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Repealing Internet Tax Freedom Act’s “Grandfather Clause” Could Harm All States

Legislation before Congress to repeal the Internet Tax Freedom Act’s (ITFA) “grandfather clause” could cost all states money, not just the seven states that the clause authorizes to continue taxing Internet access services directly.  That’s one reason among many why the House and Senate should reject this legislation (which would also permanently extend ITFA) when it comes up for separate votes in the next few days.

Enacted in 1998 and renewed several times, ITFA temporarily prohibits states and localities from taxing monthly subscription fees for fixed and mobile Internet access.  The grandfather clause permits the seven states that directly taxed this service in 1998 — Hawaii, New Mexico, North Dakota, Ohio, South Dakota, Texas, and Wisconsin — to keep doing so.

This week, long-time proponents of making ITFA permanent attached a permanent extension to an unrelated measure covering federal customs and border protection.  The legislation also would repeal the grandfather clause in 2020. 

Repeal would deprive these seven states of several hundred million dollars in annual revenue.  It also would place every state and thousands of local governments at risk of losing tax dollars they use to pay teachers and police, provide financial aid to state university students, repair roads, and provide other critical services. 

That’s because the clause preserves not only the seven states’ pre-1998 direct taxes on Internet access service but also all states’ pre-1998 taxes that could be considered indirect taxes on Internet access.  Examples include 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.  (For more, see this section of my 2014 analysis.)

Internet access providers haven’t used ITFA too aggressively to challenge these kinds of taxes because they know that Congress might close any loopholes they exploited the next time it renewed the law.  But permanently repealing the grandfather clause and permanently extending ITFA would eliminate this constraint.  It could open the floodgates to legal challenges to state and local taxes on Internet access providers that many congressional supporters of ITFA probably didn’t intend to ban.

The best course would be to simply let ITFA expire.  There’s no longer any justification for banning states and localities from imposing the same taxes on Internet access service that they impose on cable TV, telephone calls, physical books, and other ways to transmit entertainment and information.  But if lawmakers want to make ITFA permanent, they should do so in conjunction with legislation now before Congress empowering states to tax most online purchases by consumers, in order to offset the revenue loss. 

And, if lawmakers make ITFA permanent, it’s essential that they make the grandfather provision permanent as well.  If Congress makes ITFA permanent but doesn’t do the same for the grandfather provision, it will harm every state’s ability to finance critical state and local services.