The Internet: Why the Taxman Should Not Cometh

State politicians are in an uproar over a U.S. Senate bill,S. 150, that would prevent state governments from imposing taxes on Internet services. The state legislators are saying they need the money to balance their budgets.

Their efforts are misguided, and would stifle innovation.

Congress should make permanent the moratorium on Internet taxes -- first passed in 1998, and renewed in 2001 -- with two significant changes:

1. Ten states would have to end their existing taxes on Internet services that were in place before the first moratorium, and
2. The moratorium would be explicitly applied to telecommunications services used for Internet access.

Stark Choice About Innovation

An email circulating for several years now warns of a bill in Congress -- 602P -- which would place a tax on each email sent. The email is a hoax. But sometimes life imitates fiction, and Web surfers are rightfully suspicious that many politicians would like to tax their Internet usage. And even small taxes tend to become big taxes.

Yet, the debate transcends who will get a pot of money. It starkly illustrates a choice policymakers will make about innovation in America: 

• Are new technologies a Thanksgiving turkey to be tapped for government coffers?
• Or, will policymakers leave their hands off, enabling consumers to reap the full benefits of this golden goose?

History of Net Taxes

This Internet tax issue goes back to 1998, when Congress first passed a three-year moratorium on new taxes on the Internet. Barred were:

• New taxes on Internet access, and
• "Multiple or discriminatory taxes on electronic commerce."

In short, states and localities were barred from imposing taxes that were specifically targeted to the Internet, or were higher for the Internet. The moratorium was renewed in 2001 for another two years, expiring last Sunday.

Importantly, this moratorium did not specifically address the related issue of whether sales taxes can be imposed on Internet purchases. Such taxes were already limited by a 1992 U.S. Supreme Court decision limiting states' taxation to sellers with a sufficient "nexus" to their state. Recently, a number of states have agreed to an interstate agreement, which would allow such taxation. This agreement must be approved by Congress to become effective.

Permanent Tax-Free Surfing

The legislation now pending in Congress would make permanent the existing moratorium, with two significant changes:

1. Ten "grand fathered" states would have to end existing taxes on Internet services. Under the legislation the House passed last month, this would be immediate, while the Senate version allows for a three-year phase-out. This is sensible, as it makes no sense for these 10 states to be treated differently simply because they imposed taxes early.
2. Secondly, the moratorium would be explicitly applied to telecommunications services, used for Internet access. This has been a particular point of contention, as states are concerned that they would lose the revenue they receive from telephone taxation. The tax ban, however, would only apply to services used only for telecommunications services - such as high-speed DSL lines. Taxation of traditional, analog, voice telephone service would not be affected.

Critics say this still leaves a long-term worry for the states: What happens if the bulk of telephone service starts to travel over the Internet? For instance, they point out that "voice over Internet protocol," or VOIP technologies are predicted to take off in the next few years. Yet, these concerns are misplaced, for three reasons:

1. It will be years before VOIP is used comprehensively - allowing plenty of time for states or intern Congress to adjust.
2. Adoption of such new technology would provide huge benefits for the economy, possibly leading to economic growth (and tax revenues) far exceeding losses.
3. Perhaps most importantly, the states "worst case" scenario - a reduction in telephone taxes - may not be such a bad thing. Telephone service is one of the most heavily taxed in America - with consumers typically facing a half-dozen or so taxes and fees, averaging 25 percent of their bill. This system needs re-examination, not protection.

Good for Consumers, Not State Coffers

Over the past few weeks, legislators in Washington have been bombarded with facts, figures and arguments about this issue, one of the most hotly debated in years for technology policy. In the end, however, legislators have to make a choice: what kind of bird will the Internet be? One camp sees it as a fat Thanksgiving turkey, ready to be plucked and served, or a golden goose that can provide immense benefits, if left to do what it does best.

Making the ban on taxation of the Internet would be a good step forward for U.S. consumers and the economy. The Internet, and related digital technologies - have changed daily life for Americans, and its continued success may be critical toward reviving the U.S. economy. It cannot be seen as just another source of revenue for the taxman.