Where They Have Taxes Coming and Going

by Andy Oram
September 22, 2000

The subject of Internet taxation has been aired a lot, mostly by business economists and career politicians. If a grass-roots movement ever gets involved, I can only imagine the kind of ads they might use.

(A beady-eyed, straggly-haired Caucasian man in fatigues stands behind a pile of gold bullion, holding an M16.) “I try to buy everything over the Internet, so I can keep my money out of government treasuries.” (Hoists his M16.) “I got this gun online, for instance.” (Looking down at the gold bullion.) “Only problem is, I can’t get most sites to accept my form of payment.”

Well, opponents of Internet taxation have better arguments than this guy to offer. But the other side is marshaling its forces too. While the politicians and media use speak loosely of “taxes on the Internet,” the topic should be broken down into at least four different policy areas, each with its own legislative history and controversies:

Now that I’ve neatly delineated these categories, I have to report that the boundaries between them don’t hold firm. If an advantage is provided in one area, businesses will find ways to reclassify their money-making operations to fall under that area.

Talk about multiple, indirect, and discriminatory taxes complicates the debate even more. If someone has to pay a tax for Internet delivery in order to obtain a service that already has its own tax, the company offering the service can complain that it is burdened with multiple taxes, that the service is taxed indirectly, and that the option of Internet delivery is a victim of discrimination.

It is no fairer, on the other hand, to exempt a movie or trade publication from taxation simply because it is delivered online. In the 1998 Internet Tax Freedom Act, Congress struggled with the difficult balance between imposing extra taxes and providing unwarranted tax breaks for Internet delivery.

The United States has never claimed that services over the Internet should be tax-free, according to Michael Mazerov of the Center on Budget and Policy Priorities. It’s true that the U.S. delegation to the World Trade Organization recommended in May 1998 (to sympathetic listeners) that it refrain from extending tariffs to goods on the Internet. Some news outlets mistakenly reported that the ban would cover all taxes, but that is a much broader category.

For an explanation of the hidden gotchas in Internet tax policy, I recommended a paper from the Center. (Much has happened on the issue since the paper was written, of course, but it remains valuable background material). Since the Center was founded to promote budget policies benefiting low-income people, they take the side of protecting state and local revenues. I’ll return to them later, but first I’ll examine each of the four major areas of taxation.

Direct taxes on Internet services

A few states put a tax on the fees collected by Internet providers. In the current climate of technology boosterism, such taxes are heresy and a grievous blow against technology. But the most expensive forms of Internet access are provided to large businesses, and there is no reason to consider this cost of doing business to be more exempt from taxation than buying pencils or hiring a carpet cleaning company.

What about Internet use at home? It’s overwhelmingly found in affluent families, and the traditional notion of progressive taxation calls for taxes on services used by the affluent.

But of course, progressive taxation is no longer the beacon it used to be. Over the past few months, four changes in federal taxes have passed one or both branches of the U.S. Congress favoring the affluent (lowering the level of social security payments that can be taxed, lowering taxes on married couples with disparate incomes, supporting a retirement savings plan, and repealing estate taxes).

Personally, I’d tend to support tax breaks for Internet access, because the progressive vision is to eventually make such access universal. But technology promoters who rave about the possibilities of the Internet should be putting their energies into turning the possibilities into realities. They could, for instance:

In short, help make the Internet valuable to a broad range of citizens before you circulate claims about its value.

Taxes on material provided over the Internet

In its 1998 tax moratorium, Congress banned not only taxes on Internet access, but taxes on “proprietary content, information, and other services.” Initial drafts of this Internet Tax Freedom Act contained even broader language, but it was removed after lobbying by state and local governments.

A better title for the bill would be the “Red Carpet for AOL Time Warner” act. Any company with grounds for calling itself an Internet service provider now has an advantage over traditional companies providing material online. And the amount of traffic in online services is growing rapidly: music, movies, games, corporate newsletters that can go for hundreds of dollars, technical support, education—even psychotherapy!

Leaving aside the AOL Time Warner clause, Internet access is a territory with porous borders. If you signed up in the Boston area with The World (the first company to offer dial-up Internet access to the general public), twenty dollars per month in 1990 would get you an email account abd twenty hours of access to a shell prompt from which you could telnet and ftp. Comparable Internet access today might include a VPN and Quality of Service options. But if the access fee includes your own personal Web page, domain name registration, and free music samples, should these all be tax-free?

Taxes on phone services

Now that ADSL and cable modems are popular, many traditional telecom fees appear to be taxes on Internet access. But they come from a completely different regime. Most aren’t taxes at all, but cogs in a payment system of dizzying complexity that balances price regulation, income transfers between different parts of the telephone system, and the universal service fund. Tinkering with them is a risky game of pick-up sticks that could upend the whole pile.

The Federal Communications Commission has already been reviewing its system of fees and transfers over the past few years, and has changed it significantly to let prices better represent actual costs. Savvy Internet activists in the U.S. eschew demagoguery and instead are trying to comprehend the regime so they can make constructive comments that take the whole system into account.

The notorious “modem tax” has been sighted about as often over the past decade as extraterrestrial aircraft, but it’s still unclear which is more likely to be real. The FCC could remove the exemption they awarded back in the 1980s to Internet access providers (under the term “enhanced service providers” or ESPs), thus landing them squarely in the middle of the complex regulatory regime. But successive commissioners have promised repeatedly not to remove the exemption.

The FCC has also exerted itself in complex legal arguments to avoid anything that could have a deleterious affect on Internet usage, steering away especially from per-minute charges. The other pricing issue that has seen years of wrangling—and is now even reaching Congress—is reciprocal compensation, which has an indirect effect on Internet costs. But it’s a historical oddity embedded in the contracts between phone companies and will probably go away eventually regardless of regulatory activity.

Sales taxes

In the United States, sales taxes represent one quarter of all state and local revenues. I have no corresponding figures for other countries, but one can glean the importance of sales taxes and value-added taxes from the battles that France, Britain, and other West European countries have undergone this past month over taxes on gasoline (petrol).

One simple argument against Internet taxation—a leftist argument, just to confound the libertarians—is that sales taxes are effectively regressive. That is, a sales tax is supposed to apply to everybody equally, but it falls disproportionately on lower-income people. That’s because the lower one lies on the income scale, the more money one spends on taxable goods. However, it would take a revolutionary overhaul of the income tax system to let states and cities give up their sales taxes. Ironically, the sales tax will become even more regressive as businesses and affluent people increase Internet purchases.

As with Internet access, people forget that most Internet transactions are business-to-business. Both personal and business purchases over the Internet are expected to grow rapidly. So maintaining the status quo is actually a way to starve state and local governments. Furthermore, the status quo is an illegal one, because purchasers are supposed to pay a “use tax” in their home state equivalent to its sales tax.

In testimony before the a U.S. Senate committee last February, the Center on Budget and Policy Priorities reported on current efforts to make the old system work in a new technological era. One compromise, appropriately enough, employs technology to adapt the tax regime to technological change. It harmonizes state and local tax laws (as the European Union is trying to do among member nations) and then creates an intermediary to collect the taxes on Internet purchases.

A group of state government employees called the Streamlined Sales Tax Project is currently working on harmonization. With major brick-and-mortar retailers organizing to keep a level playing field with their mail-order and Internet competitors, Mazerov thinks chances are strong that a compromise will be adopted. Meanwhile, efforts to extend the tax moratorium seem to be dying in the Senate. The California legislature is trying to establish that a retailer with a presence in the state can’t avoid paying sales tax on Internet orders, just by calling the Internet branch of the company a separate subsidiary.

There is nothing sacrosanct about the Internet when it comes to taxation. But there is nothing sacrosanct about current taxation structures either. Let the technological shake-up brought by the Internet foster deeper discussions about what services we want from governments and how we want these services funded.

During the research I put into this article, I was surprised to find how little has been published for the average citizen about tax policy and the social impacts of taxes. Since taxation is the topic that comes up most repeatedly and most contentiously in political discussions, you’d expect books for laypeople that lay out various sides of the issue. But those who are in the know apparently want to the rest of us not to know. One cannot expect rational policies for the Internet or anywhere else until the public can intelligently join the debate.


Andy Oram is an editor at O’Reilly & Associates. This article represents his views only. It was originally published in the online magazine Web Review.