Making the “Internet Tax Freedom Act” Permanent Could Lead to a Substantial Revenue Loss for States and Localities

PDF of this report (23pp.)

By Michael Mazerov

Revised August 30, 2007

Key Findings:

  • Making the 1998 “Internet Tax Freedom Act” permanent — as proposed by S. 156/H.R. 743 — could adversely affect state and local government revenues, and therefore the availability of funds for important services like education, health care, and law enforcement, in three ways:
  • Potentially block states and localities from extending their normal sales taxes to music, movies, and television programming delivered over the Internet, which is rapidly becoming a major marketplace for such services.
  • Allow Internet access providers to try to escape a host of general taxes that other businesses must pay, such as sales taxes on equipment purchases;
  • Deprive nine states of $80m-$120m in annual revenues from non-discriminatory and heretofore grandfathered taxes on Internet access services;

The enactment of this legislation is unwarranted:

  • Studies by GAO and U. of Tennessee economists show that existing taxes on Internet access have not adversely affected household subscriptions to access or the availability of broadband access in particular locations.
  • All of the 14 developed nations that outrank the U.S. in broadband adoption do tax Internet access services. Taxation is not the issue.

Background

On May 23 and July 26, 2007, the Senate Commerce Committee and the Subcommittee on Commercial and Administrative Law of the House Judiciary Committee, respectively, held hearings on the “Internet Tax Freedom Act” (ITFA).  ITFA was enacted in 1998 and renewed in 2001 and 2004.  The law generally bars state and local taxation of “Internet access” services.  That means that state and local governments may not levy their normal sales taxes on the typical $10-$50 monthly charge that households and businesses pay to a company like America Online, Comcast or Verizon to be able to access the World Wide Web and use email.  State and local taxes on Internet access that were in effect prior to 1998 were “grandfathered” by ITFA, however, and this provision was maintained in both the 2001 and 2004 renewals.  The 2004 legislation extending ITFA also broadened it by barring state and local taxation of most telecommunications services involved in obtaining or providing Internet access, including high-speed “DSL” telephone lines.

ITFA sunsets on November 1, 2007.  As was the case in 2001 and 2004, bills have been introduced in both houses of Congress to make ITFA a permanent prohibition and to eliminate the grandfathering of pre-1998 taxes on Internet access.  The identical bills are H.R. 743/S. 156, the “Permanent Internet Tax Freedom Act of 2007” (PITFA).  The sponsors of PITFA are Representative Anna Eshoo and Senator Ron Wyden.  Both bills could be scheduled for mark-up at any time.

On May 23rd, the “Internet Tax Freedom Extension Act,” S. 1453, was introduced by Senators Tom Carper and Lamar Alexander as an alternative to PITFA.  S. 1453 would extend ITFA for four more years, but it would retain the grandfather provision and modify the definition of tax-exempt “Internet access” to address concerns long raised by state and local officials about the definition’s scope.

The Effects on State and Local Government Revenues of a Permanent ITFA

Making ITFA permanent and eliminating the grandfathering of existing taxes on Internet access could have three distinct, adverse impacts on the ability of state and local governments to raise revenues needed to fund health care, education, public safety, and other critical services: 

  • The current, extremely broad definition of “Internet access” in ITFA arguably encompasses virtually all goods and services delivered over the Internet.  Keeping this definition in a permanent ITFA could prevent states and localities from extending their conventional sales taxes to online music, movies, games, television programming, and similar products.

    A serious flaw in ITFA’s original definition of tax-exempt “Internet access” potentially would allow sellers of valuable “digital content” and similar services delivered over the Internet to avoid any state/local sales taxation of such content and services.  Two separate readings of ITFA’s “internet access” definition lead to such a conclusion.

    First, many sellers of such content, even if they do not truly provide an end-user with a connection to the Internet, arguably are selling “Internet access” as defined in ITFA: “a service that enables users to access content, information, electronic mail, or other services offered over the Internet. . .”  For example, the “Rhapsody” service sold by RealNetworks, Inc. streams an unlimited amount of music on demand to a subscriber for a fixed monthly fee.  Real Networks literally is providing “a service that enables users to access content. . . over the Internet.”  Accordingly, the company could take the position that the Rhapsody service is tax-exempt “Internet access” under ITFA’s definition and refuse to charge tax on it.[1]

    Second, the definition of “Internet access” includes “access to proprietary content, information, and other services as part of a package of services offered to consumers.”  Nothing in this definition places any limits on the type or quantity of such “content, information, and other services.”  Thus, any Internet access provider could achieve tax-exempt status for such content and services by “bundling” them with “Internet access” as conventionally understood and selling the package for a single, combined price.

    States and localities likely receive hundreds of millions of dollars in annual revenue from their sales taxation of conventional cable TV service and the hard-media versions of music, movies, software, and computer games sold in stores.  As is illustrated by the rapid growth of Apple Computer’s iTunes music service, the majority of such “digital content” is likely to be distributed over the Internet eventually.  The same is likely with respect to the majority of television programming, which in some parts of the country is already being distributed via so-called “Internet Protocol TV” (IPTV).  Accordingly, a permanent ITFA with a definition that seems to encompass all online content and services and that places no limits on what a telecommunications or cable TV company bundles with tax-exempt Internet access is likely to lead to a serious long-term drain on sales tax revenues.

    (See pp. 8-16 of the full report for an expanded discussion of this problem.)

ITFA Does Not Prohibit Taxation of Physical Goods Sold Over the Internet

The primary effect of the Internet Tax Freedom Act is to prohibit states and localities from applying their taxes to Internet access services — such as a sales tax on the $20 monthly fee that Verizon charges its customers for high-speed access.  This is the focus of the debate.

There is often confusion about whether ITFA also bars state and local governments from applying their sales taxes to physical goods ordered over the Internet — such as a book purchased from Amazon.  ITFA does not prohibit a sales tax on such a transaction, assuming that the tax would equally apply to the item if purchased in a local store. 

Most people are aware, however, that state and local sales taxes often are not charged on goods ordered over the Internet.  This is due to a 1992 U.S. Supreme Court decision that held that a state cannot require an out-of-state merchant to charge sales tax to the state’s residents unless the seller has a physical presence, such as a warehouse or call center, within the state’s borders.  Even if the merchant is not required to charge the tax, the purchaser is legally obligated to self-remit the tax to the state revenue department.  Of course, many purchasers are unaware of this requirement or choose to ignore it.

  • Eliminating ITFA’s grandfather clause could invalidate a wide array of state and local taxes currently paid by companies providing Internet access, such as sales taxes levied on their equipment purchases.

    Eliminating ITFA’s grandfather provision could have far-reaching, unintended consequences.  ITFA defines a “tax on Internet access” as “a tax on Internet access, regardless of whether such tax is imposed on a provider of Internet access or a buyer of Internet access.”  Because of the inclusion in the definition of taxes on Internet access providers, state and local officials have long been concerned that Internet access providers could take the position that a wide variety of taxes to which all types of businesses are subject constitute indirect taxes on Internet access services and are therefore banned by ITFA.  Acknowledging the legitimacy of such concerns, language was added to ITFA in 2004 expressly “carving-out” from the definition of a “tax on Internet access” four categories of taxes imposed on Internet access providers — taxes on “net income, capital stock, net worth, or property value.”  However, this list by no means covers all of the types of taxes Internet access providers may have to pay.  For example, it does not include sales taxes on computer servers purchased by such companies or state unemployment compensation taxes.

    The very limited coverage of the tax carve-out language added to ITFA in 2004 did not overly-concern state and local officials, because virtually all of the significant taxes on Internet access providers potentially at risk had been enacted prior to 1998.  Accordingly, ITFA’s general grandfather clause served as a back-stop to the explicit protection added in 2004.  With the grandfather clause eliminated, however, all state and local taxes on Internet access providers other than the four types carved-out in the 2004 provision could be at risk.  It is not at all clear that states could convince a court that any taxes except for the four types explicitly named are still legal when applied to an Internet access provider.  If anything, the fact that some taxes on Internet access providers were explicitly preserved might create an inference on the part of a court that Congress intended to ban all other taxes on providers.

    (See pp. 16-19 of the full report for an expanded discussion of this problem.)

  • If ITFA’s grandfather clause were repealed, state and local governments in nine states would lose existing revenues from currently protected taxes on Internet access services.

    If ITFA’s grandfather clause were repealed, Hawaii, New Hampshire, New Mexico, North Dakota, Ohio, South Dakota, Texas, Washington, and Wisconsin — and some of their local governments — would lose collectively between $80 million and $120 million in annual revenue flowing from previously-grandfathered taxes on Internet access services.  These figures were developed by the Congressional Budget Office at the time ITFA was last renewed in 2004 and are still believed to be a reasonably accurate estimate of the current direct revenue loss from eliminating the grandfather provision.[2]  Revenue losses of this magnitude are sufficient to trigger the provisions of the Unfunded Mandates Reform Act of 1995, which classifies federal preemptions of state and local taxing powers as an unfunded mandate.  Most of the taxes directly affected by repeal of the grandfather clause are conventional state and local sales taxes that apply to a wide array of goods and services in addition to Internet access. 

    In and of itself, the direct impact of repeal of the grandfather clause on revenue in the affected states is not significant.  In combination with the other impacts discussed above, however, state finances would be adversely affected.  Due to balanced-budget requirements, these nine states and their affected local governments would either have to reduce state services or increase other taxes to compensate for the lost revenue. 

A Permanent Extension of ITFA Is Unnecessary and Unwarranted

Apart from the damage that would be done to state and local government finances, there is no justification for either eliminating ITFA’s grandfather clause or making ITFA permanent: 

  • Ten years ago, Internet commerce was still in its infancy, and high-speed Internet access was just beginning to become available to individual households.  In considering ITFA, Congress needed to balance the interests of state and local governments in being able to finance essential services and its desire to encourage the development of the Internet industry.  Even in 1998, Congress decided that striking that balance entailed grandfathering existing taxes and prohibiting new taxes on Internet access only temporarily.

    Today, almost 70 percent of American households subscribe to Internet access services, and hundreds of billions of dollars worth of commerce is done over the Internet annually.  These facts raise significant questions as to whether there is any need to continue treating the Internet as an “infant industry” and exempting it from state and local taxes that other industries must pay.  But even if Congress wishes to renew ITFA, surely the Internet’s 2007 vitality demands that it be granted tax treatment no more favorable than what it received in 1998 — temporary protection, with pre-1998 taxes still grandfathered.

  • Making ITFA permanent would represent a fundamental breach of faith with state and local government officials.  As documented in the text box below, when ITFA was first considered in 1997-98, Internet industry representatives and the adopting committees alike disavowed any intention to make the Internet a permanent “tax-free zone.” ITFA has repeatedly been described as a “moratorium” on state and local taxation.  A “permanent moratorium” is a contradiction in terms.[3]
  • Studies by both the Government Accountability Office and economists at the University of Tennessee find that the existing, low taxes on Internet access in the grandfathered states have not had an adverse impact on either household decisions to purchase Internet access services (“uptake”) or industry decisions concerning where to make “broadband” (high-speed) Internet access services available (“deployment”).[4]  Both studies use statistical techniques that correct for differences between the taxing and non-taxing states in income and education levels, population density, and other factors that might affect Internet uptake (by consumers) and deployment (by providers).   The studies find that the existing taxes on access in the grandfathered states have not had statistically-significant impacts on either uptake or deployment.  (See the Appendix of the full report for a more detailed description of both studies.)
  • All of the 14 developed nations that have achieved a higher rate of household broadband adoption than has the United States subject Internet access services to the normal consumption taxes that apply to household purchases.  These taxes are often imposed at rates that are 2-3 times higher than typical combined state and local sales tax rates; indeed, the world leader in broadband penetration, Denmark, taxes Internet access at a 25 percent rate. (See Table 1 in the full report.)  Clearly (and as verified in the GAO and University of Tennessee reports cited above), non-discriminatory taxation of this service is consistent with healthy rates of household broadband adoption.

Sales Taxes Are a Critical Revenue Source for State and Local Governments

Sales taxes are a vital source of revenue for state and local governments.  The possibility that ITFA might interfere with applying normal sales taxes to online “digital content” and services in the future creates a major risk for the ability of states and localities to provide the education, infrastructure, public safety, and health care services for which they are responsible.  Sales taxes comprised 24 percent of combined state and local tax receipts in 2005.  They represented 33 percent of state taxes and 11 percent of local government taxes.

Sales taxes are especially important to Florida, Nevada, South Dakota, Washington, and Wyoming, which have no state income taxes, and to New Hampshire and Tennessee, which have only limited income taxes. In Florida, for example, sales taxes provide 34 percent of all state and local tax receipts.  Sales taxes are also important to local governments in many states because the only other significant tax they are permitted to levy under state law is the property tax.

The few states that were grandfathered under ITFA to continue taxing Internet access are often criticized for targeting or singling-out Internet access for taxation.  This accusation is inaccurate.  Sales taxes are intended to be broad taxes on consumption, on what people spend their money on.  Grandfathered states typically apply their sales taxes equally to cable TV and Internet access, for example.  Indeed, non-grandfathered states are discriminating in favor of Internet access; it is arguably unfair to impose a sales tax on a person who chooses to allocate $40 of her monthly budget to cable TV service while exempting someone who chooses to spend $40 of her budget on high-speed Internet access.

If ITFA is to be extended, it is critically important that its definition of tax-exempt “Internet access” be amended to ensure that digital goods and online services that do not constitute true Internet access — that is, a connection to the Internet — cannot be considered sales-tax-exempt. Otherwise, the inequity already created by the tax exemption for Internet access described above could be compounded further: people who choose to rent DVDs or video games at the local video store will pay sales taxes, while people who download them online will be tax-exempt.

Making ITFA Permanent: A Breach of Faith with State and Local Governments

When the Internet Tax Freedom Act was introduced in 1997, its moratorium on the taxation of Internet access service was justified as a temporary “time out” to ensure that a variety of complex administrative and definitional issues that can arise in the taxation of this service could be addressed carefully and uniformly by state and local governments.  For example, sponsors objected to the fact that Internet access was defined as a “telecommunications service” in some states and as an “information service” in others.  They also raised concerns about potential double-taxation of Internet access by people who connected to their service provider in multiple states.

In the nearly two years that it took to enact ITFA, these aims were restated many times by ITFA proponents in both Congress and the private sector.  At no time did ITFA supporters suggest that Internet access was deserving of or needed permanent tax-exempt status:

  • In July 1997 testimony, Michael Liddick, director of taxes for AOL, stated: “The Act provides the opportunity for federal and state policymakers, industry members and other concerned citizens to work together to develop a uniform, fair and simple state tax system that will be administratively feasible for industry members and other affected taxpayers. . . . AOL believes that the temporary moratorium provided by the Act . . . will allow the development of effective tax policies that maximize the welfare of all concerned persons in the context of a process which respects the rights of states to determine their individual tax policies subject only to normal constitutional limitations.”  [Emphasis added.]
  • A year later, Jill Lesser, AOL Director for Law and Public Policy, testified: “We are also not here to avoid paying taxation [sic] or to set up a system ultimately that basically holds the Internet as a tax-free zone.  We are here to talk about Internet tax neutrality. . . [W]e hope at the end of the discussions. . . that there will be a uniformed [sic] system of taxation, one that gives guidance about, for example, what it means to be providing Internet access. . . In addition, where customers should be taxed [and] how we should collect.  Once we solve all of those problems, all of the revenues that I spoke about will actually I imagine be subject to some kind of taxation.”
  • The Senate Commerce Committee report on ITFA expressed similar goals: “Most State and local commercial tax codes were enacted prior to the development of the Internet and electronic commerce.  Efforts to impose these codes without any adjustment to Internet communications, transactions, or services. . . will lead to State and local taxes that are imposed in unpredictable and overly burdensome ways. . . [A] temporary moratorium on Internet-specific taxes is necessary to facilitate the development of a fair and uniform taxing scheme.” [Emphasis added.]
  • The House Judiciary Committee report on ITFA stated: “[T]his is the appropriate time. . . to pause and examine the welter of issues raised by electronic commerce and to create a coordinated and rational subfederal tax structure.  For this proposition, the Committee finds support in the Clinton Administration’s Framework for Global Electronic Commerce.  That document . . . recommends that ‘[b]efore any further action is taken, states and local governments should cooperate to develop a uniform, simple approach to the taxation of electronic commerce, based on existing principles of taxation where feasible.’”

Now, ten years later, the fears of state and local government representatives about this “temporary time-out” have been substantiated.  After having made little effort in the intervening years to implement the stated goal of ITFA to “facilitate the development of a fair and uniform taxing scheme” applicable to Internet access, Congress is again considering permanently banning taxes on this service.  States and localities may continue to impose their sales taxes on long-distance phone calls and faxes, voice mail, cell phone text messages, cable TV, and a host of other services for which Internet access and e-mail are close substitutes.  Permanently enshrining such tax discrimination in federal law would be unwise.

It is questionable whether any extension of ITFA is warranted.  Originally justified on the grounds of preventing alleged tax discrimination against the Internet, ITFA has instead fostered discrimination in favor of it.  A business that pays $50 per month for a conventional phone line attached to a fax machine pays state and local taxes on the phone line and long-distance calls; a business that pays $50 per month for a DSL phone line used to transmit as e-mail attachments the exact same kinds of documents is exempt from state and local taxes on the DSL line.  A person who sends a message as a conventional cell phone text message on a Blackberry pays state and local taxes on the message; if she sends the exact same message on the exact same phone as an e-mail or Internet “instant message” the transmission is tax-exempt.  Such a state of affairs can hardly be characterized as “technological neutrality” — the long-time mantra of many ITFA proponents.

The Choice Confronting Congress

There are three choices that Congress could make this year:

  • Congress could enact the Wyden-Eshoo bill (S. 156/H.R. 743), with its permanent prohibition in all states of the taxation of “Internet access” — as expansively defined in ITFA.
  • Congress could enact the Carper-Alexander bill (S. 1453), with its temporary ITFA extension that preserves the current grandfather clause and begins to address the problems with ITFA’s definition of “Internet access.”
  • Congress could allow ITFA to expire and return the decision as to whether to tax Internet access services to the discretion of state and local elected officials.

The best policy would be to allow ITFA’s prohibition on taxation of Internet access to expire.  If that is not possible, the Carper-Alexander bill is the better of the remaining two options.  Carper-Alexander will fully maintain the existing ITFA moratorium on state and local taxation of Internet access for four more years.  It will preserve the grandfather clause, ensuring that routine taxes on Internet access providers will not be unintentionally invalidated.  It will, for the first time since 1998, reform the definition of Internet access and limit it to its original conception of encompassing a direct connection to the Internet and closely associated services (like email and instant-messaging).  It will compel Congress to reevaluate both ITFA’s continuing relevance and its impact on state and local governments in 2011 in light of what seems likely to be a very different Internet economy in existence at that time.

Click here to read the full-text PDF of this report (23pp.)

End Notes:

[1] Rhapsody does not, in fact, charge sales tax on its service in any state.  (E-mails from two different representatives at Rhapsody Customer Support dated May 24, 2007 and June 6, 2007.)  It is not known whether this is due to the company’s interpretation of ITFA, an interpretation that its service is not subject to tax in any state under state law, and/or an interpretation that it is not obligated to collect any applicable state sales tax because it does not have a physical presence in any state sufficient to create a taxable “nexus.”  See the expanded discussion of this issue on pp. 16-17 of the full report.

[2] Congressional Budget Office Cost Estimate on S. 150, Internet Tax Nondiscrimination Act, September 9, 2003.

[3] The Merriam-Webster dictionary defines a “moratorium” as “a legally authorized period of delay in the performance of a legal obligation or the payment of a debt” or, alternatively, as “a suspension of activity.”  A “suspension” is further defined as a “temporary abrogation of a law or rule.”  Emphasis added.

[4] United States Government Accountability Office, Broadband Deployment Is Extensive throughout the United States, but It Is Difficult to Assess the Extent t of Deployment Gaps in Rural Areas, report GAO-06-426, May 2006, pp. 21-22, 31-32, and Appendix III. Donald Bruce, John Deskins, and William F. Fox, “Has Internet Access Taxation Affected Internet Use?” Public Finance Review, V. 32, No. 2, 2004.

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