Congress poised to slam states on Internet access charges

The House is slated to vote this week on a bill to permanently bar states from applying their normal sales taxes to the monthly charges that households and businesses pay companies like Comcast or Verizon Wireless for Internet access – potentially costing states roughly $7 billion a year in potential revenue.

For starters, the bill would strip Hawaii, New Mexico, North Dakota, Ohio, South Dakota, Texas, and Wisconsin of at least $500 million in annual state and local revenue from their existing taxes on these charges.

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Beyond costing states the $7 billion a year in potential revenue to support education, healthcare, roads, and other services, the bill would violate an understanding between Congress and the states dating back to the 1998 Internet Tax Freedom Act (ITFA):  that any ban on applying sales taxes to Internet access charges would be temporary and not apply to existing access taxes. 

Enacted when Internet commerce was still in its infancy, ITFA sought to balance Congress’ desire to encourage development of the Internet against states’ and localities’ need to finance essential services.  Thus, it imposed only a temporary “moratorium” on new taxes on Internet access and protected existing taxes through a “grandfather” clause.  

Congressional extensions of ITFA in 2001, 2004, and 2007 maintained those two key features.  This latest ITFA legislation, though, eliminates both — the first time Congress has seriously considered doing so.

Every state would feel the impact.  The seven states with taxes would start losing revenues this year, forcing some to cut services or raise other taxes to keep their budgets balanced.  The remaining states would continue to lose as much as $6.5 billion in potential revenue each year from their inability to tax Internet access charges. 

The forgone revenue would likely grow substantially over time as more people sign up for Internet access and current subscribers trade up to faster, more expensive, service.

The House bill would have other, unintended effects.  Eliminating the grandfather, for example, 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 fiber-optic cable, or gasoline for their vehicles.  Almost all of these taxes existed before 1998, so the grandfather protects them from legal challenge.  But if Congress eliminates the clause, Internet access providers could challenge these taxes in court as indirect taxes on access service and therefore voided by ITFA.

The bill’s proponents argue that banning taxes on Internet access charges is necessary to close the “digital divide” between low- and high-income households.  Keeping monthly Internet access as inexpensive as possible by exempting it from roughly $2-$4 in taxes will encourage low-income people to subscribe and service providers to extend broadband service to low-income neighborhoods, they claim.

But there’s scant evidence to support this argument.  Studies haven’t found a significant difference, in either the share of households with broadband or the availability of broadband service, between states that tax access and those that don’t.  And numerous studies find that Internet access costs are a smaller cause of the “digital divide” than unfamiliarity with computers and the Internet and a belief that the Internet is irrelevant to the person’s life. 

In fact, a permanent ITFA would likely impede the goal of getting more people online — especially low-income people who don’t have Internet at home.  Many people first use the Internet in public schools, libraries, and community centers, all of which rely on state and local tax revenue.  The less state and local revenue that such institutions receive, the less they could provide Internet service.

Some in Congress argue that states and localities should accept a permanent ITFA as part of a deal that would also include enactment of the Marketplace Fairness Act, which would empower states to require large Internet merchants to charge sales tax on all taxable sales.  Any extension of the moratorium, however, must include the grandfather clause.  Eliminating that clause would threaten to invalidate many existing taxes on Internet access providers, as noted earlier.

Congress’ proper course would be to end, not extend, the ban on state and local taxation of Internet access.  The Internet is no longer an infant industry needing protection from taxes that apply to other services for which Internet access is a close substitute.  Cable television service is widely taxed, for example, but if someone decides to pay Verizon $50 a month so that they can stream Netflix to their TV, ITFA bans the taxation of the access charge.  This unequal treatment doesn’t makes sense. 

Even if Congress wants to renew ITFA, surely the terms should be no more favorable than in 1998 — a temporary exemption for taxes on access service, with pre-1998 taxes still grandfathered — and must include the Marketplace Fairness Act, which the Senate has passed with broad bipartisan support.

Mazerov is a senior fellow with the State Fiscal Project of the Center on Budget and Policy Priorities.