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The Internet Tax Battle Transformed
by Drew Clark
The debate over tax policy for the Internet has become as much a battle over the future of telecommunications policy as it has a philosophical struggle over taxation in the online world.
The Senate approved a four-year Internet tax moratorium last week, and nearly every interest -- telephone companies, cable providers, the technology industry, and state and local governments -- expressed satisfaction with the result. Because the four-year ban differs from the House-passed permanent moratorium, lawmakers still must resolve that issue, with Rep. Christopher Cox, R-Calif., advocating "at least some elements of permanency" for the final legislation.
But two telecommunications issues that were barely a flicker in the regulatory landscape last September, when the House passed its moratorium, may complicate the House and Senate negotiations. Those issues involve the tax status of high-speed Internet service offered over the digital subscriber lines (DSL) of telecom firms and of Internet-based phone service.
A Taxing Issue In The Telecom World
The 93-3 passage of the Senate's four-year compromise attracted the support of nearly everyone, including those who led the fight against the original bill, S. 150. The key critics were a trio of former governors now in the Senate -- Republicans Lamar Alexander of Tennessee and George Voinovich of Ohio, and Democrat Tom Carper of Delaware -- who fought for current state governors and mayors concerned about a loss of telecommunications tax revenue.
States and localities collect $18 billion every year in such taxes, according to the National Governors Association. The group cited a Congressional Budget Office finding that a permanent ban -- including language to expand the definition of tax-free Internet access as approved in the original 1998 moratorium -- would cost states between $80 million and $120 million annually. They also said a provision in the House bill to prohibit taxes on telecommunications "used to provide Internet access" could easily start undermining broader telecom taxes.
"It is a political trick because it means lower taxes here and higher taxes there," Alexander said on the floor Thursday. "I suggest that my colleagues might go home and ask legislators and mayors whether they plan to fire teachers or raise local property taxes, whether they plan to raise college tuition or raise their state's tax on food, or whether they plan to let prisoners out of jail or put in a new state income tax."
Another top concern during the debate was the rapid adoption of technology that breaks phone conversations into tiny digital packets, bounces them around the Internet like e-mails and reassembles the digital data stream as a voice conversation. The process, called Voice-over-Internet protocol (VoIP), cannot occur apart from the Internet but in many respects resembles traditional phone service. It became a prime telecom policy issues last fall.
To satisfy that concern, Sen. John McCain, R-Ariz., introduced an amendment that would exempt VoIP service from the moratorium to the extent that it mimics traditional phone service. The final bill also says that section "shall not apply to any services that are incidental to Internet access," like voice-capable e-mail or instant messaging.
That means voice conversations that accompany online games like Microsoft's X-Box Live will not be taxable, said Jim Kohlenberger, executive director of the VON Coalition that represents Internet telephone companies. "People recognize that the Internet is a powerful innovation and has fundamentally been a benefit for this country as we keep it exempt from taxation," he said.
Kohlenberger added that the Senate "tried to craft something that was fairly neutral," but he believes the House will move to strip the VoIP language in conference.
A Grandfather Gunning For Methuselah
Though a consensus amendment resolved the VoIP controversy, the tax status for some forms of high-speed Internet access prompted a showdown between Democratic Sens. Ron Wyden of Oregon and Dianne Feinstein of California. The debate centered on the 17 states that tax DSL service, all of which imposed their taxes after the 1998 ban took effect.
The original moratorium included a "grandfather clause" permitting the 10 states then taxing Internet access to continue doing so. Wyden and Sen. George Allen, R-Va., wanted that practice to stop immediately and pushed that idea as part of their original bill, but they ultimately agreed to a four-year extension for that grandfather clause. Because that provision would last as long as the Senate moratorium, those states need not change their practices.
Feinstein said the same right should extend to states that have begun to tax DSL since 1998, but moratorium proponents would not budge from the two-year grandfather clause for DSL they offered in the McCain compromise.
"I do not understand why one is four years and the other is two years," Feinstein said on the floor. "I do not understand why these companies cannot wait four years before they are going to end up socking it to the cities."
Wyden countered that "some of these grandfathers in this bill are going to live longer than Methuselah," a biblical character who lived to age 969. Wyden said states are discriminating against DSL and in favor of service delivered over cable modems to the detriment of advancing broadband access -- something he called "contrary to the spirit of everything we have done over the last seven years."
"I say to the Senate, if they vote for the Feinstein amendment, they are rewarding bad behavior, he said. "They are encouraging technological inequality. We have already taken steps to let some of these grandfathers live longer than I certainly would."
The Senate tabled Feinstein's amendment by a vote of 59-37.
A Fight For The FCC And Supreme Court?
The anomaly between the treatment of DSL and cable arose principally because the FCC regulates the regional Bell telecom companies as "telecommunications services." On the other hand, the agency regulates cable modems as "information services" under a 2002 decision, and information services face less regulation and no taxation.
That differential treatment might have led to different lobbying approaches by phone companies and cable providers were it not for an October 2003 decision by a panel of the 9th U.S. Circuit Court of Appeals. That decision, Brand X Internet Services v. FCC, essentially overturned the FCC's 2002 decision and put cable back into the telecom regulatory bucket.
This month, the full appeals court upheld the decision. Both the FCC and the National Cable and Telecommunications Association are expected to ask the Supreme Court to overturn the decision.
But the FCC also has proposed loosening the scope of regulations imposed on phone companies that offer broadband service. The agency approved new rules in February 2003, and they have not been overturned. With those rules now potentially applying to both cable and Bell companies, both industries urged Congress to pass the McCain compromise and praised it for doing so.
The Brand X decision "shifted the playing field because cable no longer enjoys the protection of information services," said David McClure, executive director of the U.S. Internet Industry Association. "Why would they want to be treated equally when they were treated better?"
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