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No Justification for Permanently Banning Sales Taxes on Internet Access Charges

For the first time since Congress enacted the Internet Tax Freedom Act (ITFA) in 1998, lawmakers are seriously considering permanently extending the moratorium on new state and local sales taxes on Internet access service and eliminating the “grandfather clause” exempting existing taxes — changes that could cost states $7 billion a year in potential annual revenue.  Our new paper explains why Congress should do the opposite: allow all states to apply their normal sales tax to this service, just as they tax similar communication and entertainment services like long-distance telephone service and cable TV.

Even if Congress isn’t prepared to let ITFA lapse, there’s no justification for making the law permanent and eliminating the grandfather clause, as a bill that the House is expected to consider next week would do.  Congress can achieve all of its major objectives by enacting another temporary extension that leaves the grandfather clause intact.

A temporary extension would ensure that no new states and localities tax Internet access.  It also would continue ITFA’s ban on “discriminatory taxation” of Internet access service and other types of Internet commerce — for example, taxing these items at higher rates than other kinds of interstate communications or consumer purchases.

At the same time, another extension would avoid the problems that the House bill would cause, namely:

  • Eliminating the grandfather clause would strip Hawaii, New Mexico, North Dakota, Ohio, South Dakota, Texas, and Wisconsin of at least $500 million in annual state and local sales tax revenue they use to pay for education, police, and other services.  These states (and many of their localities) would have to reduce services or increase other taxes to offset the revenue loss. 
  • Eliminating the grandfather clause would put at risk numerous other state and local taxes that Internet access providers pay on the things they buy in order to provide Internet service, such as computer servers, fiber-optic cable, or even gasoline for their vehicles.  Almost all of these taxes existed before 1998, so the grandfather clause protects them from legal challenge.  But if Congress eliminates the clause, Internet access providers could challenge these taxes in court as indirect taxes on Internet access service and therefore voided by ITFA. 
  • Permanently extending ITFA risks widespread legal challenges by Internet merchants to a host of state and local taxes based on the law’s prohibition of discriminatory taxes on electronic commerce.  ITFA’s definition of “discriminatory tax” is broad and vague, but Internet companies have largely refrained from using it to challenge state taxes because they knew that if they were too aggressive, ITFA opponents could use this to argue for repealing the law when it came up for renewal.  But with ITFA permanently on the books, that restraint would disappear, potentially leading to widespread litigation.

Congress first enacted ITFA when Internet commerce was still in its infancy and high-speed Internet access was just becoming available to individual households.  Congress sought to balance state and local governments’ need to finance essential services against Congress’ desire to encourage the development of the Internet industry.  Even then, Congress decided that striking that balance entailed grandfathering existing taxes and prohibiting new taxes on Internet access only temporarily.

There is no 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 its tax treatment should be no more favorable than in 1998 — a temporary exemption for taxes on Internet access service, with pre-1998 taxes still grandfathered.