The Economic Impact of Taxing Internet Access

Report Technology

The Economic Impact of Taxing Internet Access

February 11, 2004 6 min read

Authors: Norbert Michel and William Beach

The Internet Tax Freedom Act of 1997 imposed a moratorium on taxing Internet access, which expired in November 2003. The House passed legislation to continue the moratorium, but the Senate has failed to pass a corresponding bill. Critics of the House bill contend mistakenly that it does more than extend the moratorium and threatens states' ability to collect sales taxes. Even if this were the case, though, economic analysis predicts that such taxes would reduce GDP, disposable income, and employment.


Legislative Background

The House bill ( H.R. 49), sponsored by Representative Christopher Cox (R-CA), permanently prohibits Internet access taxes, such as fees that would be added to an America Online bill. In the Senate, George Allen (R-VA) and Ron Wyden (D-OR) introduced a bill ( S. 150) that would permanently extend the access tax ban and extend its scope. Complicating matters, Lamar Alexander (R-TN) and Thomas Carper (D-DE) are expected to introduce another bill this week that would extend the moratorium for only two years, with a more limited scope, thus allowing many more services to be taxed.[1]

In addition to the competing versions of the legislation, the fact that critics have unfairly linked H.R. 49 to separate tax issues further diminishes prospects for a quick resolution.


Two Taxes, Two Separate Issues

For several years, state and local governments have complained that Internet commerce threatens their ability to collect sales taxes.[2] Now, groups such as the Multistate Tax Commission (MTC) have pinned the sales tax issue on H.R. 49. For instance, a new MTC report says that H.R. 49 goes "…beyond access by customers to the Internet…" and that it expands "…the scope of the preemption to income, property and other business taxes…"[3]

In fact, there is nothing in H.R. 49 (or S. 150) that prevents governments from levying these taxes. Nonetheless, the MTC claims that H.R. 49 would "…reduce revenues from current taxes levied by the 50 states, the District of Columbia and local governments a minimum of $4 billion and up to $8.75 billion annually by 2006." The MTC also notes that, because their estimates do not include the full impact of the bill, they are "conservative" in nature.


Economic Impact of Taxing the Internet

In effect, the MTC is saying that H.R. 49 would reduce "income, property and other business taxes" relative to current levels. Since the bill only deals with Internet access taxes, this claim seems somewhat dubious. Still, their estimates imply that H.R. 49 would lower taxes and thus contribute to economic growth in the private sector.

Of course, the MTC does not want these taxes to be reduced; they maintain that governments need these funds. An interesting question, therefore, is, would these taxes negatively impact economic activity? To investigate this possibility, CDA analysts converted the MTC's estimates into increases in the average effective personal income tax rate (at the federal level).[4]

These changes in the tax rate were introduced into the Global Insight (GI) model of the U.S. economy beginning with the first quarter of 2004.[5] Taxes were allowed to remain above baseline (or those levels without any access tax) through the fourth quarter of 2013.[6] The GI model produced two sets of estimates, one that depends on the MTC's "low" forecast of revenue reductions and the other that depends on the "high" forecast.

By the fourth quarter of 2006 - when the MTC believes the full impact of the revenue reductions will be felt - the GI U.S. Macroeconomic Model predicts the following outcomes:

  • Total non-farm employment is lower by amounts that range between 91,000 and 209,000 workers;
  • The nation's unemployment rate rises from 5.44 to 5.47 percent in the low revenue scenario, and from 5.44 to 5.53 percent in the high revenue scenario; 
  • Inflation adjusted Gross Domestic Product falls by amounts between $8.7 billion and $19.6 billion (between $79.10 and $178.21 per household);
  • Personal consumption falls by amounts ranging between $4.1 billion and $9.2 billion (between $37.28 and $83.65 per household); and
  • Inflation-adjusted disposable personal income (income left over after taxes have been paid) falls by amounts between $11.3 billion and $25.4 billion (between $102.74 and $230.95 per household).

Taxes Slow Growth

By the MTC's own assumptions, failing to implement H.R. 49 would come with an economic price. Not only would these taxes slow the growth of the Internet's penetration rate (and perhaps its usage), but they would also slow economic activity throughout the country. Tax increases, especially when levied on an activity engaged in by a large percentage of the population, frequently have a negative impact on economic activity.[7]

The estimates above are suggestive of how important Internet technology is to our economy. And, it is precisely because the technology sector has been a key source of economic growth in the U.S. that it is an attractive source of tax revenue for various constituents. Interestingly, these groups are discovering that the technology itself presents serious challenges to conventional methods for collecting taxes.


Technology Threatens Tax Collections

Contrary to what the MTC may argue, state and local governments only have a "right" to collect taxes in the statutory sense. In other words, popularly elected officials have passed legislation giving themselves the right to impose and collect taxes, but they have no inherent right to collect any taxes. If recent technological changes make it harder for governments to collect taxes, then they also make it easier for individuals to keep their own money.


Norbert J. Michel, Ph.D., is a policy analyst in, and William W. Beach is director of, the Center for Data Analysis at The Heritage Foundation.

[1] Part of the controversy over H.R. 49 (and S. 150) stems from the difficulty in conclusively defining "Internet Access." For instance, the Alexander-Carper bill would exclude from taxation Internet transmissions directly to consumers, but not transmissions on the Internet "backbone."

[2] See Jennifer Beauprez, "Governor Opposes Net-tax Bill: Owens to Testify in Congress Against Proposed National System," Denver Post, September 29, 2003, pg. E01.

[3] Dan Bucks, Elliott Dubin and Ken Beier, "Revenue Impact on State and Local Governments of Permanent Extension of the Internet Tax Freedom Act," September 24, 2003. This report is available at /static/reportimages/83C97EC44525A5EED8F4E9629898DB57.pdf.

[4]Instituting a tax at the federal level and instituting the same type of tax at the state level (in all 50 states) would be expected to produce similar outcomes.

[5]CDA used the DRI-WEFA Mark 11 U.S. Macroeconomic Model, owned by Global Insight, to conduct this analysis. The model was developed by Nobel laureate Lawrence Klein and several col­leagues at the University of Pennsylvania's Wharton School of Business. The methodologies, assumptions, conclusions, and opinions in this report are entirely the work of Heritage Foundation analysts. They have not been endorsed by and do not necessarily reflect the views of the owners of the model.

[6] Additional information on the methodology for these simulations is available from the authors upon request.

[7] The U.S. Department of Commerce estimates that, by September 2001, 174 million people were using the Internet in the U.S. (66 percent of the population). See U.S. Dept. of Commerce, "A Nation Online: How Americans Are Expanding Their Use of the Internet," February 2002.


Norbert Michel
Norbert Michel

Former Director, Center for Data Analysis

William Beach

Senior Associate Fellow