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A Policymaker's Guide to Internet

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A Policymaker's Guide to Internet A Policymaker’s Guide to Internet Tax BY SCOTT ANDES AND ROBERT D. ATKINSON | MARCH 2013 Within the first two months of 2013, identical bills in the U.S. House and Too often Internet tax Senate have been introduced that would provide a federal framework in issues are confused, or which states could opt to require remote sellers to collect state sales taxes. even worse, lumped together by the bumper- A bill has been introduced in the U.S. Senate to permanently extend the sticker debate between moratorium on taxation of Internet access, the Florida legislature passed a “Don’t Tax the Net” and law to tax Internet sales from out-of-state sellers, and the online retail “Level the Tax Playing giant, Amazon, has agreed to collect a 6.35 percent sales tax from Field,” but in fact these consumers in Connecticut.1 Are these decisions inconsistent or unrelated issues are distinct and deserve distinct policy to one another? Why should Amazon pay taxes in Connecticut and not in, responses. say, Oklahoma? There is no shortage of interest among states and localities in new or better-enforced sources of revenue from the Internet, yet in the current legal environment of Internet taxes, there is confusion over the most appropriate policy options moving forward. This guide explains the state of current law and how policymakers should approach taxing online, digital activity. It focuses on four particular areas: the Internet tax moratorium, multiple and discriminatory taxes of digital goods, discriminatory taxes on wireless services, and the collection of sales taxes for online purchases of products. Too often these issues are confused, or even worse, lumped together by the bumper-sticker debate between “Don’t Tax the Net” and “Level the Tax Playing Field,” but in fact these issues are distinct and deserve distinct policy responses.2 ITIF believes Congress should address each of these four areas through proposed legislation. PAGE 1 Legislation Description Recommendation Internet Tax Freedom Act Prohibits taxing Internet Congress should make the (ITFA) access, multiple taxes on current moratorium Internet transactions, and permanent and eliminate discriminatory taxes on the grandfather clause. online transactions. The Digital Goods and Prohibits state and local Congress should Services Tax Fairness Act governments from creating reintroduce and pass the multiple or discriminatory Act. taxes on digital goods and services. Wireless Tax Fairness Act Impose a five-year Congress should moratorium on all new reintroduce and pass the discriminatory taxes on Act, make the moratorium mobile phone services or permanent, and require providers. states to eliminate discriminatory taxes in this area. The Marketplace Fairness Authorizes states to require Congress should pass the Act of 2013 collection of sales and use Act to create a cross- taxes on goods sold online, channel tax parity. provided states meet minimum requirements for simplification. PRINCIPLES OF INTERNET TAX POLICY Regardless of whether taxes are collected at the local, state or federal level, Internet tax policy, as with all tax policy, should seek to follow four principles of optimal taxation. The first three principles, as suggested by tax economists, are that an efficient commodity tax: 1) induces little change in consumer behavior (unless the explicit purpose is to change behavior, as is the case with emission taxes, for example); 2) is not borne disproportionally by low-income individuals and households; and 3) is not placed disproportionally on activities with strong positive externalities.3 In addition, a fourth principle should be included: a commodity tax should reflect what is sold and not how it is sold. The first principle is important because the Internet introduces the possibilities of new business models with online, remote sales of goods and services. Tax policy should not advertently or inadvertently change consumer behavior either toward or away from online, remote sales. Economic growth is maximized when these decisions are made solely on the basis of consumer choice—not consumer choice influenced by unfair tax systems, imposed on one business model but exempting another. The third principle is also important, as there is clear evidence that information and communications technologies are strong drivers of growth, productivity and innovation.4 As such, taxes on Information and Communications Technology (ICT) generally have a larger negative impact on growth than taxes in other areas. Economists have long recognized that certain economic activities have positive externalities where the benefits to the broader economy extend beyond what purchasers of such goods and services pay for. Excessive taxation on these activities reduces economic welfare more than taxes on other activities. THE INFORMATION TECHNOLOGY & INNOVATION FOUNDATION | MARCH 2013 PAGE 2 There are a number of positive externalities associated with Internet connectivity and digital goods and services. For example, dematerialization—using bits instead of atoms— allows digital activities to be much less energy-intensive and have a smaller impact on the environment than creating, moving, and storing physical goods. CO2 emissions associated with purchasing a CD from a retail store are approximately 3,200g, compared to only 400g for an album purchased and downloaded online.5 ICT use also leads to network externalities, since the benefits of a network are higher with more users. The classic example is telephone service, which becomes more valuable to a user if more people are connected. Indeed, telephone network externalities have long been recognized and have been a major rationale behind universal service policies. Broadband has network effects in part because the decision to purchase broadband is dependent in part on having sufficient knowledge about it. Unlike a service like haircuts or a product like TVs that most people are familiar with and can accurately value, fewer people are familiar with wireless data and Internet services and cannot always value their benefits. Empirical evidence suggests that this is a factor that affects subscribership. Economists Austan Goolsbee and Peter Klenow found that people are more likely to buy their first Tax policy should not computer if they live in areas where a high proportion of households own computers, or if advertently or a high fraction of their friends and family members own computers—even controlling for inadvertently change other factors affecting computer ownership. If ownership rates are 10 percent higher in one consumer behavior either city than another in a given year, the gap will be 11 percent the following year, assuming all else stays constant.6 Goolsbee and Klenow explain this effect by suggesting that the number toward or away from of experienced and intensive computer users creates a “spillover” effect for non-users. They online, remote sales. conclude that the effect is most probably related to the use of e-mail and the Internet— consistent with the view of computers as the hubs of information and communications networks. But the effect is also likely to be related to the fact that people who have friends and neighbors with broadband are more likely to be able to better understand its value. Moreover, these externalities are likely to be higher in lower-income neighborhoods where individuals may have less familiarity with these technologies. Tax policies that reduce demand for Internet services have an oversized negative impact on the U.S. economy. Just as every additional Internet user increases the network and thus benefits all those within the network, each consumer that is discouraged from the digital economy due to excessive taxation reduces the value of the digital economy for everyone. Of particular concern are local and state tax authorities that view Internet services as an opportunity for revenue. When jurisdictions tax digital goods or services, they receive all of the financial benefit of the tax, but the net social cost of lower rates of access extends beyond the jurisdictions’ borders to affect residents and businesses across the entire nation. In order to avoid such a collective action problem there is a strong case that the federal government should dictate national Internet tax policies. These principles of optimal taxation are discussed throughout the paper in relation to each major area of Internet taxation. THE INFORMATION TECHNOLOGY & INNOVATION FOUNDATION | MARCH 2013 PAGE 3 THE INTERNET TAX MORATORIUM As more and more consumers began to subscribe to the Internet in the mid-1990s— initially through services like AOL, but increasingly through their broadband providers— state and local governments began to look to Internet service as a source of tax revenues. During the late 1990s, legislators proposed everything from an extension of the sales tax, to so-called “bit taxes” that would tax users based on the amount of data they consumed.7 In 1998, Congress recognized that unnecessary and excessive taxation could slow the growth of the Internet and reduce the benefits from the digital economy. It passed the Internet Tax Freedom Act (ITFA) to prohibit states from imposing new taxes on Internet access. The Act prohibits taxes on Internet service itself, whether the Internet Service Provider (ISP) is supplying dial-up, cable, digital subscriber line (DSL), fiber, satellite, or wireless Internet. It also ensures that taxes cannot be imposed on incidental services such as e-mail or instant messaging, and it prohibits multiple taxes from being imposed on online transactions from multiple jurisdictions. For example, the law prohibits two states from charging sales tax on a single online purchase unless credit is given for taxes paid in the other jurisdiction. It also prohibits discriminatory taxes on online transactions that treat electronic commerce differently from other types of commerce. The Act bars taxes that would only apply when a product is sold online, and prohibits states from imposing a higher tax rate when a product is sold online. The original ITFA expired in 2001 and was renewed in 2001, 2004, and 2007 with the most recent legislation set to expire in 2014.
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