No Internet Tax? Don’t Be Too Sure

Published May 1, 2006

In 2004 Congress passed and President George W. Bush signed into law a three-year extension of the Internet Tax Moratorium, which has been in effect almost continually since 1998. Americans thus don’t have to worry about paying extra taxes for their access to the Internet over and above what they already pay on telecom services.

Or do they?

As the Internet matures into a routine component of our daily lives, its independence from both taxation and regulation is rapidly eroding. Absent a more sweeping federal intervention to secure the Internet’s freedom, it will be an increasingly rich target for revenues and regulatory interference from all directions. Moratorium or not, the Internet already is being viewed as a potentially lush revenue source at the state, local, and even international level.

State and Local Threats

Since the moratorium on Internet taxation was devised as a check on discriminatory and distracting state and local taxes, it is striking that those governments still succeed in drawing some new revenue off the Internet. To be sure, the moratorium always has “grandfathered” certain state tax initiatives put in place before its original enactment, and the 2004 extension of the moratorium further complicated the situation by implying it would be all right, for example, to tax Voice over Internet Protocol (VoIP) services. The ostensible rationale was that VoIP is a competitor to traditionally taxed telephone services, and the Internet should not make it a safe harbor from taxation.

The problem is that a tax on VoIP can’t be distinguished from a tax on Internet Service Provider (ISP) services that facilitate VoIP, and the VoIP tax rate could be set so high that it implicitly becomes an Internet service tax. The only check on that tendency is the notion that a “level playing field” among all types of phone service providers requires that a VoIP tax be limited to the tax rate imposed on more traditional phone services.

It would be better still if competition from VoIP and other services yet to emerge were used as an occasion to rethink telecom taxation from the ground up, especially in the direction of reducing or eliminating such taxes altogether.

Florida rejected an expanded definition of its telecom tax that would embrace VoIP. However, the city of Chicago has told VoIP customers they must pay the same telecom tax that applies to traditional and wireless phone services. Meanwhile, the Federal Communications Commission (FCC) in November 2004 ruled VoIP was presumptively a federal issue (implying possible federal preemption of state taxing authority in this area), but the scope of the FCC’s ruling remains unclear.

Federal Threats

The enthusiasm for VoIP taxation is not confined to states and localities. In spring 2005, the congressional Joint Committee on Taxation proposed the option of raising revenue with an expansive redefinition of telecom services covered by the federal telephone tax. This definition would have included VoIP and essentially all types of landline, satellite, and broadband services over which communication occurs. Only a brief uproar in Congress put the kibosh on this proposal, but there it lies on the revenue options table, waiting to be picked up by any eager tax-raiser on Capitol Hill.

The FCC, moreover, is targeting VoIP for contributions to the “Universal Service Fund” (USF). The USF “dedicated fee” is a stealth tax, never directly legislated by Congress, whose very existence raises serious legal questions. The result is a program that has taken on a life of its own without even the minimum scrutiny and oversight provided by the congressional budget and appropriations process.

If anything, this issue will grow in importance in 2006. For example, Reps. Lee Terry (R-NE) and Rick Boucher (D-VA) are developing legislation to “regularize” and codify the USF on a very broad base indeed, defined as “universal services as of the date of enactment plus high speed broadband services and an evolving level of telecommunications services to be identified by the FCC.” (Terry/Boucher Discussion Draft, Universal Service Reform Act of 2005, dated November 17, 2005.)

Clouding the picture is that three federal judicial circuits have ruled the federal telephone tax cannot be imposed on call plans priced by call time rather than by the “distance” the call travels. As USA Today reports, this would mean “cellular phones, Internet phone service, and about one-third of long-distance calls would be exempt from the tax.” In theory this could lead to VoIP exemption from the telephone tax, but the legal situation remains in flux.

Before the Internet Tax Moratorium expires in 2007, Congress and the executive branch should seriously review Internet taxation from the local, state, national, and international perspective, and determine how best to sustain the largely tax-free Internet that has done more good for the world than any bureaucracy ever could.

George Pieler ([email protected]) is a research fellow for the Institute for Policy Innovation.