Virtual Sales, Real Tax

According to an article in Forbes, “Taxing Virtual Worlds,” Congress has begun holding hearings about taxing commercial activity in virtual worlds.   Discussions included the taxability of “buying” weapons in World of Warcraft, and commercial exchanges in the virtual world of Second Life.  If it weren’t so scary, it’d be funny.  Studies and research are under way estimating the potential tax revenues.  I know that Congress operates on an “if it moves, tax it” principle, but isn’t it depressing to see our tax dollars put to work figuring out new ways to tax people more?

Examining virtual worlds for taxable activities will, of course, raise all kinds of issues about how to apply the current convoluted tax code from First Life to virtual activity.  There is precedent for taxing gaming if you equate gaming online to gaming in Las Vegas on on game shows, where winnings are definitely taxable.  And then you have to figure out how to calculate realized gain–when you make a profit in Second Life’s Linden dollars or when you cash out into US dollars?  How do you establish fair market value for gifts and exchanges?

What isn’t discussed is how actions, like taxation, impact a whole system, change human behavior, and have unexpected and undesired consequences.  Creating taxable events in virtual worlds will have a ripple effect on behavior, technology use, innovation, and who knows what.  Some of it we can predict, some of it will be a total surprise.  But since I know that, shockingly, the government budget office is not allowed to estimate changes in people’s behavior in response to changes in tax policy when it estimates tax revenues of proposed tax increases, I’m pretty confident that Congress isn’t trying to anticipate the ripple past the tax coffers. It seems pretty obvious that people do adjust their behavior to pressures and incentives and vitual worlds will be no different.

So what would happen in Second Life or Club Penguin if Congress decides that commercial activity (trading, buying and selling stuff)  needs to be taxed?  Well, first of all, Lindens and Penguins alike would have to assume massive reporting obligations to keep track of all the transactions and apply, charge, collect and report a sales tax.  The cost of that bookkeeping could be sufficiently onerous that they would have to pass costs on to their consumers (or residents in Second Life parlance.)  Higher costs would impact non-committed users behavior, lowering the number of active community members.  Residents would also have to keep records of their transactions and include them in their income tax statements, or perhaps Avatars could file separately so they were subject to a lower tax bracket.  Would that effort to keep accounting records offset the enthusiasm for experimentation and innovation that virtual worlds create?  Will reduced usage change the nature of the growth path of virtual worlds, incentives to learn the relevant computer and technical skills, or make them only for people for whom the profit is sufficient to bear the cost and aggravation of reporting requirements?  Is a virtual world like Second Life the same as the World of Warcraft.

By all reports, the amount of tax revenue would, at this point, be quite small.  The amount of time and resources that Congress would spend to clarify all the applications of taxation in virtual worlds would be better spent on any number of our more pressing social problems.  Beyond that, however, the experience of the virtual environments would be altered if they were forced to comply with federal tax law–and what about the states?  They’ll want their share, too!  This would  change who uses virtual worlds and how they are used.  We should be doing everything possible to encourage people to engage in different kinds of media development and technology skill-building because the opportunities of the future will come from comfort navigating and using information in multiple communication environments.   Congress needs to be mindful that seemingly small actions can undermine environments that encourage innovation, experiential learning and entrepreneurship.  Clearly they have never played Sim City.