short, cyberspace is an impregnable tax haven, and unfortunately a haven for money laundering as well.
So far the US Treasury Department's response seems to be based on three rather unstable premises, with signs of the development of a new but very illiberal strategy. The first premise is that, as far as possible, Internet taxation should follow existing tax principles. The second is that new tax classifications should be avoided. The third is that the emphasis on taxation by source should be replaced by taxation by residence. As you cannot catch the electronic message, you go for the individual. This is already the strategy of the penal policies the Americans have adopted to stop their citizens giving up citizenship, to tax those who do, to refuse entry to the United States to those who have given up citizenship for what are deemed to be tax reasons, and to tax aliens who have been resident in the United States when they leave.
This is a real threat to turn the United States into a penal tax colony, and shows every sign of panic. In fact, an increasing number of highly paid intellectual activities can be pursued anywhere in the world. Just as the source of an electronic message cannot be identified, so most activities in intellectual property can be performed in any location and transmitted instantaneously. The United States strategy may drive its élite earners to leave early, and leave for good, but if it cannot identify the electronic transactions, it will still be unable to tax them.
This process of tax erosion is only beginning. Global electronic transactions will multiply again and again, and will become harder and harder to identify. Habits of tax payment formed in the period when transactions could be identified will weaken. Indirect taxes will become a more and more important part of revenue because you can tax what you can touch or see. Necessities will increasingly be taxed, because they are both identifiable and impossible to avoid. Property taxes will rise. Even so, the taxing capacity of governments as a percentage of gross domestic product will steadily be reduced. The tax take is likely to fall in most countries from around the French level of 50 per cent to around the Hong Kong level of 20 per cent. The ambitions of government will have to be reduced; in particular welfare systems in which most transfer payments go both from and to middle-class and middle-income people are likely to become both insolvent and unpopular.
The direction of change is unmistakable. The timing and scale are not so certain. A working assumption might be that the explosive collision between rising welfare costs and a shrinking tax base will come in the period between 2005 and 2010, three British Parliaments and three American presidential terms from now. The political debate may be about whether to cut expenditure, perhaps by about a third, or to try to penalise the taxpayer because the transactions cannot be identified. The penal policy will not work. You cannot tax the man with the laptop if you do not know who or where he is. The principle of Piedras Negras is going to change the world of the next century.