As public use of the Internet grew from the mid-1990s onward, Internet  access and electronic commerce became potential targets for state and  local taxation. Some state and local  governments raised additional tax revenues and applied existing taxes to  Internet transactions. Congress addressed  this concern when, in 1998, it adopted the Internet Tax Freedom Act,  which bars state and local taxes on Internet access, as well as multiple or  discriminatory taxes on electronic commerce. To determine the impact of the moratorium on state and local revenues,  we worked in stages. However, some providers and state officials  have expressed a different view, believing the moratorium barred taxing  acquired services in addition to bundled access services. These services are subject  to tax. A  tax on acquired services is not a tax directly imposed on the service of  providing Internet access. We acknowledge that others  have different views about the scope of the moratorium. Some States Have Applied the Moratorium to Acquired Services

As noted above, some providers and state officials have construed the  moratorium as barring taxation of acquired services. Others said that acquired  services were taxable when we contacted them but would become tax  exempt in November 2005 under the 2004 amendments, the date they  assumed that taxes on acquired services would no longer be  grandfathered. While the Revenue Impact of Eliminating Grandfathering Would Be Small, the Moratorium’s Total Revenue Impact Has Been Unclear and Any Future Impact Would Vary by State

According to CBO data, grandfathered taxes in the states CBO studied  were a small percentage of those states’ tax revenues. According to Information in CBO Reports, States Would Lose a Small Fraction of Their Tax Revenues if Grandfathered Taxes on Dial-up and DSL Services Were Eliminated

In 2003, CBO reported how much state and local governments that had  grandfathered taxes on dial-up and DSL services would lose in revenues if  the grandfathering were eliminated. For instance, Kansas’s total includes about  $2 million for localities. Timing of Moratorium Might Have Precluded Many States from Taxing Access Services, with Unclear Revenue Implications

Because it is difficult to predict what states would have done to tax  Internet access services had Congress not intervened when it did, it is hard  to estimate the amount of revenue that was not raised because of the  moratorium. Any Future Impact of the Moratorium Will Vary by State

Although as previously noted the impact of eliminating grandfathering  would be small in states studied by CBO or by us, any future impact  related to the moratorium will vary on a state-by-state basis for many  reasons. North Dakota and Texas taxed  only services delivered to retail consumers. A broader view of what could be  included in Internet access bundles would result in potential revenue  losses much greater than we indicated. However, as explained in the  appendix, we believe that what is bundled must be reasonably related to  accessing and using the Internet. On the other hand, the moratorium does not bar  taxes on acquired services. Thus, if a  telecommunications carrier sells wholesale telecommunications services to an Internet service  provider that intends to use those telecommunications services to provide Internet access, then the  exemption would apply.”
At the time the 2003 report was drafted, the sentence of concern in the draft legislation  read, “Such term  does not include telecommunications  services, except to the extent such services are used to provide Internet access.” As  adopted, the wording became, “The term ‘Internet access’ does not include  telecommunications services, except to the extent such services are purchased, used, or  sold by a provider of Internet access to provide Internet access.”  The amended language  thus focuses on the package of services offered by the access provider, not on the act of  providing access alone.
Why GAO Did This Study

According to one report, at the end of 2006, about 92 million U.S. adults used the Internet on a typical day. As public use of the Internet grew from the mid-1990s onward, Internet access became a potential target for state and local taxation. In 1998, Congress imposed a moratorium temporarily preventing state and local governments from imposing new taxes on Internet access. Existing state and local taxes were grandfathered. In amending the moratorium in 2004, Congress required GAO to study its impact on state and local government revenues. The objectives of the resulting 2006 report were to determine the scope of the moratorium and its impact, if any, on state and local revenues. This testimony is based on that report (GAO-06-273).

What GAO Found

The Internet tax moratorium bars taxes on Internet access services provided to end users. GAO's interpretation of the law is that the bar on taxes includes whatever an access provider reasonably bundles to consumers, including e-mail and digital subscriber line (DSL) services. The moratorium does not bar taxes on acquired services, such as high-speed communications capacity over fiber, acquired by Internet service providers (ISP) and used to deliver Internet access. However, some states and providers have construed the moratorium as barring taxation of acquired services. Some officials told GAO when it was preparing its report that their states would stop collecting such taxes as early as November 1, 2005, the date they assumed that taxes on acquired services would lose their grandfathered protection. According to GAO's reading of the law, these taxes are not barred since a tax on acquired services is not a tax on Internet access. In comments, telecommunications industry officials continued to view acquired services as subject to the moratorium and exempt from taxation. As noted above, GAO disagrees. In addition, Federation of Tax Administrators officials expressed concern that some might have a broader view of what could be included in Internet access bundles. However, GAO's view is that what is included must be reasonably related to providing Internet access. The revenue impact of eliminating grandfathering in states studied by the Congressional Budget Office (CBO) would be small, but the moratorium's total revenue impact has been unclear and any future impact would vary by state. In 2003, when CBO reported how much states and localities would lose annually by 2007 if certain grandfathered taxes were eliminated, its estimate for states with grandfathered taxes in 1998 was about 0.1 percent of those states' 2004 tax revenues. Because it is hard to know what states would have done to tax access services if no moratorium had existed, the total revenue implications of the moratorium are unclear. In general, any future moratorium-related impact will differ by state. Tax law details and tax rates varied among states. For instance, North Dakota taxed access service delivered to retail consumers, and Kansas taxed communications services acquired by ISPs to support their customers.