The Perpetually Postponed E-Tax Debate

Congress has extended the freeze on taxing Internet-access charges, but it left hanging the big issue of online sales taxes

By Howard Gleckman

After months of arguing, Congress has finally decided to resume its freeze on Internet-access taxes for another two years. The measure, which lawmakers approved on Nov. 8, delays yet again the resolution of an issue that Congress, governors, state legislatures, businesses, and taxpayers have been struggling with since 1997.

The freeze applies only to taxes on the monthly service fees that users pay their Internet service providers, such as AOL Time Warner or EarthLink. On its face, this involves a very modest amount of tax on a small slice of the U.S. economy. But just beneath the surface, the freeze has come to symbolize the protracted and bitter battle over how to tax and regulate a vast and growing segment of the nation's commerce.

The real debate is not over taxes on Internet access but on all sorts of other electronic transactions. Indeed, at least three main issues are driving the debate over e-taxes.

• First is the dispute over who should collect sales taxes for online and mail-order purchases. States insist that out-of-state retailers should be obligated to collect taxes on what they sell, just as Main Street businesses do today. But states are barred from requiring online and mail-order companies from collecting those taxes by a 1992 Supreme Court decision. It's worth noting that, despite all the rhetoric, the congressional freeze has nothing to do with such sales taxes.

• Second is the battle over so-called business-activity taxes, such as state corporate income taxes or franchise fees. Many companies, especially financial-services firms, worry that they could be hit with such levies as a result of having a wide base of online customers. Would Citibank, say, have to pay state income taxes in Oregon just because it has thousands of online banking customers there, or because it has a server located in the Beaver State to speed access to their accounts?

• Third is the debate over just what Internet access means. The giant providers, such as AOL Time Warner, have begun rolling out bundled services -- such as online movies, music, and telecommunications -- as part of their monthly fees. Should those products and services continue to be tax-free, as they apparently would be under the congressional moratorium on access taxes? Or should only basic access be tax-free, while someone who makes an Internet telephone call pays the same tax as if he or she used a traditional handset?

This is complicated stuff. And remember that a moratorium won't freeze all taxation of Internet transactions. Less than 24 hours after it approved the Internet-access moratorium, Congress passed the much-anticipated airport-security bill. One element of that measure: a $2.50-a-ticket tax to fund the new program. And guess what? The tax will be collected whether you buy your plane ticket at your travel agency or online through, say, No moratorium on Internet taxes here.

Much of the e-tax argument, of course, is over whether states should have the same right to collect their levies. Regardless of the congressional moratorium, this battle was about to shift to state legislatures anyway.


  The Supreme Court limited the states' ability to force e-tailers to collect such sales taxes because the justices felt it was unfair to make businesses track the thousands of levies that exist around the country. And the future of e-taxes will largely depend on whether states are willing to dramatically simplify their sales tax regimes.

Largely in response to congressional pressure, more than 20 states have already agreed -- in concept -- to a simplified tax code. But the nuts and bolts of such a plan haven't been assembled yet. Turning a concept into actual state laws will be a rough proposition, especially at a time when the economic slowdown is causing state revenues to plunge and the scramble for dough to intensify.

It would have been nice if Congress had given the states a roadmap for acceptable simplification. No such luck. But the states know what they have to do. They've got two years to substantially simplify their sales tax structures. If they do, they may be able to convince Congress -- or the Supreme Court -- to let them require e-tailers to collect sales taxes. If they cannot, we can all look forward to yet another replay of the debate in 2003.

Gleckman is a senior correspondent in BusinessWeek's Washington bureau. Follow his views every Tuesday in Washington Watch, only on BW Online

Edited by Douglas Harbrecht