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Document 12 of 27.

November 13, 1999

SECTION: TECHNOLOGY; Pg. 3304; Vol. 31, No. 46

LENGTH: 2865 words

HEADLINE: Byte-Size Taxes

BYLINE: Neil Munro

HIGHLIGHT:

The Old Economy's tax codes don't always apply to the New
Economy's services and commerce. And that suits high-tech
industries just fine.

BODY:

When tax assessors look at a home, they typically
estimate the value of the land that it's on, the cost of
construction, and all the difficult-to-measure intangibles that
make a house worth buying--beauty, proximity to good schools, a
desirable neighborhood, and so on. And, as many homeowners
discover when they receive their property tax bills, the
intangibles can make a very big difference, indeed. In Seattle,
for example, a waterfront view adds about $ 100,000 to a home's
taxable value, says Bruce Smith, a Realtor at Seattle-based
Fireside Homes.

When tax assessors look at a business, however, they use
different rules. Although they assess tangible property--
buildings, equipment, production lines--they generally don't try
to estimate the increasingly valuable intangible property of the
Information Age--software, patents, databases, customer lists,
and the like. So in King County, which includes Seattle,
Microsoft Corp. has a property tax assessment of $ 1.05 billion
and an annual tax bill of roughly $ 14 million, despite Wall
Street's estimate that the company and its intangible software
are worth $ 500 billion. Meanwhile, down the road from Microsoft,
the Boeing Co.--which Wall Street estimates is worth $ 40
billion--gets hit with a property tax assessment of about $ 5.5
billion and a tax bill of some $ 70 million because it has lots of
tangible property.

The different approaches to property assessments are
among the several ways in which the ''New Economy'' of high-tech
services and electronic commerce bypasses the old economy's tax
codes, much to the distress of many state and local officials.
''The basic problem is that our tax systems were set up for the
manufacturing economy of the 1950s, not a high-tech service-
oriented economy,'' said Ray Scheppach, the executive director of
the National Governors' Association. ''We have problems across
the board.''

Economists generally agree that the marketplace works
most efficiently when taxes are broad, equal, and low. When
government creates a tax imbalance, it pushes customers and
investors away from high-tax sectors toward low-tax ones. ''We
should not pick out electronic commerce and tax it differently
from anything else . . . (but) what we have is a tax system that
taxes very heavily physical investment,'' said William F. Fox,
the director of the Center for Business and Economic Research at
the University of Tennessee in Knoxville.

Still, there is little outcry from older industries or
groups that typically oppose taxes rather than tax disparities.
And aside from a furious fight between states and tax opponents
over Internet sales taxes (see box, p. 3307), there is no debate
so far at the federal level. Indeed, these disparities are one
portion of a sometimes deliberate, often accidental national
industrial policy that favors the high-tech sector--and has
helped generate waves of new technology and billions of dollars
of personal wealth.

Not surprisingly, companies with a stake in the New
Economy don't worry about imbalances in state tax rules, and
instead see them as an opportunity to keep their taxes low.
Executives from the high-tech industry argue that their low taxes
are more than offset by the money that eventually ends up in
government coffers, thanks to the growing high-tech work force.
It's one reason that many states--imbalances or not--are flush
with receipts from income, sales, and property taxes. Indeed,
total state and local tax revenues rose from $ 1.01 trillion in
1997 to $ 1.15 trillion in 1998. This flood of revenue gave the
states a combined surplus of $ 150 billion in 1998, which prompted
many legislatures to cut taxes.

But some state and local officials argue that the tax
disparities are a long-term problem because the New Economy is
undermining old-fashioned property and sales taxes. Unless state
and local taxes are changed before the next, inevitable
recession, they warn, many governments will lack the revenue to
cope. ''We're not in a crisis, so people say, 'Why change?' The
problem is that growth is starting to slow down (and) there are
problems right around the corner,'' said Robin C. Capehart, West
Virginia's secretary of tax and revenue. ''The best time to fix
your roof is when it is not raining.''

Although some states are debating sweeping tax reforms,
most are focusing on smaller fixes. In the process, more
attention is being paid to taxes that fall heavily on older
companies but largely miss the New Economy companies--businesses
that generate their revenues from intangible property, services,
and the Internet. Here's a look at some of those taxes:
Property Taxes. Microsoft's low property tax assessment is
perhaps the most garish example around, but similar disparities
can be found in most states. The available data suggest that
property taxes are becoming a less important source of revenue
for states and localities, partly because more property is
intangible and thus untaxed. For example, states these days get
30 percent of their revenue from taxes on property, down from 41
percent in 1971.

The main reason intangible items are not taxed is that it
is difficult to assess their value. ''Trying to establish a value
for intangibles is a nightmare; you just don't want to go
there,'' said J.D. Foster, the executive director and chief
economist at the Tax Foundation, an industry-funded group based
in Washington. For example, California does not tax the immense
value of the Walt Disney Co.'s movies, Georgia does not tax the
Coca-Cola Co. on the value of its secret recipe, and New York
does not tax the much-sought-after customer data amassed by in-
state banks and insurance companies.

Out-of-State Internet Sales. Sales taxes are usually
levied on items purchased from in-state and out-of-state sellers.
But the Supreme Court ruled in 1992 that Congress's approval is
needed before states can compel out-of-state mail-order companies
to collect and forward a sales tax to governmental tax
collectors, just as in-state sellers are compelled to do. Without
such compulsion, few in-state residents pay sales taxes.
Established companies, on the other hand, usually pay ''use
taxes'' when they buy items from out-of-state sources.

The Court's Quill decision, which has cost the states
perhaps $ 4 billion in annual taxes on mail-order sales, according
to state and local officials, is great for the new Internet-sales
industry. Without any need to collect sales taxes, it can
undersell Main Street retailers by the average sales tax of 6.1
percent. In 1999, this tax break will save Internet companies an
estimated $ 400 million and boost sales by perhaps 20 percent,
according to Austan D. Goolsbee, an economics professor at the
University of Chicago. The states' tax losses could reach $ 9
billion in 2003, as more taxable sales on Main Street are
replaced by untaxable Internet sales, say state officials.
Economic forecasters estimate that Internet sales to consumers
could amount to $ 75 billion in 2003.

Several states have tried to get Congress to close this
tax disparity. But they've been blocked by industry officials and
Governors from technology-rich states, such as California,
Virginia, and New York, who persuaded Congress last year to
postpone any action on this issue for three years. The moratorium
is needed, say Internet industry executives, because the tangle
of sales tax rules in 46 states and 7,000 local jurisdictions
would strangle their growth.

Exemption for Services. Sales taxes are rarely applied to
the sale of services--such as the advertising that pays for many
free Web goodies or, more broadly, for legal advice and medical
care--even if both seller and buyer are located in the same
state. The major exceptions are the telecommunications,
electrical power, and tourism industries. Hotels, for example,
often have specific taxes that are to be paid by out-of-town
visitors.

From 1959-97, the nation's service sector grew from 39
percent of the economy to 64 percent. To offset for this change,
states, cities, and counties have boosted their sales taxes from
a combined average of 6.74 percent in 1981 to 8.25 percent in
1998, according to data collected by Vertex Inc. of Berwyn, Pa.,
which monitors state and local tax changes. Some states don't
levy any sales taxes, and that brings the national average down
to 6.1 percent. The exclusion of services is especially useful
for the high-tech industry, much of whose revenue comes from
providing Internet access and online advertising. For example,
these two services provide the bulk of America Online Inc.'s
revenue.

Research and Development Tax Credit. Research-intensive
Internet companies are well positioned to use the federal
research and development tax credit, which is designed to boost
corporate research spending. It allows companies to deduct from
their taxable income any year-to-year increase in R&D spending. A
wide variety of companies, including pharmaceutical and high-tech
firms, use this tax credit, and it costs the federal Treasury
roughly $ 2 billion a year, say industry officials.

Telecommunications Taxes. The high-tech industry is
sometimes hurt and sometimes helped by these taxes. State and
local governments have long used the telephone industry as a cash
cow. According to a recent study by the Committee on State
Taxation, an industry-based group in Washington, taxes make up as
much as 18 percent of customers' phone bills. These taxes add up
to an annual burden of $ 35 billion, according to the Progress &
Freedom Foundation, which opposes high telecommunications taxes.
The taxes have increased the price of communications, which slows
the Internet industry's growth. Deregulation, however, is forcing
state and local governments across the nation to cut these in-
state taxes or else see their residents buying telecommunications
and electrical power services from out-of-state companies.

But at the federal level, the Internet industry has been
the major beneficiary of telecommunications taxes levied on long-
distance callers, most of whom are businesses. That's because the
taxes are used to limit the cost of local phone calls--and thus
cap the cost of dialing into the Internet, which greatly spurs
Internet usage and homeowners' technology purchases. In Europe,
where comparable limits do not exist, U.S. companies such as
America Online have found themselves at a disadvantage when they
compete against local phone companies that can subsidize Internet
service for their phone customers. Also, there is a separate
federal levy worth $ 2.25 billion per year on long-distance
charges that's used to install Internet technology in schools, a
levy that further spurs the Internet industry's growth.
State Tax Debates
So far, attempts to rewrite state taxes have not gotten very far.
Consider Washington state, home of Microsoft and Boeing. In 1991
and 1997, in response to efforts by local assessors to add some
forms of intangible property to their lists of what could be
taxed, industry lobbyists persuaded the state Legislature to bar
taxation of intangible property.

''We basically put in a law that preserved the status
quo . . . (codifying) the property tax as a tax on tangible
property,'' said Tom Dooley, the director of fiscal policy for
the Olympia-based Association of Washington Business. These
victories barred county officials from taxing such items as a
power company's list of subscribers, a bank's specialized
software, or a software company's original software, including
the ''Golden Disks'' that hold the master copy of Microsoft's
core product, its Windows 98 software program.

In West Virginia, Republican Gov. Cecil H. Underwood
established a tax reform panel that early this year recommended
the elimination of 13 taxes and 30 tax credits--some dating to
the 1930s--in exchange for a single business tax. This tax, a
variant of the value-added tax, or VAT, would be levied on the
contribution made by each company to the final sale of an item or
service. These contributions include licensing an intangible
product, manufacturing a component, assembling a finished
product, transporting it, or selling it in a store. Reliance on a
VAT would remove tax penalties that deter investment by local
mining and timber companies, said Capehart, while capturing
revenues from intangible property, such as royalties and
licenses.

''What keeps West Virginia poor is that we tax capital
investment (in factories and mines) very heavily. . . . We tax
the first thing you have to do to create jobs,'' he said. Despite
the proposal's simplicity, and its inclusion of a sharp increase
in family exemptions, it faces an uphill fight, Capehart said.
''Anytime you have massive change it takes a great deal of
education with the public.''

In Montana, Republican Gov. Marc Racicot has tried to
reduce the state's heavy reliance on income and property taxes,
which hit miners and loggers hard, by proposing a single business
tax modeled on the value-added tax. Just as in West Virginia,
this single tax would encompass revenue from the New Economy's
services and intangible property. But opponents succeeded in
scuttling much of the plan. What resulted were incremental
changes, including a decision this year to exclude intangible
property from property taxes.

In Michigan, legislators decided this year to phase out
over a 20-year period a VAT-type tax that was adopted in the
1970s. From the start, the 2.3 percent tax had encountered
opposition, especially from small businesses, largely because it
levies taxes even during a recession when the companies are not
making a profit, said Mark A. Murray, the state's treasurer.

These tax debates--and others in such states as Florida,
Massachusetts, Tennessee, and Texas--exemplify the difficulty of
changing the tax system, particularly in good economic times,
when state legislators are reluctant to tamper with the flow of
revenue.

Moreover, U.S. history is replete with examples of tax
disparities. Similar combinations of tax breaks, subsidies, and
loose regulation spurred the development of heavy manufacturing,
the railroads, and the auto and aerospace industries. Also, it is
politically difficult to cut one industry's advantages without
also looking at the advantages held by others--from the real
estate industry's mortgage interest deduction to the restaurant
industry's business meals write-off.

Still, there is some rhetorical support from business
groups for change. For example, officials with the American
Electronics Association, the National Association of
Manufacturers, and the U.S. Chamber of Commerce say that there is
a need for overhauling state and local tax codes. ''The
frustration that state and local officials feel is
understandable. . . . What we need now is drastic and radical
simplification,'' said Caroline Graves-Hurley, the AEA's director
of tax policy. Added Dorothy Coleman, the director of tax policy
with the NAM: ''The whole tax system is a drain on business and
should be replaced.'' None of these business groups, however, has
dared endorse any specific reform, although executives at the
chamber say they are eyeing a VAT tax.

Grover G. Norquist, the president of Americans for Tax
Reform, dismisses much of the industry rhetoric as ''good-
government sales talk.'' In reality, he said, companies will
fight proposed new state taxes by hiring lobbyists and
threatening to move their facilities out of state. Because the
New Economy allows companies such as Microsoft to easily shift
people and intangible assets out of high-tax jurisdictions,
states will have no choice but to cut taxes by 50 percent over
the next decade, he predicted. ''In a more mobile society, you
can't extract the same level of taxation as you used to. You
can't do it, (so) don't come and whine about what you would like
to do, because it ain't an option,'' he declared.

Moreover, voters don't trust legislators enough to let
them fix their tax problems through changes that capture taxes
from intangibles and services, he said. So states will just have
to tighten their belts and become more efficient by contracting
out tasks, such as education, he said.

But Scheppach sounds more hopeful. ''Any kind of reform
will be incremental, but that's the way tax policy is done,'' he
said. It could take two or three decades to deal with the issues,
he said, but ''as long as the economy is good, we'll get through
this.''

LOAD-DATE: November 16, 1999

Document 12 of 27.


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