Governments Want a Cut of the Net

If fickle subscribers, low profits and an unsettled future weren’t enough to worry about, online service providers are now confronted by another problem: the growing movement among governments to try to tax the Internet.

Many state and local governments looking for revenue sources see Internet access providers and online service companies as freeloaders, escaping the taxes and access fees that other telecommunications services such as telephone and cable TV companies must pay.

Moreover, tax advocates view the transmission of Internet content and programming as a taxable sale. Also adding fuel to the taxation fire is the growing use by consumers of the Internet to make mail-order purchases from out-of-state firms, which deprives the states of sales tax revenues.

The industry’s biggest tax scare came last spring in Florida, when the state nearly imposed a tax that could have added 12% or more to the cost of online services such as those sold by America Online, CompuServe, Prodigy and other Net providers.

Bowing to industry pressure, Florida Gov. Lawton Chiles this month deferred action until 1997. But Chiles served notice that the industry was fair game.

“The Internet is now an extremely viable marketplace with routine business transactions taking place every minute of every day, fundamentally changing traditional business relationships,” Chiles said earlier this month when he formed the Florida Telecommunications Taxation Task Force to study how to ensure “the long-term integrity of our tax base.”

At least four other states are studying the possibility of imposing new Internet taxes, including California, which is reexamining its entire telecommunications tax regime.

California doesn’t tax services now, but many municipalities and counties levy utility taxes on cable, telephone and other telecommunications companies. It is the smaller jurisdictions that are applying pressure for new Internet taxes, said Dean Andal, a Stockton-based member of the state Board of Equalization, which sets tax policy for the state.

However, Andal opposes any new taxes on Internet providers, saying they would have a chilling effect on California’s three “industries of the future”: entertainment, computers and telecommunications.

“Taxation of Internet services makes the products that go over the Internet more costly and takes some customers out of the pipeline,” Andal said. “If you tax, fewer people can afford to purchase services, less money will be generated in sales, and that means less capital will be invested and our three major industries will have less economic incentive to expand. I can’t think of a dumber idea.”

The city of Tacoma, Wash., begs to differ. Its finance department decided earlier this year that a 6% tax on online providers is reasonable, concluding that the municipal telecommunications tax now paid by phone companies applies to online services as well.

Tacoma’s City Council is scheduled to hold a public study session Tuesday to debate the issue, a meeting that will be closely scrutinized by the online industry, said Bruce Reid, director of state taxes at Microsoft., which operates the third-largest online service after AOL and CompuServe.

On the federal level, Internet providers’ biggest concern is to avoid being subject to the access charges that apply to all long-distance telephone calls and are used to subsidize phone service in high-cost areas and for low-income households.

Although that doesn’t appear imminent, Federal Communications Commission Chairman Reed Hundt raised the specter of an assessment of some kind last week. In a speech before the Interactive Services Assn. in San Diego, Hundt suggested that the telecommunications industry should somehow finance the estimated $10-billion cost of bringing the Internet into the nation’s classrooms.

“That’s so small,” Hundt said of the cost, calculating it as 0.2% of the $5 trillion in total “information sector” annual revenue.

“No matter how you measure it, the cost of networking every classroom is painfully modest,” he said.

Industry executives, who met at last week’s 11th annual ISA, said the consumer would feel the immediate effect of any tax increase.

“Once you build an industry up, there are people who want to tax you to death,” said Edward A. Bennett, president of Prodigy Services. “You have no choice but to pass it along to the consumer. You tell them what’s going on and have them call their congressman if they are unhappy.”

Although some industry figures in San Diego disputed the notion held by many that additional Internet taxes are inevitable, they were united in arguing that any new assessments would be an impediment to the online industry’s efforts to improve on its 11% penetration of U.S. households.

The industry announced last week that it had commissioned the Ernst & Young consulting firm to survey the various online tax and fee schemes being proposed in state and local jurisdictions and to come up with a proposal for a coherent tax policy, an action that implicitly concedes that more taxes are on the way.

“If this year was the year of tax awareness, then 1997 could be the year of tax implementation,” said Jeff Richards, a Washington-based marketing executive and an ISA board member.

“Since we recognize what’s looming, the purpose of the paper should be to give an analysis of the various proposals and their impacts. The problem is that every aspect of the interactive industry is changing, so we need to understand that before we put something on the books that will last years and years,” Richards said.

Dave McIntosh, chairman of the Florida Telecommunications Taxation Task Force, said Internet taxes are “one of the most important issues facing Florida because it’s a frontier-type issue that has drawn the attention of tremendous amounts of people in the industry. They are going to want something that’s fair, not rife with problems.”