As electronic commerce continues to gain momentum, and as the national and international barriers to e-commerce continue to tumble, governments are wondering what to do about a major problem that a decade ago didn’t even exist.

In a paper titled "Taxing the Net: Governing the Digital World Economy" (published in World Link magazine as "The Tax Man Cometh"), Stephen J. Kobrin, director of Wharton’s Lauder Institute, examines the downside to electronic commerce – the potentially huge pot of revenues that state and local governments may miss out on because they don’t collect sales or income tax on many Internet-based transactions.

Kobrin notes that American cities, counties and states typically levy a sales tax on most retail transactions, which is collected by merchants and turned over to the appropriate government tax authorities. In Europe, the revenue is similarly generated through a value added tax.

But tracking and collecting these are difficult when the sales medium is the Internet. Besides the fact that there may be no audit trail with electronic payments, a more basic issue arises: Which jurisdiction’s tax laws take precedence?

"Consider a consumer in France who downloads her favorite album from a Web site in the U.S., which may well be linked to a number of music companies’ servers in other countries," observes Kobrin. "Where does the transaction take place? Where should sales or value added tax be paid?"

Similar problems arise with the issue of income tax.

"Generally, income is taxed at its source, in the jurisdiction where it is created," Kobrin says. "However, as the U.S. Treasury notes, in cyberspace it is difficult if not impossible to apply source concepts…’to link…income with a specific geographic location.’"

Assume a hypothetical programmer in Bangalore, India installs, via the Internet, a software upgrade to a computer in a bank in New York City. "Where did the transaction take place?" asks Kobrin. "What happens if the programmer is a freelancer working on a powerful portable who moves from country to country? How do you determine which country or locality imposes sales/value added or income taxes?"

The numbers are mind-boggling. American local and state governments, for example, will forgo sales taxes on the $100 billion retail e-commerce market that is forecast by 2003, he says. Worldwide, governments will give up value added tax on $1 trillion of business-to-business transactions.

Kobrin argues that even a minimalist approach to government assumes a need for a sizeable tax base. "Streets and bridges have to be repaired, children educated, justice systems run, wars and police actions fought and heath care provided," he says. "Commerce, whether physical or virtual, is going to be taxed. The questions are how and by whom?"

While many aspects of electronic commerce are truly revolutionary, a market is a market whether real or virtual. It is a "place" where goods and services are bought and sold, according to Kobrin. "No market, virtual or real, can exist in compete isolation," he says. "Instead it must be embedded in a social order to survive. That requires some minimal social control over economies and economic actors."

He admits that it will not be an easy task.

Quoting an official from the International Monetary Fund, Kobrin notes that "the tax systems of many countries originated when both international trade and capital flows were very limited. The current, geographically-based system of taxation can barely cope with globalization, multinational firms, transfer prices, tax havens and tax competition, much less the Internet."

As the migration of markets to the web renders geographic jurisdiction, including national markets, much less meaningful, Kobrin urges the consideration of an international tax organization to administer tax collection, and perhaps take on responsibility for the collection of taxes.

But he cautions that even if tax codes are harmonized ( and the current experience in the EU makes that seem unlikely) and complete information becomes available, the conceptual problems of trying to map geography on cyberspace remain.

"These questions are not going to be answered by calls for a moratorium on Internet taxes," he says. "As business migrates to the Internet, sales/value added and perhaps even income taxes are going to become increasingly problematic. New principles and modes of taxation will have to be developed. Perhaps most important, the very concept of geographic tax jurisdiction will become much less meaningful. The ‘where’ question is unanswerable. If strangulation of e-commerce by means of thousands of tax jurisdictions claiming a piece of the action is to be avoided, new non-geographic, and perhaps non-national, modes of collection have to be developed. It is important that multinational firms and their leaders play an informed role in this process."