Economics and Technology, Inc. -- Views and News, November 2010

November 2010

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Has the Internet matured to the point where its tax exemption can be safely rescinded?

When Congress originally passed the Internet Tax Freedom Act (ITFA) in 1998, the measure was intended to bar the states from imposing “multiple and discriminatory” taxes on the nascent Internet access market and to provide the time necessary for the development of policy guidelines that would help avoid widely varying and inconsistent frameworks of State and local taxation. As stated in the Report of the House Commerce Committee:

H.R. 3849 was introduced for a number of reasons: (1) to ensure that the Internet service providers and online service providers are free from Federal and State regulation regarding the prices they charge to consumers; (2) to bar special Internet taxes, and multiple and discriminatory taxes on electronic commerce; and (3) to commission a study on State and local taxation of the Internet and to ensure that any taxation of the Internet or electronic commerce does not burden interstate or foreign commerce. These policies are inextricably linked to the success and development of electronic commerce.

The original Internet Tax Freedom legislation was narrowly tailored to achieve these goals. Actually, with respect to the first goal, it is unclear whether any additional Congressional mandate was even required. At the time, the FCC was already treating Internet and other online services as “information services,” making them exempt from rate regulation. The ITFA’s goal of preventing “multiple” and “discriminatory” taxation was also narrowly addressed. While barring the taxation of ISP services, the law nonetheless permitted states to tax the underlying telecommunications furnished to the Internet access provider and used by it as an input to its Internet access services. In other words, while Internet access was not to be “double-taxed,” the telecommunications used by the ISP to create its Internet access information service would be treated no differently than other telecom services. Finally, as enacted, the law was temporary in nature, and was set to expire after six years, in 2004. During that time, a special advisory commission on electronic commerce was established to study and prepare a report on various aspects of Internet-related taxation (including, inter alia, the impacts upon e-commerce activities and on state/local tax collection) That report was completed in 2000.

Since 1998, the ITFA has twice been extended beyond its original 2004 expiration date, and some have advocated that the law be made permanent. Meanwhile, the ITFA as modified no longer serves its original goals. Clearly, there remains nothing “nascent” about Internet access and the Internet economy in general, such that the emerging industry tax preferences embodied in the ITFA can no longer be justified. Moreover, the 2004 law had broadened the definition of “Internet access” in ways that go far beyond insulating ISPs from discriminatory taxes – they actually confer unique advantages not available to other economic sectors that compete directly with those doing business in cyberspace. Beginning with the 2004 law, the tax exemption was extended to include the underlying telecommunications used as an input to Internet access, and was further amended in 2007 to also apply to backbone transmission – a change that uniquely benefits ISPs relative to other retail and wholesale purchasers of telecommunications that were and that remain subject to state and local taxes.

To the extent that content accessed over the Internet is taxed differently from content distributed over transmission facilities that are not classified as Internet access, there is a distortion of the economic signals affecting consumer choices. If a state has one tax for telecommunications services and another for cable, and both of these compete with video programming that customers can download from services such as Netflix over their broadband connection, there can be three completely different tax treatments of similar services. (Last year Netflix alone accounted for 20.6% of peak period Internet downloads and real-time entertainment in the aggregate accounted for 47.5% of data consumption on fixed networks in North America. See accompanying article.) Under existing law, states may – and often do – tax video content provided as part of a “cable TV” service, but under the ITFA may not tax the Internet access transmission service (which uses the very same physical transport medium) used to download what is often identical content from the Internet.

The requirement for a “substantial nexus” for states to apply sales tax to a transaction occurring via the Internet creates an additional level of complexity. In its 1992 decision in Quill Corp. v. North Dakota, the U. S. Supreme Court held (consistent with precedent) that, for purposes of determining whether a state tax violates the Commerce Clause, there is a “sharp distinction” between mail-order sellers that have a “physical presence” in the state (who may be taxed) and sellers “who do no more than communicate with customers in the State by mail or common carrier as part of a general interstate business” (who may not). This distinction has resulted in a major disparity between sales tax requirements applicable to “pure” online retailers vis-a-vis those that also maintain brick-and-mortar retail outlets in particular states – even though in both cases the online purchase is typically accomplished entirely online, via the company’s website. Thus, a book seller that does business online and also at brick-and-mortar retail stores is required to charge sales tax on any online sale delivered to a jurisdiction where it maintains one or more retail outlets. However, online-only retailers, such as Amazon, have no such requirement. Indeed, earlier this year Amazon notified its Colorado-based “affiliates” (independent online merchants who do business via the Amazon website) that it was eliminating its affiliate program in Colorado in response to a new state law that would operate to confer a Colorado nexus upon Amazon generally and upon other online merchants that maintained relationships with Colorado businesses.

Even without the issue of nexus, legitimate concerns remain about the potential negative impacts of ISPs and Internet merchants having to administer inconsistent rules under fifty or more different tax laws. Although there has been significant study and discussion of how to simplify multi-state taxation of telecommunications and information services, the political and economic complexities (including non-uniformity of actual and perceived interests among various states) have thus far prevented a full consensus from developing. In the meantime, however, rather than being the target of burdensome and discriminatory taxation, activities connected with the Internet frequently enjoy an economic advantage over directly competing commerce in the “brick-and-mortar” economy.

Forrester Research has projected 2010 online retail sales at $172.9-billion, with year-over-year growth projected at 7%. While it is not possible to develop a precise estimate of lost sales tax revenue from this aggregate data, state+local sales taxes, where present, generally fall in the 6% to 10% range. On that basis, somewhere between $12- and $15-billion in annual sales tax revenues are being lost by state and local governments. Moreover, to the extent that customers are being encouraged to make purchases online from out-of-state retailers due to the opportunity to avoid sales taxes, local retail businesses are being injured, jobs are being eliminated, and other business tax revenues besides those from uncollected sales and use taxes are being lost as well.

Disparities in tax treatment distort technology choices. They may favor video downloads via the Internet over similar content offered by taxable cable television services. They may favor online retail transactions made with out-of-state sellers over taxable retail purchases made at local retail stores. Tax policy should be agnostic as to such choices, allowing the more efficient producers and processes to survive and to replace less efficient business models on their own respective economic merit. There can be no economic justification for these disparities to persist and, given the current challenges facing state and local governments, these loopholes need to be closed.

ETI has extensive experience with telecommunications and Internet taxation issues.

For more information, contact Helen Golding at hgolding@econtech.com

Read the rest of Views and News, November 2010.

About ETI. Founded in 1972, Economics and Technology, Inc. is a leading research and consulting firm specializing in telecommunications regulation and policy, litigation support, taxation, service procurement, and negotiation. ETI serves a wide range of telecom industry stakeholders in the US and abroad, including telecommunications carriers, attorneys and their clients, consumer advocates, state and local governments, regulatory agencies, and large corporate, institutional and government purchasers of telecom services.