Tax Freedom or Telecommunications Windfall?

There is considerable confusion about the debate on Internet taxes. One issue is whether items sold over the Internet should be taxed. Another issue is whether there should be a tax on access to the Internet; similar to the tax we pay for use of telephones. This second issue – charges a user pays to an Internet Service Provider to connect to the Internet, as well as taxes that would discriminatorily apply only to Internet technology and use – is now being debated in Congress.

The "Internet Tax Freedom Act" was a temporary "moratorium" banning state and local taxation of Internet access and prohibiting "discriminatory" taxes that single out the Internet for special taxation. It was enacted in 1998 and subsequently renewed through November 1, 2003. The purpose of this temporary moratorium was to encourage the growth of the Internet.

Given the expiration of the moratorium, Congress is moving to permanently ban taxation of Internet access. During the last congressional session, the House passed "The Internet Tax Non-discrimination Act" (H.R. 49). A vote on a companion bill in the Senate (S.150) was postponed. It is likely to be brought to the floor this session.

Besides making the moratorium permanent, the bills include two other provisions that significantly expand the scope of the original moratorium:

  • One would eliminate a "grandfather" clause included in the original legislation that allowed state and local taxes on Internet access if the taxes had been in effect prior to October 1, 1998. (State and local governments in 11 states would be affected.) The House bill would immediately eliminate the grandfather clause. The Senate bill would eliminate it after three years.
  • Another would expand the definition of "Internet access" to prevent states and localities from any taxing of telecommunications services "used to provide Internet access." This provision could (depending on interpretation) prohibit states and localities from taxing: 1. telecommunications services purchased by Internet access providers; 2. DSL telephone service (27 states and D.C. currently get sales or excise taxes on DSL); and, 3. telephone service itself as it shifts to the Internet (e.g., VOIP), a process that has already begun.


Rather than a simple continuation of the original moratorium on the taxation of Internet access, the proposed legislation would provide a huge tax break to the telecommunications industry, while dramatically reducing sources of state and local revenue, at a time when many states are experiencing severe fiscal imbalances.

The full impact on state and local government revenue is not even known because the interpretation of "telecommunications services used to provide Internet access" is so broad and ill defined. The telecommunications industry will certainly argue for the widest possible interpretation. The elimination of the grandfather clause would cost the 11 states and local governments from between $80 million and $120 million annually. The loss of the ability to tax DSL would cost those states and localities about $70 million annually. Even more technical issues could arise due to the broad definitions in the legislation that could unintentionally cost state and local government much more. For a more complete examination of this issue from which the cost estimates were drawn, see the Center on Budget and Policy Priorities analysis.

Supporters of the legislation argue that taxes on Internet access exacerbate the so-called "digital divide." Cloaking the financial self-interest of the telecommunications industry in concern for low-income people’s ability to access the Internet is a disingenuous argument. It is far more likely that cuts in the services that state and local government provide due to inadequate state and local revenue, like Internet access or training at libraries and schools, would make it more difficult for people to access the Internet.

The underlying question is "Why should telephone service be taxed, and Internet service not?" In contrast to the prohibition of taxes on Internet service, the charges a user pays to a company for telephone service are taxed, and have been since the federal tax was first imposed as an "excise" or "luxury" tax during the Spanish-American War. That tax on telecommunications services has also become an important source of revenue for state and local governments, amounting to more than $20 billion a year in revenues. While a moratorium on Internet taxation might have been a good idea to allow its growth, it is probably time to reexamine its purpose now.

Even without addressing that question, since Internet access has become more complicated than the original "dial-up" connection, and the technology for Internet and telephone access is rapidly changing, a permanent ban on taxation of Internet access, without more careful study and consideration, is a bad idea. The possibility of depriving states and localities of long-standing telecommunications revenue by broadening the definition of Internet access, especially given the fiscal crises in most states, is difficult to justify. In the absence of a compromise to proceed with taxation of Internet access, Congress should not permanently prohibit such taxes. One solution is to provide an extension of the original moratorium on taxation in order to allow more time to develop a well-considered policy.

Sens. Lamar Alexander (R-TN) and Thomas Carper (D-DE) are working with a number of groups who are concerned about this issue, and intend to introduce a compromise bill sometime this week. The bill would extend the moratorium for two years and also exempt DSL Internet access from taxation.

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