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U.S. House of Representatives
Committee on the Judiciary
Subcommittee on Commercial and Administrative Law

Hearing on H.R. 49

April 1, 2003

The Honorable James S. Gilmore, III
Kelley, Drye & Warren
1200 19th Street, NW
Washington, DC 20036
www.kelleydrye.com

Former Governor
Commonwealth of Virginia

Former Chairman
Congressional Advisory Commission on Electronic Commerce

Distinguished Fellow
The Heritage Foundation

Introduction

Chairman Cannon, Congressman Watt, and Members of the Commercial & Administrative Law Subcommittee, thank you for inviting me to explain why the permanent and national prohibition against Internet access taxes proposed in H.R. 49 is critically important to the future of the United States economy and to ubiquitous access to the Internet by the American people.

Let me preface these remarks by recognizing the tremendous vision of your colleague, Congressman Chris Cox, who had the foresight over five years ago to protect the Internet from multiple and discriminatory tax burdens with passage of the Internet Tax Freedom Act of 1998. Without the Internet Tax Freedom Act, I doubt our Nation would be as advanced as it is today in terms of widespread Internet access, broadband rollout and international dominance of electronic commerce and the exchange of information and digital content on-line.

I also would like to recognize Senator Allen and Senator Wyden for their efforts in the Senate to move tax freedom for Internet access forward. And, of course, I would like to acknowledge President Bush and Vice President Cheney for the Administration's strong support for a permanent federal prohibition against taxes on Internet access.

History of Advisory Commission on Electronic Commerce (1999-2000)
I have been blessed with several noteworthy honors in my career. The highest honor was to be elected by the people of Virginia to serve as their Governor from 1998 to 2002. In that role, I had the opportunity to pass the nation's first comprehensive Internet policy and steer Virginia's tax policy to promote Internet access and electronic commerce. I also presided over unprecedented economic growth in the Information Technology sector.

While I served as Governor, I also had the privilege to serve as the Chairman of the Advisory Commission on Electronic Commerce from 1999 to 2000. The Advisory Commission on Electronic Commerce was established by Congress to conduct a thorough study of federal, state, local and international taxation of electronic commerce. Speaker Hastert asked the Commission to send "sound policy proposals for the individual taxpayers of America," and former Senate Majority Leader Lott requested us to forward "a clear and unambiguous policy proposal , especially if that proposal is bold and innovative." For nearly a year, 19 Commissioners and their staffs devoted their creativity and thousands of hours of work deeply engaged in that endeavor.

The Commission's membership was comprised of distinguished leaders, from both the public and private sectors, representing diverse perspectives on the issue Internet taxation.

They included several distinguished leaders from the private sector: Michael Armstrong of AT&T, Grover Norquist of Americans for Tax Reform, Richard Parsons of Time Warner, Bob Pittman of AOL, David Pottruck of Charles Schwab, John Sidgmore of MCI WorldCom and UUNet, Stan Sokul on behalf of the Association of Interactive Media, and Ted Waitt of Gateway. And they included an equally impressive group from the public sector representing state and local governments: Dean Andal, Chairman of the California Board of Equalization, Delegate Paul Harris of the Virginia General Assembly, Commissioner Delna Jones of Washington County, Oregon, Mayor Ron Kirk of Dallas, Texas, Governor Mike Leavitt of Utah, Gene LeBrun of the Commissioners on Uniform State Laws, and Governor Gary Locke of Washington State. And representing the Clinton-Gore Administration were Joe Guttentag of the Department of Treasury, Andy Pincus of the Department of Commerce, and Bob Novick of the Office of U.S. Trade Representative.

In nearly a year of work and four two-day meetings and several remote teleconference meetings, the Commission heard testimony from over 55 experts, academics, think-tanks and interest groups representing as broad a range of perspectives on tax and electronic commerce policy as has ever been organized into one study. Each Commissioner was able to invite his or her own experts to express a viewpoint. We heard from every quarter, from the Heritage Foundation to the National Governor's Association and Wal-Mart.

A year of robust debate yielded a sophisticated set of ideas that the Commission reported to Congress in April of 2000. I am confident that conclusions we reported to Congress represent an excellent policy blueprint that will have tangible and beneficial effects for the people of the United States. A copy of the Commission's final Report to Congress and its library are archived on-line by George Mason University Law School at www.ecommercecommission.org.

Advisory Commission on Electronic Commerce's Policy Proposals
The Internet Tax Freedom Act and H.R. 49 address two distinct tax policy issues: (1) state and local taxes on Internet access provided by a traditional Internet service provider (or "ISP"), and (2) "multiple and discriminatory" taxes that treat electronic commerce differently than any other kind of commerce. The Commission I chaired for Congress studied these two tax policies in detail and a majority of the Commission voted to extend the federal prohibition against both of these taxes.

The Commission also studied other taxes, some imposed by the federal government and others imposed by state or local governments. Before focusing my remarks on the tax question presented by the Internet Tax Freedom Act and H.R. 49, however, I would like to summarize the other distinct policy questions the Commission addressed. It suffices to note that these policies are not necessarily dependent upon one another, and each of the Commission's policy proposals should be considered on its unique merits. Certainly, resolution of H.R. 49 should not be dependent upon the policy debate over other issues such as interstate sales tax collections on the Internet.

A majority of Commissioners approved policy prescriptions that, in my view, advance the important objectives of promoting Internet connectivity and individual empowerment for the people of the United States. Among the ideas submitted in the Commission's April 2000 Report, you will find proposals for the following tax reforms:

(1) First, Congress should eliminate the 3% federal telephone tax - an immediate tax cut of over $5 billion annually for the American people. This tax was originally established as a luxury tax for the few Americans who owned a telephone to fund the Spanish American War of 1898. Since that time, it has been scheduled for extinction for decades, but was finally made permanent in the late 1980s. In the Information Age, it is important to stop taxing people's telephones. Elimination of this regressive tax is an important first step in reducing the expense of Internet access, one of the contributing factors to the digital divide. While this tax once was justified as a luxury tax on the few Americans who owned a telephone, it has no rationale in the Information Economy.

(2) Second, extend the current moratorium on multiple and discriminatory taxation of electronic commerce for an additional five years through 2006.

(3) Third, prohibit taxation of digitized goods sold over the Internet. This proposal would protect consumer privacy on the Internet and prevent the slippery slope of taxing all services, entertainment and information in the U.S. economy (both on the Internet and on Main Streets across America). Moreover, this tax prohibition is essential to maintaining U.S. global competitiveness since the United States currently dominates the world market in digitized goods.

(4) Fourth, make permanent the current moratorium on Internet access taxes, including those access taxes grandfathered under the Internet Tax Freedom Act. This proposal is another crucial initiative, targeted to reduce the price of Internet access and to close the digital divide. By expanding the moratorium to eliminate the current grandfather provision, consumers across the country would participate n electronic commerce without onerous tax burdens.

(5) Fifth, establish "bright line" nexus standards for American businesses engaged in interstate commerce. The cyber economy has blurred the application of many legal nexus rules. American businesses need clear and uniform tax rules. Therefore, Congress should codify nexus standards for sales taxes in a way that adapts the law of nexus to the New Economy and the new "dot com" business model. Codification of nexus would serve several important policy objectives: (1) provide businesses "bright line" rules in an otherwise confusing system of state-by-state nexus rules; (2) protect businesses, especially small businesses, from onerous tax collection burdens; (3) reduce the amount of costly litigation spurred by confusing nexus rules; (4) nurture the full growth and development of electronic commerce; and (5) give consumers and individual taxpayers who participate in Internet commerce a tax break.

(6) Sixth, place the burden on states to simplify their own labyrinthine telecommunications tax systems as well as sales and use tax systems to ease burdens on Internet commerce. This effort will be particularly important for small and medium-sized retailers with nexus in two or more states. It also will be important for telecommunications companies as they build out the Internet infrastructure and offer new technologies and services. Radical simplification will be necessary in the New Economy if small and medium-sized businesses are to succeed.

(7) Seventh, clarify state authority to spend TANF funds to provide needy families access to computers and the Internet, as well as the training they need to participate in the Internet economy. This is one strategy the Commission formally recommends to close the digital divide and make the personal computer and access to the Internet as ubiquitous as the telephone and television.

(8) Eighth, provide tax incentives and federal matching funds to states to encourage public-private partnerships to provide needy citizens access to computers and the Internet. This is yet another strategy the Commission formally recommends to close the digital divide.

(9) Ninth, respect and protect consumer privacy in crafting any laws pertaining to online commerce generally and in imposing any tax collection and administration burdens on the Internet specifically. This is a formal recommendation of the Commission.

(10) Ten, continue to press for a moratorium on any international tariffs on electronic transmissions over the Internet. This idea also is a formal recommendation of the Commission.

(11) And eleven, a majority of the Commission endorsed a comprehensive framework for addressing international tax and tariff issues based upon the following core principles: no new taxes or tax structures on electronic commerce in the world marketplace; tax neutrality toward electronic commerce; simplicity and transparency of tax rules applied to electronic commerce; and a call for the Organization of Economic & Community Development (OECD) to continue fostering international dialogue and cooperation on international tax issues.

It is important to note that the Commission's study of the Internet Tax Freedom Act and its prohibitions against taxes on Internet access and multiple and discriminatory taxes targeting electronic commerce elicited little if any controversy. And there was consensus that the national goal of any policy addressing the Internet should be to promote ubiquitous access. Those issues only became controversial in the context of political bargaining over other, more controversial topics.

Background on Internet Tax Freedom Act (1998)
When Congress passed the Internet Tax Freedom Act in 1998, it was difficult to predict, or even catalogue, the many policy dimensions of federal, state and local taxation of Internet access and Internet-based commerce. Mindful of the axiom to do no harm, Congress acted cautiously in the beginning:

(1) First, Congress prohibited state and local taxes targeting Internet access temporarily, for three years, so that the ramifications of the federal prohibition could be measured;

(2) Second, Congress "grandfathered" about ten states that already had enacted some form of state or local tax on Internet access to allow them time to reverse their policies in light of countervailing federal policy without any dramatic revenue impact and/or to keep their policies in place in the event Congress might eventually reverse national policy; and

(3) Third, Congress established the Advisory Commission on Electronic Commerce to study Internet tax policies and report back to Congress on its deliberations, policy debate and majority proposals, as well as any formal findings or recommendations that could garner a supermajority.

Congress wanted to move forward deliberatively and carefully because the Internet economy and all of its dimensions were not fully understood. Yet, Congress needed to act quickly because state and local governments already had begun to target Internet access services, websites and content under disparate and often illogical tax theories.

Tacoma, Washington, for example, implemented a plan in September of 1996 to tax Internet Service Providers as telephone utility companies (a law the state legislature later repealed). Wisconsin enacted a 5% sales tax on Internet access, subjecting its taxpayers to two taxes to log on the Internet - a tax on their telephone service used to dial up the Internet and a second tax on their Internet service. Connecticut, on the other hand, started taxing Internet access at 6% under the theory that it constituted a "computer and data processing" service (Connecticut terminated the tax in 2001). New Mexico began imposing a gross receipts tax Internet access and continues to this day. Even small towns, like Chandler, Arizona, started imposing local utility taxes on Internet access service in the mid to late 1990s.

The real threat of hundreds if not thousands of differing tax theories, rates, jurisdictions, audits and regulations getting heaped upon Internet access the way it had local and long-distance telephone service spurred Congress to enact a federal moratorium against the proliferation of such taxes. Congress grandfathered the handful of states that had started taxing Internet access.

The grandfather provision implicitly told those states that had rushed to tax Internet access that Congress disapproved of the imposition of a myriad of state and local tax burdens (including both the costs of taxes as well as the costs of regulatory compliance, audits and collection) upon inherently interstate Internet access services. These grandfathered states faced a choice. They could either reverse their hasty decisions to tax Internet service or they could wait to see if Congress might change its mind.

Since its original enactment in 1998, several states have dismantled or significantly curtailed their taxes on Internet access. Texas, for example, eliminated its tax on Internet access priced below $25 per month. Connecticut decided to phase out its tax on Internet access altogether. Washington State repealed the local tax on Internet access that the City of Tacoma had imposed.

In 2001, Congress voted overwhelmingly a second time to extend the federal prohibition an additional two years to 2003, endorsing once again a national policy of promoting ubiquitous Internet access by prohibiting onerous tax and regulatory burdens on access.

Avoiding the Consumer Telephone Tax Labyrinth on the Internet
We now approach the conclusion a five-year federal moratorium on Internet access taxes and Congress faces a fundamental policy choice:

(1) Should Congress adopt the policy that myriad state and local tax burdens on Internet access are antithetical to an enduring national policy of promoting ubiquitous and competitive Internet access by making the moratorium on access taxes permanent and universal across all states?

(2) Or should Congress reverse course, eliminate the federal prohibition, and allow state and local governments to proceed to tax Internet access as they see fit?

I believe the policy goals and purposes that justified Congress' original adoption of the Internet Tax Freedom Act in 1998 are equally compelling today and justify a permanent and universal prohibition against taxes on Internet access throughout the United States.

Abolishing the federal prohibition would force the Internet superhighway to navigate the same labyrinthine maze of overlapping and disparate state and local tax regulations and burdens that currently strangles the Nation's telecommunications services. Presently, a national telecommunications service provider might be required to file as many as 55,000 different tax returns each year to comply with the tax burdens of all state and local jurisdictions. The effective transaction tax rates that apply to telecommunications services exceed the effective transaction tax rates applied to almost all other sales. Average effective state and local tax rates average about 14% as compared to 6.3% for most other sales. When all state, local and federal telephone taxes and fees are counted, it is not uncommon for 20% or more of a consumer's telephone bill to be taxes.

Also, many state and local governments apply different tax structures and tax rules and bases depending upon the type of telecommunications services. In one jurisdiction, different tax rates might apply to telecommunications services provided by traditional wire line, cable, Internet, or wireless firms. Companies that offer essentially the same services over different technological media often are uncertain regarding the appropriate tax treatment of their service.

These transaction taxes are complex and compliance is costly. Telecommunications service companies bear the compliance costs for calculating, collecting, auditing and remitting these taxes, and these burdens are prohibitive for small telephone companies. More importantly, individual consumers pay these exorbitant taxes. Thus, the taxes not only impose significant costs and burdens on businesses, but they significantly increase the cost of using the telephone in an Information Society where citizens who are elderly, poor and shut-in must have a telephone.

Regardless of one's perspective regarding whether telephone service should or should not be taxed, or at what rate, I do not believe anyone asked to design an interstate telephone tax structure on a blank slate would craft the kind of disparate, complicated and costly system we have in place now. It's too complex, it's regressive, and it's a drag on the telecommunications infrastructure and connectivity in America. We can't let that happen to Internet access too.

But that is precisely the tax structure being proposed by opponents of H.R. 49. If Congress does not pass H.R. 49, small independent Internet service providers will face the immediate prospect of filing dozens or perhaps hundreds of tax returns and remittances each year. The large national Internet service providers will face the daunting task of filing 50,000 each year. The big ones might be able to hire the administrative overhead, accountants and lawyers to manage that task, and pass the cost to their customers in higher prices. But many small ones would never be capable of competing in such an environment.

It is imperative that Congress enact a permanent and national prohibition against state and local taxes on Internet access to prevent Internet access, the industry that provides access to the Internet, and the individual citizens who log on the Internet from the detrimental effects of a telephone-like tax system.

Why Congress Should Enact a Permanent and National Prohibition Against Internet Access Taxes
Moreover, there are numerous compelling policy rationales for a permanent and national prohibition against Internet access taxes.

(1) It should be the National Policy of the United States to promote freedom and ubiquitous Internet access and connectivity in America. The economic, social and political benefits are great. The potential for individual empowerment is tremendous. We should not inhibit the full outgrowth and ubiquitous access to the Internet by allowing onerous tax burdens to slow down the Internet superhighway. Taxes would inhibit full outgrowth in several ways: (1) by increasing the cost to users and (2) imposing significant new administrative and regulatory costs upon Internet access providers.

(2) The federal government and many state and local governments are subsidizing Internet access and broadband rollout in many regions of the United States. It would be counterproductive to then take back the subsidies through burdensome taxation of the very services we subsidized. For example, North Carolina has established the North Carolina Rural Internet Access Authority. The Authority's mission is to wire rural communities throughout North Carolina in partnership with local telephone companies. North Carolina has provided over $30 million in public funds to support the project. The U.S. Department of Agriculture's Rural Utilities Services makes direct grants totaling in the tens of millions of dollars to wire rural communities and small towns. U.S.D.A. also implements the Rural Broadband Loan and Loan Guarantee Program Rural Utilities Service (RUS) which, this year, will make over $1.4 billion in government-subsidized loans and loan guarantees available to companies deploying broadband service to communities of less than 20,000 people.

(3) Small, independent and rural Internet Service Providers (ISPs) will be at a competitive disadvantage in rolling out access across local and state boundaries if multiple state and local taxes and their attendant regulatory and compliance burdens are imposed. They can't compete with the big national ISPs in complying with regulatory and administrative burdens. This would reduce choice for rural consumers and force them to higher-cost services.

(4) America still suffers from digital divides - rich vs. poor, urban vs. rural, white vs. black, educated vs. uneducated, young vs. old. Taxes will only widen these divides at a time when our goal should be to make the personal computer and Internet access as affordable and ubiquitous as the telephone and television. According to the U.S. Department of Commerce's report, A Nation Online (February 2002), large disparities remain in Internet usage rates between certain classes of citizens. The access gap between citizens with incomes over $75,000 versus those making less than $15,000 grew from 35% in 1997 to 54% in 2001. The gap between white and black citizens expanded from 12% in 1997 to 20% by September 2001. We still have a way to go to close these gaps. Imposing tax burdens that increase consumer costs and reduce competition among ISPs would be counterproductive.

(5) We need continuous economic stimulus to spur economic activity and investment, especially in the e-commerce and technology sectors. A permanent moratorium will be a positive signal to investors and Internet entrepreneurs.

(6) Failure to extend the moratorium is effectively a tax increase on American consumers who have Internet access in their homes and offices. An economic downturn is the worst time for a tax increase. For example, if Congress lifted the moratorium and allowed states and localities to tax Internet access pursuant to their telecommunications tax rates, a consumer paying $20 per month for Internet access might pay, in an average state, an additional $3 per month and $36 per year just to log on the Internet.

(7) The federal prohibition prevents double taxation of ISP service as well as taxation of the phone and cable lines people use to access their ISP. For many consumers, the $36 noted above would duplicate taxes already paid for a local telephone line.

(8) America currently dominates the world market in electronic services, software development and digital content. We should strive to build on our competitive position even further. Tax policy favorable to Internet access and the content and information transferred over the Internet is critical to maintaining our competitive position in the world marketplace. Europe is looking for more ways to tax the Internet and the content, software and information exchanged over the web. We should resist the European paradigm of imposing VAT taxes on Internet service and the content and information accessed over the Internet.

(9) States and localities are not currently dependent upon Internet access taxes because Congress enacted the moratorium in 1998. The few states that enacted access taxes before 1998 are not heavily dependent upon the revenues. In fact, since enactment of the Internet Tax Freedom Act (ITFA) in 1998, many states trended away from access taxes. Texas, Connecticut and Washington State are good examples. Yet, what we do know from experience in the states that enacted these taxes prior to 1998 is that their tax rules are unclear and difficult to administer. Nevertheless, states with Internet access taxes have been provided five years of clear notice that national policy disfavors these taxes.

(10) There is a general consensus that the federal moratorium is sound policy. Congress has passed it twice (1998 and 2001). Even in the ACEC, the moratorium on access taxes was not controversial. And in the nearly ten years that I have been working on policies regarding information technology, the Internet, economic growth, electronic commerce and state and local taxes, I have never heard anyone articulate a thoughtful reason for why a panoply of state and local taxes on Internet access would be sound or constructive policy for the people of the United States.

Conclusion
The Internet is the most transforming economic development since the Industrial Revolution. Information Technology drove America's economic boom in the late 1990s, it has buoyed the economic slowdown, and it will lead our economic resurgence. It created new jobs, increased our National productive and efficiencies in every sector of the economy, and generated new wealth in America. Even in rural areas long ago ignored by the economic progress in metropolitan areas and bypassed by the Nation's huge investment of public resources on the interstate highway system, small businesses are prospering by selling products worldwide on the Internet and American consumers have been able to obtain everything from information and educational opportunities to goods and services otherwise beyond their reach. Every person on the Advisory Commission on Electronic Commerce recognized that our national economy, U.S. global competitiveness, and American culture depend vitally upon nurturing full development of the Internet.

Most importantly, the Internet and the personal computer have empowered individual people as citizens in a democracy, as consumers, and as entrepreneurs in unprecedented fashion.

America can embrace these positive developments and promote more of it by keeping taxes and regulatory burdens on Internet access to a minimum, or it can thwart them by taxing Internet access. I would urge Congress to keep tolls off the Internet superhighway by passing H.R. 49.

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