Internet Tax Freedom Act

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					                                                       QUANTITATIVE ECONOMICS
                                                       & STATISTICS




Critique of Multistate Tax Commission’s State and
Local Revenue Impact Estimates of H.R. 49



Prepared by:
Ernst & Young’s Quantitative Economics and Statistics Practice



                                                      e#
______________________________________________________________________________




             Critique of Multistate Tax Commission’s
      State and Local Revenue Impact Estimates of H.R. 49




                                Prepared by:

                                Robert Cline

                            Ernst & Young LLP
               Quantitative Economics and Statistics Practice


                                October 1, 2003




ERNST & YOUNG LLP
______________________________________________________________________________



                 Critique of Multistate Tax Commission’s State and Local
                           Revenue Impact Estimates of H.R. 49


Introduction

The House of Representatives passed the Internet Tax Nondiscrimination Act on September 17,
2003. Based on testimony and debate in the House Judiciary Committee, it is clear that the
intent of H.R. 49 is to modify the current Internet Tax Freedom Act (ITFA) law to:

          make the ITFA permanent,
          eliminate the “grandfather” clause that allows a handful of states to collect pre-
           existing state and local taxes on Internet access, and
          ensure a uniform tax exemption for state and local taxes imposed on Internet access by
           including telecommunications services to the extent they are used to provide Internet
           access.

The new language in the definition of Internet access is needed to eliminate the current law
disparity that allows taxes to be imposed on certain types of Internet access, such as DSL and
wireless Internet access, while cable modem and direct satellite access go untaxed.

The intent of the law change is to ensure that all Internet access providers and the different
technologies used to provide access to the Internet are treated the same under the ITFA. The
uniform exemption language was added as an amendment in committee. As described by
Representative Watt: “The amendment is designed to make the underlying bill technologically
neutral.”1 There is nothing in legislative language nor the discussion of the bill by committee
members, tax staff or industry proponents that would suggest that the change is intended to
exempt services provided over the Internet from state and local taxes.

The Multistate Tax Commission just issued a report claiming that H.R. 49 will reduce state and
local taxes by up to $22 billion annually.2 This result is based on the erroneous assumption that
the law changes will exempt all telecommunications services from all state and local taxes. The
statutory language, as well as the legislative intent, does not support this unrealistic conclusion.
As discussed below, the MTC analysis is fundamentally flawed because it ignores the simple
meaning of the terms used in the ITFA and the proposed new law and the clear legislative intent
of current and proposed law. The following discussion examines the problems with the MTC
estimates in more detail.




1
 Reported in “Senate Commerce Approves Permanent Ban on Internet Access Taxes, Tax Analysts, July 31, 2003.
2
 Multistate Tax Commission, Revenue Impact on State and Local Governments of Permanent Extension of the
Internet Tax Freedom Act, September 15, 2003.


ERNST & YOUNG LLP                                                                                             1
Incorrect Interpretation of H.R. 49

The MTC estimates of the loss in state and local taxes from the passage of H.R. 49 violate the
most fundamental principle of revenue estimation: revenue estimates analyze the impact of tax
bills based on the actual language of the legislation, as guided by legislative intent. The MTC
has not estimated the actual legislation, H.R. 49. They have estimated their interpretation of
legislation that is not reflective of the statutory language or the legislative intent of H.R. 49.
Instead, they have estimated the impact of a bill that simply does not exist.

The MTC’s estimate of up to an $8.75 billion annual “short-run” state and local tax loss from
H.R. 49 is based on a clearly erroneous MTC “interpretation” of the simple language and clear
intent of the bill. Their estimate is based on the assumption that courts will decide sometime in
the future that the bill exempts all telecommunications services from all state and local taxes, in
clear contradiction of the intent of the legislation. This is the case despite the fact that the MTC
is able to identify the clear intent of the ITFA and the objectives of H. R. 49 in the first section of
their paper.

The combination of the clear language in the ITFA, as modified by H.R. 49, and the well-
understood legislative intent provide a firm foundation for reasonably estimating the expected
state and local tax impacts of H.R. 49. The following points explain how the MTC estimates
must be adjusted to correct their misinterpretation of H.R. 49.

Correcting the MTC Estimates

The expected impacts of H.R. 49 on state and local tax collections is relatively small, despite the
claim by the MTC that the revenue loss may approach $22 billion a year. The actual impact
comes from two separate pieces. The first impact comes from the elimination of the grandfather
clause in ITFA that currently allows up to 10 states to continue to impose state and local taxes on
Internet access. The Congressional Budget Office has estimated this cost to range from $80-
$100 million annually.

The second state and local tax revenue loss comes from the changes to the definition of Internet
access to explicitly include telecommunications services used to provide Internet access. Based
on MTC’s own estimate, which still has several erroneous assumptions, this loss may not exceed
$529 million annually. The following explains why this is the upper bound on the expected
revenue loss due the changes in H.R. 49 related to the state and local taxation of
telecommunications services used to provide Internet access.

H.R. 49 Does Not Eliminate All State-Local Taxes on Telecommunications

The MTC study presents a “long-run fiscal estimate” of the impact of H.R. 49. The study begins
with estimates reported in a study of the total state and local taxes paid by the
telecommunications industry in 1999 prepared by Ernst & Young (the 50-State Study).3 The
MTC extrapolates these numbers to 2002 levels and then states that this total, $22 billion, would

3
 “Telecommunications Taxes: 50-State Estimates of Excess State and Local Tax Burdens,” State Tax Notes, June
30, 2002, p. 932.


ERNST & YOUNG LLP                                                                                              2
be the long-run loss of state-local revenues due to H.R. 49.4 The following points explain why a
revenue estimate based on this assumption bears no relationship to a realistic estimate of the
bill’s impact.

H.R. 49 Will Only Affect Transaction Taxes

The bill extends the ITFA exemption only to transaction taxes applied to telecommunications
services purchased or used to provide Internet access. It is clearly the intent of both current law
and H.R. 49 to apply this exemption to state-local taxes imposed on the value of the Internet
access services provided, the fundamental definition of transaction taxes that includes sales and
gross receipts taxes.5 In fact, the committee report on H.R. 49 states:

         In general, taxation of Internet access refers to applying State and local taxes to
         the monthly charge that subscribers pay for access to the Internet through ISPs.
         When applied, the tax on Internet access is most commonly a retail general sales
         tax, but may also take the form of other transactional taxes such as a
         telecommunications or gross receipts tax.6

The 50-State Study does present an estimate of the total state and local transaction taxes imposed
on the telecommunications industry. In 1999, transaction taxes were an estimated $12.8 billion,
71 percent of total telecom taxes. As a start, 29% of the total telecom taxes reported in the 50-
State Study have to be excluded from the MTC estimate because only transaction taxes will be
affected by H.R. 49. In addition, the MTC estimate of corporate income taxes on
telecommunications companies must also be excluded. Because the actual language of the bill
and Congress’ expressed intent, the only taxes that should be included in the revenue impact of
H.R. 49 are transaction taxes.7

H.R. 49 Will Only Affect Transaction Taxes Imposed on Telecommunications Services Used to
Provide Internet Access.

The legislative intent of H.R. 49 is to ensure the ITFA exemption is applied only to those
telecommunication services that are used to provide Internet access, not separate, non-
telecommunications services provided through the Internet. This is clear from the unchanged
existing language of the ITFA that defines Internet access as a “service that enables users to
access content, information, electronic mail or other services offered over the Internet ... ”
(Section 1104(5), emphasis added). It is this Internet access service that would be exempted by
H.R. 49.

It appears that the MTC’s position is that the new language in H.R. 49 that exempts taxes on
telecommunications access charges interacts with the current ITFA language that includes an

4
  The MTC added an estimate of state-local corporate income taxes paid by the telecommunications industry to the
estimates reported in the 50-State Study.
5
  It has been suggested that removing the grandfather clause will automatically result in all state and local taxes
being subject to the ITFA exemption. Again, there is no evidence related to the analysis and debate of H.R. 49 to
provide support for such an assumption in estimating the bill’s revenue impact.
6
  U.S. House of Representatives, Report on H.R. 49, July 24, 2003, p. 7.
7
  The transaction category is column 2 in Summary Table 2 in the MTC report.


ERNST & YOUNG LLP                                                                                                     3
exemption for taxes on Internet access that is “bundled” with services provided over the Internet.
The MTC appears to assume that this interaction automatically exempts any telecommunications
services provided over the Internet from state and local transaction taxes. There is no apparent
basis for this assumption.

Because the language of the new exemption in H.R. 49 only applies to telecommunications
services providing access to the Internet, there is no “ambiguity” in determining how H.R. 49
affects the tax base. It is clear that the changes only apply to telecommunication services
purchased or used to provide Internet access. Therefore, the $8.75 billion short-run impact
scenario (“ambiguities interpreted more broadly by courts”) presented in Summary Table 2 of
the MTC report is irrelevant.

To put the issue in perspective, compare DSL revenues, one component of Internet access
telecommunications revenue, to total end-user telecommunications receipts. In 1999 this ratio
was less than one percent. Even if DSL revenue has doubled since 1999, it is still a relatively
small percentage of total telecommunications revenues. Additionally, not all states have taken
the position that the underlying transmission associated with providing DSL Internet access
might be taxable today as a telecommunication service. Another component is the transmission
services provided to Internet Service Providers to provide Internet access. Again, many states
and localities take the position that these are non-taxable interstate or private communications
services. As a result, only a small percentage of total state and local transactions on
telecommunications used to provide Internet access will be affected by H.R. 49.

In addition, the actual revenue impact is independent of any future shift of local and long-
distance telecommunications to the Internet. While this shift may require states to adopt their
existing tax systems to the new methods of transmission, H.R. 49 does not extend the ITFA
exemption to these services provided over the Internet, as asserted in the MTC analysis.
Therefore there is no state-local tax loss from H.R. 49 related to this on-going technological
change. As a result, there is no difference between the “short-run” and “long-run” impacts of
H.R. 49 as implied in the MTC study.

Summary

As explained in this analysis, if done correctly, the estimated state and local tax revenue loss
from H.R. 49 is relatively small. It includes the impact of removing the grandfather clause and
the changes to the definition of Internet access to ensure that the telecommunications services
used to provide Internet access are covered by the exemption from state-local taxation.

The correct way to estimate the impact of H.R. 49’s changes in the definition of Internet access
is to assume that the tax loss 1) is limited only to transaction taxes on telecommunications
services used to provide Internet access, 2) is independent of future court decisions, and 3) is not
affected by changes in the technology for providing telecommunications services.

Finally, credible revenue estimates must be founded on reasonable assumptions about the
legislative language and intent. The MTC’s study and estimates of the state and local tax
impacts of H.R. 49 lack this essential foundation as they are not based on reasonable or
supportable assumptions.


ERNST & YOUNG LLP                                                                                 4

				
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