Traditional telecommunications services often face the full range of federal, state, and local taxes imposed on other businesses, as well as a broad array of taxes and tax-like fees that are levied only on them. Some of these are relics of the telecommunication industry’s regulated past, while others are rooted in the budgetary politics of the 1980s and early 1990s.

Although the controversy surrounding the taxation of electronic commerce has attracted attention in the press, there is also growing recognition that taxation of telecommunications services needs to be reformed.² This sentiment was most recently evident in widely reported debates of the Advisory Commission on Electronic Commerce. Despite disagreement on the Commission about the merits of taxing Internet commerce, there was general agreement on the desirability of reforming state and local telecommunications taxes and repealing the federal excise tax;³ and proposals to repeal the federal telecommunications excise tax have been introduced in the U.S. Congress.⁴

Although calls to reform state and local telecommunications taxes are relatively recent, proposals to repeal the federal telephone excise tax predate the deliberations of the Advisory Commission on Electronic Commerce. In the 1980s, the Treasury Department issued a report recommending that the tax, which had its origins as a temporary luxury tax to help finance the Spanish American War, should be allowed to expire as scheduled at the end of 1987.⁵

Despite the Treasury report, the federal communications excise tax was extended in 1987 mainly because large and persistent budget deficits made it difficult, if not impossible, to enact tax cuts. Similar budget pressures facing state and local governments in the late 1980s and early 1990s also led to increases in state and local telecommunications taxes and fees. Today, however, with sizable actual and projected budget surpluses at all levels of government, the fiscal equation has changed, and the pace of technological change is creating pressures to rethink the rationale for the current array of taxes and fees that are imposed on telecommunications services.

This paper provides a brief overview of the current state of federal, state, and local taxation of telecommunications services. We summarize the range of taxes and tax-like fees that are imposed on telephone services, and provide estimates of the total amount of taxes on telecommunications that are collected at the federal, state, and local levels. We then discuss how the current system measures up against the three-fold standard of fairness, administrative simplicity, and economic efficiency that is commonly used to evaluate alternative ways of raising government revenue.

II. TELECOMMUNICATIONS TAXES IN THE UNITED STATES

Telecommunications services in the United States are subject to three levels of taxation: federal, state and local. Under the current system there are literally thousands of different taxing entities levying hundreds of different types of taxes and fees.⁶

A. FEDERAL TAXES AND CHARGES

The oldest and most familiar telecommunications tax is the three percent federal excise tax that is levied on all telecommunications services. The tax was first levied as a luxury tax during the Spanish-American War. Though scheduled to expire at the end of 1987, the tax was renewed and made permanent in the Revenue Reconciliation Act of 1990.

The federal communications (telecommunications) excise tax (FET) is levied at a rate of 3 percent of the amount paid by individuals and businesses for local and toll (long distance) telephone (as well as telewriter services). Local telephone service is defined as "access to a local telephone system and the privilege of telephonic quality communication with substantially all persons having telephone or radio telephone stations constituting a part of the local system." Toll telephone service is defined to be a "telephone quality communication for which there is a toll charge that varies with the distance and elapsed transmission time of each communication and the charge for which is paid in the United States."⁷ The "amount paid" on which the excise tax is applied includes mandated federal charges, such as the Federal Subscriber Line Charge, as well as certain state and local fees such as right-of-way and 911 charges.

As may be seen from Table 1, among general excise taxes collected by the federal government, the tax ranks second after the federal tax on cigarettes in terms of tax collections. Roughly half of this total is paid directly by consumers on their phone bills.⁸ Based on information about annual expenditures for telecommunication services from the Consumer Expenditure Survey, the amount of FET directly paid by households is estimated to range from approximately $18 per year for households with incomes of less than $20,000 to $36 per year for households with incomes greater than $70,000.⁹

The other half of the FET is paid by businesses. Although this portion of the FET is not directly paid by households, the burden of the "business half" of the FET is nonetheless ultimately borne by households in their roles as business owners and employees. (See Section 3.2).

Table 1: Federal Excise Taxes

In addition, Federal regulations mandate that telecommunications providers assess fees to defray the cost of subsidizing certain types of service. Before 1996, U.S. telecommunications policy relied on a complicated, implicit system of transfers among various groups of telecommunications users in order to promote "universal service," which is defined to be "the highest level of telephone connectivity by individuals."¹⁰ These transfers were made through a pricing system in which telephone companies charged urban and business users more than their share of costs to help offset the costs of serving rural and residential customers. Local telephone service was also subsidized by pricing long distance service above its cost. Until 1996, this system of cross-subsidies was financed outside the federal budget through rates and charges assessed by private telephone companies.

The mechanism for financing these subsidies was changed by the Telecommunications Act of 1996 which converted many of these implicit transfers into explicit fees and charges that are now part of the federal budget. Accordingly, both the Congressional Budget Office and the Office of Management and Budget now count payments into the Universal Service Fund as federal revenues and payments from the fund as federal outlays, so that the budgetary treatment of the fees charged to support universal service is similar to the treatment of other federal fees and user charges.

In addition, the Telecommunications Act of 1996 also required the FCC to establish a system for subsidizing the provision of advanced telecommunications services – mainly in the form of enhanced Internet access – for schools, libraries, and some rural health providers. Like Universal Service, these subsides are financed by charges imposed on telecommunications carriers that, in turn, are passed forward to users of these services. The budgetary treatment of these charges is similar to that of fees and charges collected to defray the cost of providing universal services.

Technically, these fees and charges are not treated as taxes in the federal budget; and a recent federal court case has upheld the status of these charges as fees rather than taxes. Normally, the legal distinction between taxes and fees is based on whether a charge is levied for "purely private benefits" that are received by the parties that pay the charges – in which case the charge is a fee; or whether a charge confers "public benefits that are independent of, rather than incidental to, private benefits," in which case the charge would normally be considered to be a tax.¹¹

An important exception to this principle, however, is that Congress may delegate to agencies the authority to levy "charges that require private beneficiaries to pay for services that confer a public benefit", provided the Congressional intent to do so is clear and the guidelines for setting charges are adequately set forth in the legislation.¹² In this latter case, the legal distinction between fees and taxes becomes moot, and a charge that may have the economic attributes of a tax may nonetheless be treated as a fee.

Aside from its legal status, the charge that finances subsidies for expanded Internet access in schools and libraries has all of the economic attributes of an additional tax on phone service. The universal service charge may look less like an "overall" tax on telecommunications services because it is a transfer from unsubsidized to subsidized users of telecommunication services. Yet, for the vast majority of telephone users who pay the universal service charge without receiving the subsidy, it acts much like a tax. (See footnote 35 below).

Hence, while existing federal telecommunications charges are technically fees rather than taxes, for many telephone users, they are economically equivalent to an additional federal tax on telecommunications. The Congressional Budget Office has projected that receipts and outlays from all these fees and charges together will rise to about $14 billion by the year 2007, of which roughly four-fifths will reflect charges and outlays associated with providing universal service, while the remaining fifth will reflect charges and outlays associated with subsidizing enhanced telecommunications services.¹³

B. STATE AND LOCAL TAXES AND CHARGES

It is much harder to characterize the scope of state and local telecommunications taxation because of the multitude of different jurisdictions that collect these levies. As shown in Table 2, there are upwards of 20 different broad types of state and local taxes and fees levied on telecommunications providers; and the range of specific state and local variation in these charges is almost as broad as the number of different taxing jurisdictions that assess these charges.

Until recently, it would have been extremely difficult to summarize the breadth and depth of telecommunications taxes at the state and local level, because there was no single source that provided a comprehensive and coherent description of the scope of these taxes. However, data compiled by the Committee on State Taxation (COST) allow one to paint a reasonably complete picture of the range of taxes and fees that presently apply to telecommunications services.¹⁴

The purpose of the COST study is to describe and compare the full range of transactions taxes and charges levied on telecommunications services as compared with comparable taxes levied on other goods and services.¹⁵ The information on these taxes and charges was compiled by representatives of the tax departments from telecommunications companies that are members of the COST Telecommunications Task Force. The taxes and fees levied by each state (and Washington D.C.) were analyzed by one telecommunications company and subsequently reviewed by a second telecommunications company.

1. Property Taxes

In addition to providing information about transactions taxes on telecommunications services, the COST study also provided information about whether property owned by telecommunications providers is treated differently from property owned by general business. A detailed discussion of the relative tax treatment of telecommunications property is outside the scope this paper, but a brief summary and discussion of the main findings of the COST study regarding the taxation of telecommunications property is included in the appendix.

2. Should State and Local Fees Be Included in the Tax Burden?

The COST study combines charges that are legally designated as fees with those that are legally designated as taxes into a single measure of the overall telecommunications tax burden. Thus, as in the case of federal telecommunications fees, the question arises as to whether state and local charges that are legally designated as fees are truly fees, or are economically more like taxes.

The issue again turns on whether the charges in question are assessed for "purely private benefits that are received by the parties that pay the charges" – in which case they would be properly viewed as fees or user charges and not as taxes – or whether state and local telecommunications fees "confer public benefits that are independent of, rather than incidental to, private benefits" – in which case they are taxes.

Determining when a charge that is levied on a telecommunications provider "crosses the line" that divides fees from taxes is not easy. Nonetheless, many telecommunications charges do not appear to finance specific services provided to telecommunications providers or their customers by state and local governments, but instead are either relics of the days when telecommunications providers were heavily regulated by state and local governments, or are charges that effectively defray "public benefits." Some of the issues that arise are illustrated by right-of-way charges and 911 fees.

3. Right-of-way charges

Right-of-way charges that are often assessed on telecommunications and cable providers are intended to recoup costs associated with laying telephone or cable lines under public streets. If such charges are commensurate with the added cost that maintenance of the telecommunication infrastructure imposes on the maintenance of public roads, then a right-of-way charge could be appropriately viewed as a fee rather than a tax. If, however, the charge is set at a level that exceeds a reasonable estimate of these costs, or if these additional costs are defrayed from additional taxes levied on telecommunications providers but not other businesses, then a case could be made that at least some portion of a right-of-way charge that is labeled a fee is really a tax.

4. 911 Fees

Many states and localities charge a fee for 911 service. Again, the issue is whether the fee is set at a level commensurate with the added public costs of responding to 911 calls. Recently, a state legislative analyst in Virginia uncovered evidence that some localities were using revenue from the 911 charge to pay for items other than the direct costs of providing 911 service, such as general outlays for equipment and staffing in local police and fire departments.¹⁶

As these two cases illustrate, the dividing line between what constitutes a true fee and what is a tax can be fuzzy. Nonetheless, as in the case of federal charges, a reasonable case can be made for treating many, if not all of the state and local charges as economically equivalent to taxes, notwithstanding their legal status.

5. Complexity of State and Local Telecommunications Taxes and Charges

One objective of the COST study was to document the range and complexity of state and local telecommunications taxes and charges along the following dimensions: rates, base, frequency of remittance filings (from a business to the state or local revenue authority), uniformity of base, number of jurisdictions, and uniformity of tax exemptions. The findings of the study are summarized in Figure 1 and Figure 2.

As shown in Figure 1, one feature of state and local telecommunications taxes is their number and complexity. When specific differences in these taxes and fees are taken into account, the COST study indicates there are over 300 separate state and local taxes and fees that are applied to almost 700 different tax bases. In part, this complexity reflects the fact that many state laws allow local jurisdictions to specify a base for a particular tax or fee that differs from the base that applies to the state and to other local jurisdictions.

The complexity of collecting state and local taxes may be contrasted with transactions taxes imposed on general businesses. As may be seen from Figure 2, telecommunications providers must maintain records for approximately the same number of taxing jurisdictions as do other businesses, but generally need to keep to keep track of more different kinds of transactions taxes and charges. The end result of this disparity is that compliance with telecommunications taxes and fees requires the filing of over fifty-five thousand different forms, compared with just over seven thousand forms for companies providing other goods and services.

C. AVERAGE BURDEN OF TELECOMMUNICATIONS TAXES

Translating information about the legal structure of state and local telecommunications taxes and fees into summary measures of the average effective burden of these taxes and charges is difficult for two reasons. The sheer number of different state and local taxes and fees is one complicating factor. Another is that many of these charges are either levied in fixed amounts – e.g. so many cents per phone bill, or per call – or are capped – e.g. 20 percent of the amount billed up to some dollar limit.

A crude measure of the average effective financial burden imposed by these taxes and fees is obtained by first expressing the dollar amount of state and local taxes and/or fees that are fixed or capped as a percentage of the monthly charge paid by households for basic local service. These percentages are then added to the percentage rates of taxes or charges that are levied on an ad valorem basis to arrive at a measure of the overall burden as a percentage of the basic monthly phone bill.¹⁷

Using this yardstick results in the measures of "average burdens" shown in Table 3, which ranks states by the burden of local and state telecommunications taxes and charges as a percentage of the monthly charge for basic service. Column (1) of Table 3 shows the average burden that would result if telecommunications services were taxed at the same rate as other goods and services; column (2) shows the average burden of the taxes, fees, and charges that are assessed on these services, as estimated by COST; and column (3) presents the combined burden of state and local telecommunications taxes, fees, and charges plus the federal excise tax and the federal fee for enhanced Internet access. Column (4) is the estimated additional tax burden on telecommunications taxes in each state resulting from the combined impact of state and local taxes, fees, and charges and the federal telecommunications tax and federal fee for enhanced Internet access.¹⁸

The average burdens reported in the COST study indicate that millions of American households face substantial taxes on their use of telecommunications services. Over two out of five households live in states where the average burden of state and local telecommunications taxes (excluding federal taxes and fees) can equal or exceed 20 percent of the basic monthly phone bill; more than one half of households live in states where the combined burden of state and local telecommunications taxes and fees plus federal taxes and fees can be more than 20 percent; and almost three of four households live in states where the combined burden of federal, state and local telecommunications taxes and fees can be more than 15 percent.¹⁹

The budgetary environment that prevailed in many states from the late 1980s into the 1990s is one important reason for the prevalence of relatively high rates of state and local taxation on telecommunications services. During this period, many states faced with revenue shortfalls broadened their revenue base by expanding sales and use taxes to services. In the case of telecommunications services, these "new taxes" were simply added to existing taxes and charges that had been collected from telecommunications providers in their status as regulated industries.²⁰

1. Total Amount Paid in State, and Local Telecommunications Taxes, Fees, and Charges

Estimating the total amount of revenue collected by state and local governments from the taxes and fees described above is complex because some of these taxes and charges apply only to revenue from local calls, others to revenue from all intrastate calls, and still others to all revenue. It is, however, possible to arrive at a rough estimate of the overall burden of these charges on consumers and businesses.

According to FCC data, telecommunications providers reported receiving just over $230 billion in revenue in 1997, which translates into estimated total revenue in the year 2000 of just under $270 billion, if one assumes an annual growth rate in revenues of 5 percent per year. Roughly 45 percent of this total comprised revenue from local calls, while revenue from all intrastate calls (including local calls) made up 55 percent of the total.²¹ As a rough first estimate, these data suggest that state and local telecommunications taxes and fees may apply to about 50 percent of telecommunications revenue, or about $135 billion in the year 2000.

Treating the average burdens shown in Table 3 as average tax rates, and multiplying these tax rates by 50 percent of total projected telephone revenue in each state, suggests that state and local telecommunications taxes and charges will impose a total burden of $22 billion in 2000. This estimate equals roughly eight percent of total telecommunications revenue.²²

2. The Total Telecommunications Tax Burden

The estimates of the tax burdens from federal, state and local telecommunications taxes and charges suggest that telecommunications providers and their customers will pay almost $30 billion ($7.9 billion plus $22 billion) in federal excise taxes and fees and state and local taxes and charges, not counting the impact of federally-mandated fees for universal service. Roughly two thirds of this amount, or $20 billion, is attributable to additional taxes and fees that are paid by telecommunications providers and their customers, and not other businesses.²³

III. ASSESSING TELECOMMUNICATIONS TAXES AS SOURCES OF REVENUE

From a broad tax policy perspective, the question is whether the existing panoply of telecommunications taxes and fees is a desirable way of raising public revenue according to standard criteria that are used to judge the fairness and effectiveness of different forms of taxation. Before turning to this subject, however, it is helpful to highlight some distinctive economic characteristics of telecommunications taxes and (tax-like) fees.

A. THE SIMPLE WELFARE ECONOMICS OF TELECOMMUNICATIONS TAXES

Figure 3 presents the standard partial equilibrium diagram of the incidence of an excise tax. The basic conclusion is that the effects of imposing a constant per unit excise tax of $t on good X is to impose a total economic burden on consumers of X equal to the direct tax payment of $T plus an excess burden of $E.

The effects of taxes on telecommunications services can differ from those of a simple excise tax for several reasons. One is that some taxes and (tax-like) fees are either imposed as fixed charges or are capped. A second difference is that the production technology of telecommunications requires producers to incur substantial fixed costs in order to provide the service. These fixed costs are covered by charging a price to consumers that exceeds the marginal cost of service.²⁴

Lastly, the consumer effectively makes two decisions in acquiring telecommunications services: whether to pay for access to the service, and conditional on paying for access, the amount of telecommunications services to consume (e.g. volume of long-distance calls, call-waiting, etc.). Telecommunications taxes can thus affect the decision to pay for access or the decision of how much to consume of services. The two-part decision facing the consumer is mirrored in the pricing structure of telecommunications services which typically involves a charge for access to the service, which does not vary with the level of usage, plus charges that vary with the quality and level of service.

Figure 4 illustrates the effects of charging a fixed charge, F. The fixed charge is a burden to the consumer. Depending on its magnitude, the fee could affect whether a consumer chooses to pay for access, but conditional on the consumer’s decision to pay for access, does not have a marginal effect on how much of the taxed service is consumed.

Figure 5 shows the implications of charging a price in excess of marginal cost. As in Figure 3, imposing an excise tax on the service imposes a direct burden of $T, and an excess burden on consumers of $E_C. But, unlike Figure 3 (where X is assumed to be priced at marginal cost), taxing the telecommunications service also imposes an excess burden on producers equal to the loss in producer’s surplus, $E_P, from the reduced consumption of the service.

Figure 5 can also be used to model the effects of taxes and fees on access. Assume that in order to have access to C, the consumer must pay an access charge of $A. Then, in the absence of taxes, the decision of whether to pay for access will depend on whether the net benefits from access, measured by the consumer surplus $(B+T+E_C) exceeds the access charge, $A: that is, whether $(B+T+E_C)-$A > 0.

Taxing telecommunication services reduces the net benefit to $B; and causes some consumers to avoid paying for access. These consumers suffer a welfare loss equal to the net benefit they would have enjoyed from access which equals $(B+T+E_C)-$A. In addition the providers of the service lose the producers surplus they could have earned on providing the service, which equals $(D+E_P).

B. FAIRNESS

An important principle of public finance is that taxes should distribute the burden of financing government fairly. Two broad principles of fairness in taxation are generally used to judge the fairness of taxes: the benefit principle and the ability-to-pay principle.²⁵

1. Benefit Principle

The benefit principle holds that the burdens of raising public revenue should be distributed according to the benefits that taxpayers receive from the public goods and services provided by government. One way of seeing to it that those who benefit from specific public services also pay for them is to assess fees and other beneficiary charges for the use of specific public services. Alternatively, one can tax goods or activities whose use or conduct bears some identifiable relation to benefits received from government. For example, federal and state taxes on gasoline are seen as providing a kind of tax fairness by distributing the burden of paying for public roads according to how much people drive.²⁶

The benefit principle provides no rationale for a federal communications excise tax. There is no basis for presuming that telecommunication providers and their customers derive distinctive benefits from the range of goods and services financed in the federal budget that would justify subjecting telecommunication services to an additional layer of federal taxation not faced by other businesses.

The justification on benefit principle grounds for assessing state and local taxes and fees on telecommunications services above and beyond those imposed on other goods and services is mixed. The ability to conduct business directly or indirectly depends on a range of public goods and services provided by state and local governments, such as a judicial system, policy and fire protection, roads and schools. But, there is little evidence that telecommunications providers and their customers impose special burdens on these services that justify subjecting telecommunications services to the current additional layer of taxation not faced by other businesses. Some fees, such as right-of-way charges and 911 fees, may be justified as beneficiary charges, but only to the extent that the amount of such fees is commensurate with actual benefits received.

The other widely-used principle of tax fairness is the ability-to-pay principle, which holds that tax burdens should be distributed among taxpayers in line with their ability to pay taxes, as typically measured by their annual income. This criterion is often applied in practice by measuring how the percentage tax burden changes as a taxpayer’s income rises. A tax is said to be regressive if the percentage of income paid in tax falls as income rises, proportional if the percentage of income paid in tax stays the same as income rises, and progressive if the percentage income paid in taxes rises as income rises. Many public finance scholars agree that taxation on the basis of ability-to-pay requires that the tax burden be distributed at least somewhat progressively; and there is even more widespread agreement that tax burdens should not be regressive.

As noted in a recent Treasury Department working paper on the distributional analysis of taxes, the overall distribution of the burden of taxes and charges on telecommunications services depends on the separate distribution of the burden of the share of telecommunications taxes and charges that is paid by businesses, and the share that is paid by individual consumers. In the case of telephone taxes and charges that are paid by businesses, it is plausible to assume that the incidence of these taxes is comparable to a broad-based consumption tax, that is borne by households in proportion to capital and labor income.²⁷

Telecommunications taxes and charges paid directly by households on their phone bills are distributed regressively with respect to income.²⁸ As shown in Figure 6, the estimated share of telecommunications taxes paid by households with annual incomes less than $40,000 exceeds these households’ shares of total income ? in some cases by a considerable margin.²⁹ Figure 6 also shows the burden of telecommunication taxes paid by consumers is distributed more regressively than federal taxes on alcoholic beverages.³⁰

C. TAX SIMPLICITY

Society has an interest in keeping its tax system as simple as possible. Government, businesses and individuals often must spend considerable time and effort to administer and comply with taxes. Some of the time and money needed to collect taxes is an unavoidable consequence of raising public revenue. But, it is also wasteful because scarce economic resources that could otherwise be used more productively are used to transfer resources to the government. It is thus considered good public policy to design revenue systems that are relatively simple to comply with and to administer.

As noted in the COST study, numerous complexities are involved in complying with the myriad of different telecommunications taxes and fees. As with any transactional tax, complying with telecommunications taxes and fees requires that a number of issues be addressed.³¹

• Where did the transaction take place?
• In which taxing jurisdiction did the transaction occur?
• Which transactions are taxed in each jurisdiction?
• Which transactions or customers are exempt from the tax?
• Does the taxing jurisdiction compensate sellers for collecting transactions taxes?
• Where does the tax that is collected need to be remitted?
• Has the tax been properly applied?

To some extent, these issues need to be confronted by any business that is obligated to collect state and local sales and use taxes; and, as acknowledged in the COST study, these issues become even more complex for businesses that, like many telecommunications providers, operate in different taxing jurisdictions.

Nonetheless, there are several features, both of the taxation of telecommunications services, and the market for these services, that make dealing with these issues especially complex for telecommunications providers. One of these special factors is the number of different taxes that are applied to the same type of transaction. As shown in Figure 1, there are 310 different forms of telecommunications taxes and charges, levied on 687 different bases, as compared with 103 different general business taxes levied on 184 different bases.

1. Estimating Compliance Costs

It is difficult to quantify the cost of tax compliance, even in the case of general business taxes; and there is no direct estimate of the cost of complying with the myriad of state and local telecommunications taxes and fees. A recent study by Ernst & Young indicates that multi-state retailers face costs of complying with sales taxes that equal roughly eight percent of total revenue collected.³² This ratio cannot, however, be applied directly to telecommunications taxes because the Ernst & Young estimate includes administrative costs attributable to credit card purchases that are quite important for sales but not telecommunications taxes. When a rough adjustment is made to remove this component of compliance costs, a crude estimate is that a multi-state retailer faces compliance costs, other than those attributable to credit purchases, equal to about two percent of the total amount of revenue collected. Thus, if complying with telecommunications taxes and fees is as complex as complying with the retail sales tax, this estimate suggests that the compliance cost of raising revenue from these charges may also be about two percent of the revenue collected, or about $360 million.³³

2. Drawing the Line Between Taxable and Nontaxable Transactions

Other complexities arise from the pace of technological change that is rapidly changing the nature of telecommunications services, and the way in which these services are provided. In the 1980s, for example, it was still a relatively simple matter to determine what was a telecommunications service. It was a telecommunications service if it was offered by the phone company. But, in the new millennium, the intertwining of data services, including but not limited to Internet access, with traditional telephone services, raises important and potentially difficult questions of what is and is not a telecommunications service.

For example, in August of 1999, the U.S. Court of Appeals for the District of Columbia granted the FCC’s request to remand an August 1998 order determining that "advanced" telecommunications services (including Internet access) are either "telephone exchange’ or "telephone access" services, indicating that the FCC itself may be uncertain. This uncertainty was mirrored in the final report issued by the National Tax Association’s Communication and Electronic Commerce Project, which was unable to reach a consensus on how to define telecommunications services to reflect recent changes in the market for communications.³⁴

The same uncertainties confronting the FCC confront the U.S. Treasury and state revenue departments. For example, a fairly immediate question is raised about how to treat newly emerging broadband technologies that allow a standard phone line to be converted into a high-speed data line, e.g. Digital Subscriber Line (DSL) technology. Like an additional phone line, a DSL line allows the user to have simultaneous access to both Internet and telephone communications, but unlike a phone line, a DSL line allows the user much broader and more rapid access to the Internet.

What portion of such a bundled service should be subject to telecommunications taxes and fees? One possible answer might be that providers would need to develop methods for apportioning the monthly bill between taxable and nontaxable usage. Yet the need for such apportionment raises new complexities.

D. ECONOMIC EFFICIENCY

It is widely recognized that most taxes affect how resources are allocated in the marketplace, and that this normally imposes costs on the economy in excess of the amount of tax revenue that is collected. Telecommunications taxes exact such costs in two ways. One is by raising the price that consumers pay for telecommunications services. The other is by potentially affecting the terms under which different providers of telecommunications services compete with each other in the marketplace.

1. Demand For Telephone Service and Internet Access

Telecommunications taxes and charges raise the price of telecommunications services to households and businesses compared with other goods and services. Making telecommunications services relatively more expensive discourages the use of such services compared with other, less-heavily-taxed goods and services. This response of consumers prevents resources from being allocated between production and consumption of telecommunications services and other goods and services in the most efficient possible manner, and results in an overall loss of economic well-being, termed excess burden, that exceeds the amount of taxes collected.³⁵ This situation may be contrasted with the case of excise taxes which are intended to discourage people from consuming goods that are believed to be socially harmful such as tobacco and to a lesser extent alcohol.³⁶

The 1987 Treasury Department study noted that perhaps one of the most compelling arguments for retaining the federal telecommunications excise tax was the widely-held belief that demand for telephone service as a consumption good was relatively unresponsive to changes in its price so that any associated excess burden associated with telecommunication taxes was likely to be small. Yet, that report also noted that even though this claim had some validity, it was not a fully accurate description of the demand for telephone service in the 1980s; and it seems even less applicable today in a rapidly changing market offering services such as Internet access and wireless telephony in addition to traditional telephone service.

2. Access to Basic Telephone Services

Although the estimated response is small, studies of the demand for telephone service have found that the decision of whether or not to pay for basic telephone access is sensitive to price. For example, elasticities reported by Taylor indicate that a 100 percent increase (decrease) in basic access charges would reduce (increase) the percentage of households with telephones by roughly 3 to 5 percentage points.³⁷ The last column of Table 3 shows that federal, state, and local telecommunication taxes and fees impose an average added burden on telecommunication services of roughly 10 percentage points.³⁸ Thus, multiplying this percentage by the access elasticities reported by Taylor implies that eliminating the federal telecom tax and making the burden of state and local telecommunication taxes and fees commensurate with other services would increase the number of households with telephones by between 300,000 and 420,000.³⁹

This estimate may seem like a relatively small number, but it needs to be put into context. As noted by Hausman, the FCC was reluctant to increase the subscriber line charge in order to finance increased Internet access because it would reduce the number of households with telephones by 39,000 – a number that is less than a tenth of the estimated increase in telephone penetration.⁴⁰ Moreover, FCC data also show that, not surprisingly, the vast majority of households without telephone access also tend to be lower-income households. Thus, even low price elasticities for telephone access mean that current levels of taxation have a measurable effect on the likelihood of telephone access by low-income households.

3. Demand for Long Distance and Wireless

In addition, telecommunications taxes affect a range of services whose demand, unlike the demand for basic access, has been found to be fairly sensitive to price. One is long distance service, which has consistently been found to have a price elasticity of demand that is on the order of -0.7. Another is the demand for wireless service, where the estimated price elasticity is roughly -0.5.

Federal, state and local telecommunications taxes have a measurable effect on consumer demand for wireless and long distance services. Hausman has estimated that state and local telecommunications taxes exact economic costs in the form of reduced production and consumption of wireless service that average roughly $0.50 for each dollar of revenue raised, and that the federal fee to finance enhanced Internet access imposes an average excess burden of $0.65 per dollar of revenue raised.⁴¹ These estimates suggest that the additional layer of federal, state and local taxes imposed on long distance services and wireless telephony could impose an excess burden of as much as $7 billion.⁴²

                  4. Internet Access

The effects of telecommunications taxes on access to the Internet are potentially as important as their effects on telephone access and usage, but are also difficult to quantify at this point. Data compiled by the FCC indicate that almost 19 million households now have second phone lines, in addition to their primary lines. Currently, the principle means of access to the Internet for many households is through traditional phone lines, and recent survey evidence confirms that many, if not most households are prompted to have these extra lines as a means of being able to access the Internet and use the telephone at the same time. Thus, taxes assessed on second phone lines are a de-facto tax on enhanced access to the Internet.⁴³

Recent estimates suggest that the price elasticity of demand for second phone lines is roughly -0.5 at prices in the range of $20-$25 per month. This elasticity suggests that the combined added burden of federal, state and local telecommunication taxes reduces the number of households that have second phone lines more than 5.0 percent or by roughly one million households.⁴⁴

It is possible to make a rough calculation of the excess burden that is associated with reduced use of second phone lines. Let $T_S be the taxes owed on a second phone line. If a household elects not to have a second phone line, it must be the case that $T_S > $NB_S, where $NB_S is the value of the net benefits the household receives from having a second line. Thus, the added tax that a typical household owes on a second phone line – which is roughly $40 per year – can be taken to be a rough upper bound estimate of the net benefits foregone by households that would have paid for a second phone line.

In addition, if the amount charged for a second line exceeds its marginal cost, telecommunications providers lose producer surplus equal to the difference between the price charged for a second line less its marginal cost. There are no estimates of the marginal cost of adding a second phone line. But, Hausman states that the marginal cost of long distance service is at most about 25 percent of the price.⁴⁵ If one assumes that this factor applies to the marginal cost of service on a second phone line, then if the average phone bill for basic access is approximately $240 per year, a typical telecommunications provider may lose a producer’s surplus of approximately $180 per year on each second line that is not provided because of taxes. Thus, overall, the estimated deadweight loss would be on the order of $200 for each second phone line that is not provided. Multiplying this estimate by one million households yields a total estimated excess burden of $200 million from raising revenue of some $760 million by the added taxes that are imposed on second phone lines. This translates into an average excess burden of roughly $0.25 per dollar of revenue raised from taxing second lines.

There is also evidence that household demand for new broadband technologies, such as the DSL lines mentioned above, is at least as sensitive to price as the demand for second phone lines, mainly because individuals seem to place a surprisingly low value on time spent on the net.⁴⁶ An analysis of survey data by Rappaport, Taylor, and Kridel yields an estimated price elasticity for faster Internet access that is on the order of -0.5 at monthly subscription rates of $40 to $50 per month, and -1.23 at monthly rates of between $50 and $60, an amount at which DSL services are now becoming available in many areas.⁴⁷

At this time, it is uncertain whether broadband technologies are likely to be subject to the full range of telecommunications taxes, only some of these taxes, or none. On one hand, since users must access DSL lines through existing phone lines, it could be argued that DSL lines provide Internet access only, and hence would not be subject to telecommunication taxes. On the other hand, many state and local telecommunication taxes are levied on the revenue earned by businesses that are classified as telecommunications providers, without regard to the type of service that is offered, in which case such taxes would apply to DSL services. Further uncertainty may be created by a recent decision of the 9^th U.S. Appeals Court that Internet access over cable broadband lines is a telecommunications service under the Communications Act.⁴⁸ In any event, the elasticities reported by Kridel, et. al. imply that if DSL lines were to be taxed at the same rate as existing telephone lines, the demand for these services would be on the order of 10 to 15 percent lower than otherwise.⁴⁹

5. Competitive Neutrality

The issue of how telecommunications taxes affect the playing field between different providers may loom at least as large as the question of whether and by how much existing telecommunications taxes reduce the use of long distance and wireless services and slow the rate of Internet access. A basic principle undergirding the Treasury Department’s landmark reform of the federal income tax in 1986 was that tax systems should be neutral, and avoid giving a market advantage to some producers over others. But it is hard to envision how such competitive neutrality would be achieved in a world in which "traditional providers" of telecommunications services, such as telephone companies, are subject to the full range of existing federal, state and local communications taxes, while "new entrants" to the market, such as cable providers or providers of Internet telephony are either subject to none of these taxes, or to different taxes.

Indeed, unless the current system is reformed and simplified, it would seem that those responsible for tax policy may find themselves on the horns of a dilemma. The playing field between competing providers could be leveled by imposing the current, ineffective system of telecommunication taxation on "new" and "old" providers and/or technologies alike, which would potentially mean a significant, and somewhat hard to justify increase in taxes collected on communications services. This particular view was echoed by some members of the National Tax Association’s Electronic Commerce Project, who expressed the concern that broadening the definition of telecommunications services to include nontraditional forms of electronic communications would simply subject these emerging services to the already tangled web of existing telecommunications taxes and fees.⁵⁰

Alternatively, competitive neutrality among communications providers could be achieved by substantially lowering taxes and fees on traditional telecommunications providers to enable them to fairly compete with technologies and/or providers that are not subject to these taxes. Indeed, a similar issue prompted the Treasury Department to issue its 1987 report. At that time, the issue was how to treat the growth of private communications services, which enjoyed an exemption from the federal telecommunications tax. The report noted changes in the tax law that would need to be made in order to reduce the differential tax treatment arising from the exemption of private communications service. But instead of recommending that an existing tax, that by then had outlived its usefulness, be extended to a new area, the report recommended that the existing federal telecommunications tax be abolished.⁵¹

IV. SUMMARY AND CONCLUSIONS

In 1987, the Treasury Department concluded that "there is no policy rationale for retaining (the federal) communications excise tax." The basis for drawing this conclusion in the case of the FET is at least as strong today as it was in 1987; and there are good arguments for simplification and reform of state and local telecom taxes.

Perhaps the most important policy rationale for keeping existing telecommunications taxes is that "these taxes are already in place, and are steady revenue raisers." This argument had practical merit in the 1980s when governments at all levels were facing large and, at the time, growing budget deficits, but it is a less-compelling rationale for retaining these taxes when not only the federal budget, but also many state and local budgets, have sizable current and projected budget surpluses.

Given that excise taxes play only a small role in the overall system of federal taxation, there is a strong case for repealing the FET. The issue is more complicated at the state and local level. Since sales and use taxes are important sources of state and local tax revenues, there is a rationale for taxing telecommunications services — but not more heavily and in a more cumbersome manner than other goods and services. State and local tax reform efforts should thus focus both on simplifying telecommunications taxes, and on reducing their burden to levels that are commensurate with taxes levied on other goods. Achieving these goals will require that state governments work cooperatively not only with local governments, but also with telecommunications providers.

APPENDIX: TAXATION OF TELECOMMUNICATIONS PROPERTY

Table A-1 summarizes information in the COST study on property taxation in states where property owned by telecommunications providers is taxed differently than property owned by general business. The last column shows where each of the states that taxes telecommunications property more heavily than general business property ranks in terms of the average burden of telecommunications transactions taxes and fees.

Although the focus of this paper is on the effects of "transactions taxes" levied on telecommunications services, telecommunications providers also face a heavier property tax burden in some states. As shown in the table, ten states tax real property owned by telecommunications providers more heavily than real property owned by general businesses and fourteen tax tangible property (e.g. equipment) more heavily. In addition, in fifteen states telecommunications property is assessed by applying the unit value rule, which essentially uses the value of the business unit, instead of the cost of real and tangible property as the basis for assessing value. This practice has the economic effect of including the value of intangible assets, such as goodwill or even R&D know-how, in the property tax base.

Considered in isolation, the effect of taxing telecommunications assets relatively more heavily than other business capital would be to increase the effective tax rate that telecommunications providers pay on each dollar of profit, which increases the cost of capital on telecommunications investment. Whether telecommunication providers face a higher overall cost of capital than other businesses, however, depends not only on the comparative property tax burdens faced by telecommunications and other businesses, but also on the comparative burdens of federal and state corporate income taxes.⁵²

Table A-1: State and Local Property Tax Rates

Source: Committee on State Taxation (1999) and authors’ calculations

ENDNOTES

2. For example, see Martin Sullivan, "Will the Tax on Talking Take a Walk?" Tax Notes, April 15, 1999; National Tax Association, National Tax Association Communications and Electronic Commerce Tax Project Final Report. Washington, D.C.: National Tax Association, 1999. At, http://www.ntanet.org/. The National Governor’s Association also recently issued a report acknowledging the complexity of the current tax structure for the telecommunications industry, and calling on the states to undertake a thorough review of their telecommunications tax structure. See, Scott Paladino and Stacy Mazer, Telecommunications Tax Policies: Implications for the Digital Age, National Governor’s Association, Washington D.C., 2000. At, http://www.nga.org/Pubs/IssueBriefs/2000/Sum000202TeleCom.asp.

20. Data published by the FCC show that taxes as a percentage of the monthly phone bill increased steadily from 1985 to 1999. See, Jeff Eisenach, "The High Cost of Taxing Telecom," Progress & Freedom Foundation, November 1999, at http://www.pff.org/taxingtelecom.htm. As suggested by a discussant of this paper, this trend could reflect a combination of rising taxes and falling costs for telephone services.