The Current State and Local Telecommunications Taxes in California

Transcription

1 DETAILED RESEARCH FINDINGS The Taxation of Telecommunications in California in the Information Age James E. Prieger, Terri A. Sexton, and Annette Nellen Policy Research Program CALIFORNIA POLICY RESEARCH CENTER UNIVERSITY OF CALIFORNIA

2 Copyright 2003 by the Regents of the University of California All rights reserved California Policy Research Center 1950 Addison Street, Suite 202 Berkeley, CA Phone: (510) Fax: (510) Publications ordering information: (510) Program and publications information:

3 About the California Policy Research Center The California Policy Research Center (CPRC) is a University of California program that applies the extensive research expertise of the UC system to the analysis, development, and implementation of state policy as well as federal policy on issues of statewide importance. CPRC provides technical assistance to policymakers, commissions policy-relevant research on statewide issues, and disseminates research findings and recommendations through publications and special briefings. This research was funded by CPRC s Policy Research Program. About the Authors James E. Prieger is assistant professor of economics at UC Davis. Terri A. Sexton is professor and chair of economics at California State University, Sacramento, and associate director of The Center for State and Local Taxation at UC Davis. Annette Nellen is professor of accounting and finance in the College of Business at San Jose State University. The views and recommendations in this report are those of the authors and do not necessarily represent those of CPRC or the Regents of the University of California.

4 CONTENTS Executive Summary...vii Introduction...1 Technological Convergence in the Telecommunications Industry...2 The Importance of the Telecommunications Service Industry in California...5 Tax-Policy Implications...7 Overview of Current State and Local Telecommunications Taxes in California...9 Federal Laws and Restrictions on State and Local Taxes...10 Corporate Franchise and Income Taxes...22 Sales and Use Tax...28 Property Tax...33 Franchise Fees...41 Utility User Tax...48 Surcharges and Fees...53 Federal Taxes...62 Cumulative Tax Rate...67 Social and Economic Consequences of Existing Telecommunications Tax Policy..68 Equity...68 Efficiency...72 California Compared to Other States...83 Reforms...85 Recent Reforms...85 Reform Proposals...87 Conclusions and Recommendations...91 References Glossary APPENDIXES Appendix A: The History of Telecommunications in California: From Monopoly to Deregulation, a March Toward Technological Convergence Appendix B: An Inventory of Telecommunications Firms in California Appendix C: Utility User Tax Information

5 Appendix D: Comparison of Telecommunications Tax Obligations Appendix E: Universal Service in California FIGURES AND TABLES Figures Figure 1. Potential Calling Paths for a Long-Distance Call...3 Figure 2. Growth Rates in Contribution to Gross State Product, Employment, and Compensation of California s Communications Industry...7 Figure A-1. Alternative Access to the Long-Distance Network by a CAP Figure A-2. Interconnection of LECs and CLECs Networks Tables Table 1. Telecommunications Service Industry Statistics for California from the 1997 Economic Census...6 Table 2. Contribution to Gross State Product, Employment, and Compensation of California s Communications Industry...6 Table 3. Components of the California Sales-Tax Rate...29 Table 4. California Telecommunications Tax, Surcharge, and Fee Rates...56 Table 5. Household Income Limits, June 2001 May Table 6. ULTS Program Participation...58 Table Surcharge Rates and Revenue...61 Table 8. Recent Universal-Service Contribution Factors...65 Table 9. Cumulative Tax Rate on Telecommunications Services in California...67 Table 10. Excess Burden (Efficiency Loss) from the Current State and Local Telecommunications Tax System...74 Table 11. Decreasing Excess Burden (Efficiency Loss) Through Rebalancing Tax Rates...76 Table 12. Changes in Excess Burden (Efficiency Loss) Through Expanding the Tax Base...78 Table 13. Comparison of Telecommunications Transaction Taxes in California and Selected States...83 Table B-1. Number and Size of Telecommunications Firms in California, Table B-2. Number of Telecommunications Firms in California, Current Counts from Various Sources Table C-1. Utility User Taxes Table D-1. Comparison of Telecommunications Tax Obligations Table E-1. Percentage of Households with a Telephone Table E-2. Percentage of California Households with Telephone Service by Income (March 1984 Dollars)...158

6 EXECUTIVE SUMMARY The telecommunications industry is undergoing rapid change due to technological advances and deregulation. The industry that began with the telephone now includes cable, wireless and satellite communications, and the Internet. California s tax system has not kept pace with the telecommunications industry. The myriad taxes and charges on telecommunications in California were established for an industry that was legally, technologically, and structurally very different than it is today. Many taxes remain targeted to a specific technology (e.g., telephone taxes or cable franchise fees), despite the blurring of distinctions between technologies that provide similar services (e.g., the telephone and Internet telephony). The convergence of formerly distinct communications technologies renders the existing tax structure difficult to justify in terms of economic efficiency or equity. In this report we review and analyze telecommunications taxes and fees in California. The primary objectives of our research were (1) to provide a comprehensive overview of the telecommunications tax system in the state, including all taxes, fees, and surcharges paid by telecommunications service providers and their customers; and (2) to examine the economic consequences of current tax policy, including inequity, inefficiency, and administrative complexity. As policymakers at all levels of government confront the challenge of reforming our tax system to encourage new technology and broad access to various telecommunications services, including Internet access, while at the same time addressing the needs of tax equity and revenue sufficiency, they must first have a clear understanding of the current tax system and the incentives it creates. Tax Rates We find that the cumulative tax rates (including all taxes, fees, and surcharges) are higher for telecommunications services than other goods and services. The total tax rate on intrastate services (e.g., within-state long-distance) ranges from 7.83 to 18.83% and comprises the federal excise tax of 3%, various statewide taxes and surcharges totaling 4.83%, and a local tax that varies across cities from zero to 11%. The total tax rate on interstate services (e.g., long-distance calls to other states) is even higher, ranging from to 21.28% or higher. This rate consists of the 3% federal excise tax, a 7.28% federal universal-service charge (which is sometimes passed on to consumers at a higher rate), and the zero to 11% local tax. Equity The distribution of the burden of current telecommunications taxes is not equitable according to any accepted equity principle. According to the benefit principle, the burden of a tax should be distributed according to the benefits received from the governmental activities financed by the tax. Many of the taxes imposed on telecommunications are revenue-based, and companies pass vii

7 them along to consumers in proportion to their expenditure. However, the benefit these taxpayers receive from goods and services financed by these taxes is not linked to their tax burden in any way, as would be required by the benefit principle. Furthermore, since the share of household income spent on telecommunications decreases as household income increases, the telecommunications tax burden is distributed regressively with respect to income. This violates the ability-to-pay principle, which holds that tax burdens should be distributed among taxpayers according to their ability to pay, typically as measured by income. Finally, horizontal equity requires that taxpayers of equal ability to pay bear equal tax burdens, which is impossible with revenue taxation because taxpayers with similar incomes may spend differing amounts on telecommunications. Taxation Differences Across Technologies Today there are many alternatives to the traditional wireline telephone call, including wireless service and voice communication over the Internet (Internet telephony). Our research shows that the tax burden varies across technologies. For example, traditional telephone companies are subject to a much broader range of federal, state, and local taxes than are some of their new competitors (e.g., cable or satellite providers). Consumers of cable or satellite services do not pay the federal excise tax or federal and state taxes and charges to support universal service. The largest potential leakage with respect to voice communications is Internet telephony, which escapes federal and state universal-service taxes, the federal excise tax, and the local utility tax. Other potential sources of discriminatory tax treatment are local franchise fees, which cable companies pay and local exchange carriers do not, and property-tax laws. The property of most telephone carriers is state-assessed annually at market value, while cable television companies are locally assessed with annual increases in assessed value limited to 2%. There is little economic justification for these differences in treatment across technologies, because efficient taxes (which introduce the least distortion in consumer and producer decisions) depend on the demand for the final service produced, not on the technology underlying the service. Favoring one technology over another may reduce consumer and producer welfare over time. Efficiency Efficient economic outcomes maximize the total economic benefits received by consumers and firms. Excess burden, the term for the inefficiency caused by a tax, is the loss in a taxpayer s well-being above and beyond the tax revenue collected. Taxation of revenue causes excess burden because the higher prices that result decrease consumption of telecommunications services. The decrease in consumption and subsequent excess burden will be greater when taxing services such as cellular as compared to local-access service because cellular consumers are more sensi- viii

8 tive to price changes. Excess burden is a pure efficiency loss in the economy, reducing the consumers economic benefits by more than the amount of tax revenue that the taxing authority gains. We estimate, very conservatively, that the current set of telecommunications taxes leads to at least a 4% efficiency loss, or excess burden, in California. We show that the efficiency loss can be reduced without affecting tax collections by raising the tax rate on revenue from local exchange access (whose demand is relatively insensitive to price) and lowering the rates on other services, such as long-distance and wireless communication. The existing tax structure may also result in efficiency losses that compound over time dynamic efficiency losses. Discrimination among telecommunications firms or between telecommunications companies and other companies distorts the rates of return on investment across companies, thereby reducing the economic benefits realized from the growth of the telecommunications industry and its various components. Consumption Distortions Consumers choices between competing telecommunications services are affected by differences in taxes on these services. Consumers today have many avenues to avoid the taxes on traditional service. For example, Internet telephony services escape all telecommunications taxes, and consumers consequently have an added incentive to switch to Internet-based telephony. As consumers switch from taxed to untaxed services, federal, state, and local governments will see their tax revenues decline. Differences Across Locations Telecommunication costs vary among cities and counties in California due to variations in the local utility user tax (UUT) and local franchise fees. The UUT rate ranges from zero to 11% across cities; the UUT tax base also varies. Our comparison to neighboring and other large states shows that California has a greater number of state telecommunications taxes, which raises administrative and compliance costs for telecommunications companies doing business in the state. California, however, does not impose relatively higher tax rates on telecommunications. Telecommunications taxes, therefore, probably play a negligible role in business or household decisions to locate in California, but may influence the siting choices of some heavy users of telecommunications within the state. Conclusions and Recommendations Telecommunications represents a major path by which future economic growth will continue to travel. Although the telecommunications industry is currently a relatively small part of California s overall economy about 2% (measured by income) it has been growing rapidly and contributed significantly to economic growth as it raises the productivity of a wide range of other industries. Hence, its total impact on the economy is much greater than its size suggests. ix

9 As noted, California s tax system has not kept pace with the telecommunications industry. Technological developments and deregulation have resulted in new entities that do not fit the traditional definition of telecommunications providers under state tax laws. This situation results in differing treatment of businesses competing to provide the same service. The current treatment of the industry violates basic principles of good taxation, in that it is inefficient, inequitable, and creates excessive administrative and compliance costs. If developing the telecommunications infrastructure, and hence the economy as whole, is a goal of state economic policy, then tax policy should support this goal by encouraging (or at least not discouraging) investment in California s telecommunications industry. Although our chief objective has been to present information rather than to advocate particular reforms, we conclude by suggesting a few improvements our analysis points to. These may lay the groundwork for potential reform of California s telecommunications tax system. Some of these recommendations can be implemented unilaterally by the state. Others require California to cooperate with local governments or with other states.! California should extend the Manufacturer s Investment Credit (MIC) and sales-tax exemption for new equipment purchases to telecommunication companies. The primary purpose of the MIC and sales-tax exemption on equipment purchases is to avoid the pyramiding of taxes that can occur when both the inputs used to produce goods and services and the goods and services themselves are subject to the sales tax. While not subject to the sales tax, telecommunications services are subject to other taxes that total more than the sales tax. Since the MIC is intended to encourage investment, there is no reason for excluding telecommunications, given their importance in the new economy.! California should examine whether the income apportionment rules for its corporate franchise and income taxes are appropriate for telecommunications services. All states must cooperate to ensure that multistate income is being apportioned to the proper states to avoid double taxation.! California should work with other states and the federal government to establish new nexus guidelines for the Information Age. Federal Public Law limits a state s power to tax an out-of-state company s income from sales of tangible property within the state, when the property is shipped from out of state. This law should be broadened to cover intangibles, such as telecommunications and Internet services, and extended to other types of taxes.! California should, in cooperation with its local governments, simplify and consolidate the various taxes and charges imposed on end-user revenues by local jurisdictions and the Public Utilities Commission. California telecommunications customers currently pay seven different statewide taxes, fees, or surcharges in addition to the federal excise tax and universal-service charges, and possibly a local utility user tax on their purchases of telecommunications services. Consolidation of statewide charges would significantly reduce the administrative burden of telecommunications companies in the state. Switching to a simple perline charge to fund universal-service programs would result in fewer consumption distor- x

10 tions, less excess burden from taxation, and greater efficiency. If nonuniform rates are desired, long-distance service should be taxed less than local service to minimize the efficiency loss caused by taxation (which is the opposite of the current tax structure).! California should encourage local jurisdictions to unify the local utility user tax. The compliance burden on telecommunications companies could be significantly reduced if local jurisdictions were to adopt a uniform rate and base for the utility user tax.! California should establish uniform assessment of business property. Neither the assessed value of business property nor the allocation of the property-tax revenue from a particular property should be dependent upon who assesses it. Market-value assessment would be the most equitable and efficient method.! California should urge local governments to examine their local franchise fees. Local franchise fees should be set to cover no more than the costs to local governments of managing public rights-of-way, and not to fund general municipal budgets. All providers of telecommunication services should be equally subject to these minimal franchise fees so as to avoid competitive advantages that influence the future development of new technologies.! California and other states should urge the federal government to clarify issues regarding Internet and cable telephony. Currently telephone calls placed over the Internet are not subject to federal, state, or local taxes, and thus enjoy a competitive advantage. As the quality of such calls improves, more consumers will switch, which may lead to decreased economic efficiency and reduced government revenues. Certain forms of cable telephony raises unresolved issues regarding the applicability of the franchise fee and whether the property is subject to state or local assessment.! California and other states should monitor and work with the federal government in its efforts to restrict state and local tax systems. Maintaining a competitively neutral tax system in California may require expanding the tax base to include previously untaxed services such as Internet access. Currently, federal and state moratoria prevent such reforms.! California should work with local governments to provide uniform relief for lowincome individuals and households. The taxes currently imposed on telecommunications services are regressive: Taxes represent a larger percentage of a low-income household s income than a high-income household s. A few cities offer UUT exemptions for low-income individuals and some relief from statewide surcharges exists, but the relief is not uniform. xi

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12 INTRODUCTION The telecommunications industry is undergoing rapid change due to technological advances and deregulation. The industry that previously was identified with the telephone now includes television, radio, wireless and satellite communications, and the Internet. Cable television companies now offer phone service and Internet access, telephone companies similarly offer cable or video services along with Internet access, and the Internet has become a medium through which telephone and video services can be delivered. This technological convergence or blending of telecommunications, information, and computer services, together with the Telecommunications Act of 1996, has significantly changed the industry s competitive structure, and raised several concerns regarding telecommunications tax policy. The myriad different taxes and charges that currently apply to telecommunications activities in California were established for an industry that was technologically and structurally very different than that which is emerging today. In particular, many of the existing taxes were historically viewed as payments for the special monopoly status granted to telephone and cable companies and these two types of companies were treated differently, a distinction that was justifiable based on the differences in the services provided. However, the blending of once-diverse and distinct communications technologies into a single technology renders the existing tax structure difficult to justify in terms of economic efficiency or equity. A brief example illustrates the difficulties that technological convergence can create for an outmoded tax system. Cable companies can offer telephone service to their subscribers. Conversely, telephone companies can now operate Open Video Systems (OVS), which provide a substitute for cable television. However, as we discuss in Overview of Current State and Local Telecommunications Taxes in California, cable companies and telephone companies are subject to different franchise-fee and property-tax rules. Differences in tax treatment may discourage competition in service provision if the rules end up favoring one transmission technology over another, even though the final consumer product (telephony or television programming) is similar. This study provides a comprehensive review of California s telecommunications taxes and fees. In the second section, Overview of Current State and Local Telecommunications Taxes in California, we describe the history, rationale, and structure of all existing taxes, fees, and surcharges paid by California telecommunications service providers and consumers. This material is mainly for reference, and readers who are more interested in an analysis of the current tax system and our recommendations may skip or skim over that section. In the next section, Social and Economic Consequences of Existing Telecommunications Tax Policy, we examine the economic consequences of the existing tax treatment of the telecommunications industry, including equity, efficiency, and administrative complexity. In particular, we find the following:! The burden of the existing tax treatment of telecommunications services and providers is not distributed equitably, by any measure.! The existing tax system imposes different tax burdens on the providers (or consumers) of similar services. 1

13 ! The existing tax structure is not the most efficient means of raising the current level of tax revenue. A more efficient tax system could raise the same tax revenue, or more, with less harm, or no greater harm, done to consumers.! The existing tax system may distort the consumer s choice between competing telecommunications services or technologies.! The existing tax system may distort the locational decisions of telecommunication providers and consumers. In California Compared to Other States, we compare California s telecommunications taxes to those in the neighboring states of Oregon, Nevada, and Arizona, as well as to those in other large states, including New York and Texas. Several states have already taken steps to reform their tax treatment of the telecommunications industry; these reforms are described in the fifth section, Reforms, along with proposed reforms. Our conclusions and recommendations are presented in the final section. In the remainder of this opening section we summarize the recent history of telecommunications regulation and technology. We note explicitly that our research goals do not include seeking out new opportunities to increase telecommunications tax revenues to ease the state s current budget crisis. A message that emerges from the next section, Overview of Current State and Local Telecommunications Taxes in California, is that telecommunications services are already taxed higher than other goods and services in the state. In the following section on the consequences of existing tax policy, we show that the high tax rates are detrimental to consumer and producer welfare. However, should policymakers choose to seek more revenue, the analysis and principles articulated here can be a guide to raising taxes in the manner least detrimental to consumers and producers. Technological Convergence in the Telecommunications Industry The voice telecommunications service industry in California began in 1878, progressed through the years of the AT&T monopoly system, and has emerged into the current era of competition. The recent history of the industry is characterized by technological innovation that forces regulators to continually adjust and adapt outmoded forms of regulation. A more extensive history of California telecommunications is presented in Appendix A. Innovation first forced regulators to allow competition in long-distance services, beginning with MCI in the 1970s. Today AT&T is just one of thousands of long-distance firms from which subscribers can choose. More recently, the Telecommunications Act of 1996 (TA96) attempted to open the local-service market to competitors. Six years after TA96, the incumbent local telephone companies still provide 94% of residential telephone lines and 80% of business lines nationally. Notwithstanding current market shares, the rapid pace of technological innovation has left the local and long-distance markets vulnerable to entry from many different types of firms. 2

14 Figure 1 Potential Calling Paths for a Long-Distance Call 3

15 Figure 1 illustrates the many possibilities for voice-calling that exist today due to the convergence of telephony, cable, and computer technology. Traditional wired telephony is depicted in panel A of Figure 1: a telephone call passes from an end user to the local exchange company s (LEC) switching office over the local network. If the call is an out of region long-distance call, the LEC routes it to the end user s pre-subscribed long-distance company s point of presence. The interexchange carrier then routes the call to its point of presence nearest the destination, where the call passes to the destination LEC s central office and the called party. Figure 1 shows only the first half of each type of call path, given that any one kind of call can be terminated by any other kind of call. Appendix B contains more information on various types of telecommunications services and firms, and Appendix A explains the other types of calling depicted in Figure 1 more fully. Some of the more important alternative technologies are briefly explained here; Appendix A should be consulted for complete descriptions and for other available technologies. Competitive Local Exchange Carriers Companies other than the incumbent local exchange carriers that offer local services are known as competitive local exchange carriers (CLECs). CLECs may provide their own switching and transport of calls, or merely resell the incumbent s service. Several long-distance carriers are now certified to offer local service in California, including AT&T, Sprint, and MCI, and are thus considered CLECs for regulatory and tax purposes. CLECs provided 8.5% of nationwide local telephone lines in service by December 2000, nearly doubling their market share from the previous year. Wireless Communications Services Today there are several carriers licensed to offer cellular and personal communications services (PCS) in each market area, as well as several mobile satellite service providers. The number of mobile wireless telephone subscribers in California continues to grow, and wireless may soon challenge wired services for local telephony. Cable Telephony TA96 allows cable companies into the local telephony market, and they have responded by upgrading their networks to offer voice-calling ( cable telephony ). Cable telephony can be implemented using resold local phone lines, or as an Internet Protocol cable telephony service offered over the coaxial cable lines themselves. The latter is known as voice over cable (VoCable), and is closely related to the Internet telephony services discussed next. Cable telephony has been offered in California since Internet Telephony Internet telephony is a textbook example of a technological innovation in the telecommunications industry that does not fit into existing regulatory and tax treatments. In Internet telephony, communication is carried across Internet Protocol (IP) networks instead of the telephone network. 1 The market for Internet telephony is growing rapidly, although exact figures are hard to come by. 1 There is an alphabet soup of acronyms and technologies for Internet telephony, including voice over IP (VoIP) or IP (Internet Protocol) telephony (IPT), voice over packet (VoP), and voice on the net (VoN). Related technologies that may not include IP networks include voice over cable (VoCable), voice over DSL (VoDSL) (see Panel D of Figure 1), and voice over broadband (VoB). Strictly speaking, Internet telephony and IP telephony refer to dis- 4

16 Callers may use a regular phone or a netphone. 2 A netphone digitizes the voice communication so that it can be sent over the Internet like any other data. If a caller uses a regular phone, a gateway operator is needed to provide the interface between the Internet and the public telephone network. The Federal Communications Commission (FCC) does not subject gateway operators to universal-service charges. Also distinct from traditional telephony are Internet telephony calls made from PC to PC with netphones on either end. In this instance no service regulated as telephone service is involved, even though the user enjoys a service that is clearly a substitute for telephony. Self-Supply Any business can install or rent private switching equipment and networks to implement internal telecommunications services. As long as the firm does not offer to carry traffic from other originators, it is not subject to any regulation or tax placed on common carriers. Self-supply may become increasingly popular as a tax avoidance strategy, if telecommunications taxes levied on common carriers continue to rise. The Importance of the Telecommunications Service Industry in California Direct Economic Impact Although the telecommunications service industry is a major component of California s economy, it is difficult to find official statistics for the industry that conform to telecommunications as defined in this study. The closest such statistics, from the 1997 Economic Census, are reported in Table 1. By this measure, the telecommunications industry (excluding manufacturing) accounts for 1.7% of the income, 1.5% of the payroll, and 1% of the employment in California. For annual time series data, we must turn to other data, such as calculations of Gross State Product (GSP). Because the Bureau of Economic Analysis uses a different industry classification scheme, and does not disaggregate state-level data as much as the Economic Census does, GSP figures are not comparable to the Economic Census figures. 3 GSP and related statistics for the communications industry (which includes the telecommunications service industry as well as one-way communications such as television, radio, and cable broadcasting) are reported in Table 2 and Figure 2. The time series reveals that communications is a growing part of California s economy, whether measured in real or nominal terms, in levels or as a percentage of all California business, or in terms of product, employment, or compensation. The data are available only though 1999, and only the leading edge of the recent telecommunications industry boom and bust is apparent in the graph (the spike in GSP and compensation in 1999). tinct concepts. IPT involves using Internet Protocol, and may use the public Internet or the private network of a cable company or local exchange carrier. In contrast, Internet telephony is the subset of IPT that uses the public Internet. IPT over a private network would be a form of self-supply, discussed next. 2 Here we use netphone as shorthand for software or hardware that converts voice data to digital packets and vice versa. This may be done with a combination of software and hardware; examples include a microphone connected to a personal computer, specialized handsets that digitize voice, and integrated access devices (IADs) that interface a traditional analog phone with the IP network (as shown in Panel D of Figure 1 for VoDSL). 3 The Census Bureau uses the North American Industry Classification System (NAICS). The Bureau of Economic Analysis still uses Standard Industrial Classification (SIC) codes. 5

17 Table 1 Telecommunications Service Industry Statistics for California from the 1997 Economic Census Type of Business Wired telecommunications carriers Income ($ millions) Level % of all Industries Establishments Level % of all Industries Employment (thousands) Level % of all Industries Annual Payroll ($ millions) Level % of all Industries 24, % 1, % % 4, % Wireless carriers 4, % % % % Telecommunications resellers % % % % Satellite telecommunications % % % % Other telecommunications % % % % All telecommunications 30, % 2, % % 5, % Source: U.S. Census Bureau, 1997 Economic Census. Establishments are single physical locations at which business is conducted or services are provided; each company may include many establishments. Employment is as of the week including March 12. Percentage of all industries is the level divided by the corresponding figure for California total industry from all NAICS codes. All telecommunications is for NAICS The All telecommunications category represents NAICS code Table 2 Contribution to Gross State Product, Employment, and Compensation of California s Communications Industry Direct contribution to GSP (billions of current $) Direct contribution to GSP as % of all private industry contributions to GSP 2.6% 3.0% 3.4% Direct contribution to GSP (billions of 1996 $) Employment (thousands of individuals) Employee compensation (billions of current $) Other Impacts of Telecommunications Beyond the direct economic impacts of the telecommunications service sector, there are many linkages to other sectors that magnify the importance of telecommunications in the growth of California s economy. At the most basic level, telecommunications enable the dissemination and use of information, the most important resource in a decentralized market economy. 4 Although the statistics in the previous section showed that the telecommunications sector is a relatively small part of California s overall economy, the total impact of the sector on the economy is much greater than its size suggests. While figures specific to California are not available, growth in telecommunications infrastructure is estimated to have caused 17% of the per capita 4 Eliasson (1995), p

18 Figure 2 Growth Rates in Contribution to Gross State Product, Employment, and Compensation of California s Communications Industry U.S. GDP growth from 1971 to The large growth contribution occurs because communications infrastructure raises the productivity of a wide range of other industries. 6 There are other less quantifiable but no less important impacts from telecommunications. Telecommunications infrastructure contributes to the economic and community development of rural areas, for example by reducing the importance of proximity to large markets in business location decisions. 7 Broadband communication is transforming rural health care through the use of telemedicine, which can give rural residents access to the expertise of urban physicians and specialists. 8 Telecommunications also provide the backbone to e-commerce and new types of businesses operating via the Internet. Furthermore, the social import of telecommunications may be even larger than the economic aspects. Given the ubiquity of instantaneous communication in the modern social fabric, some sociologists posit that the convergence of voice, video, and data communication will have a revolutionary impact on the formation of social groups and communities in every sphere of life. 9 Tax-Policy Implications California s tax system has not kept pace with the telecommunications industry. Technological developments and deregulation have resulted in new entities that do not fit the traditional defini- 5 Röller and Waverman (2001), Table 1, based on their fixed effects specification (the most conservative estimate). 6 Nadiri and Nandi (2001). 7 See the numerous studies cited in Lentz and Oden (2001). 8 Telemedicine, a general term for the use of telecommunications to provide medical information and services, may be as simple as two doctors conferring over the telephone, or as sophisticated as videoconsulting and sending digital images such as CT or MRI scans or pathology slides. 9 Rahim (1995), p

19 tion of telecommunications providers under state tax laws. The taxes imposed on telecommunications companies and their customers were designed for a stable, highly concentrated industry in which providers offered distinct, non-substitutable services (such as telephony and cable television). This situation makes application of the law ambiguous and results in differing treatment of businesses competing to provide the same service. The current treatment of the industry violates basic principles of good taxation, in that it is inefficient, inequitable, and creates excessive administrative and compliance costs. According to a Council On State Taxation (COST) study in 2001, [t]he number of taxes and fees imposed on traditional telecommunications services that raise revenues for general fund purposes and specific social service programs remains excessive. 10 Traditional telecommunications services 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 charges that are levied only on them. In 2001, California was tied with Colorado, Illinois, and Louisiana for the second-highest number of state taxes imposed on telecommunications transactions in the nation (each had seven). 11 Telecommunication service providers in California must file, on average, 2,440 returns per year in 824 taxing jurisdictions, four times more than the 611 returns filed on average for general businesses in the state. 12 COST estimates that as of July 1, 2001, the average effective rate of transaction taxes (state, local, and federal) for telecommunications services in California was 16.28%, 13 compared to only 8.10% for general businesses. 14 We find that this figure understates the effective tax rate in many California jurisdictions, as we discuss in Overview of Current State and Local Telecommunications Taxes in California. In addition to federal taxes and surcharges, telecommunications companies in California must pay or collect state corporate franchise (income) taxes, sales and use taxes, property taxes, franchise fees, local utility user taxes, and various state surcharges. There is growing concern that the current system of property taxes and franchise fees leads to inter- and intra-industry inequities, that variations in local utility user taxes lead to inefficient location decisions, and that the combination of all taxes, fees, and surcharges results in an excessive tax burden on, and compliance costs for, California s telecommunication companies. Existing laws also seriously compromise equity: the principle of equal treatment of equal services and providers. For example, LECs and cable companies, which can now offer similar tele- 10 Council On State Taxation (COST) Telecommunications Tax Task Force (2002a). 11 Ibid, p. S-32. Results are based on taxes in effect as of July 1, COST reports that California has eight state taxes but they include the sales tax as one of the eight taxes even though it does not apply to the sale of telecommunication services. It does apply to equipment purchases by telecommunications companies and is discussed further in Overview of Current State and Local Telecommunications Taxes in California. 12 Ibid, p. S The rate reported here includes 4% taxation at the federal level. This 4% is composed of the federal excise tax on telecommunication and 1% that approximates the average effective combined rate of the federal universal-service fund charge (approximately 7% of certain interstate revenues), the FCC regulatory fee (approximately 2.25 cents per month per customer per call sign), the federal telecommunications relay service fee (0.73% of interstate and intrastate revenues), the North American Numbering Plan Administration (0.0043% of interstate and intrastate revenues), the statement of work/local number portability surcharge (percentage varies by geographical region), the microwave licensing surcharge, and the number pooling surcharge. COST (2002a) believes that the 1% estimate of all these fees and charges is both reasonable and conservative. 14 COST (2000b). 8

20 communications services, are not subject to the same number of taxes, the same type of taxes, or the same tax rates. This unequal treatment may generate both static and dynamic efficiency losses to the state economy. Static losses will occur if consumption and production decisions are distorted by the tax system, and dynamic losses will result if business investment and location decisions are affected. Finally, and perhaps most importantly, poorly designed tax policy may have important implications for the growth and development of this key industry. As important as the interstate highway system was to the growth and prosperity of the nation in the twentieth century, the telecommunications infrastructure (including the Internet) plays a similar role and holds the same or greater promise in the twenty-first century s Digital Economy. States and communities that place excessive tax burdens on this industry may not experience the same level of investment and subsequent growth. In some respects, California s growth is already lagging behind the rest of the country. While nationwide telecommunications revenues grew by 41.3% between 1995 and 1999, such revenues grew only 31.3% in California. 15 Similarly, although the number of broadband lines per capita is relatively high in California, 16 growth in this figure (a 52% increase during the first half of fiscal ) lags the national average (a 62% increase). 17 OVERVIEW OF CURRENT STATE AND LOCAL TELECOMMUNICATIONS TAXES IN CALIFORNIA Like most state governments, California imposes taxes on telecommunications businesses that do not apply to other types of businesses. In addition, some taxes (e.g., the property tax) do not apply to telecommunications businesses in the same manner that they apply to other businesses. Finally, changes in the telecommunications industry raise several tax issues for policymakers. These include e-commerce taxation issues, updating tax systems from the industrial era to the information era, simplification, and equity (treating similar businesses similarly). In this section, we provide an overview of the history, rationale, and structure of current taxes, fees, and surcharges paid by California telecommunications service providers and consumers. Some of these taxes, regulations, and laws are specific to California, while others are national in scope. 15 Federal Communications Commission, August 2001, Table As of June 2001, California had roughly 4.9 high-speed lines for every 100 people, while nationally there were 3.8 such lines per 100 people. 17 FCC, February Broadband lines here are those deemed high speed : over 200 kbps in at least one direction. Such lines include asymmetric DSL technologies that provide speeds in one direction greater than speeds in the other direction; other wireline technologies, including traditional telephone company high-speed services and symmetric DSL services; coaxial cable used for telecommunications, including the typical hybrid fiber-coax (HFC) architecture of upgraded cable TV systems; optical fiber to the subscriber s premises; and satellite and (terrestrial) fixed wireless systems, which use radio spectrum to communicate with a radio transmitter at the subscriber s premises. 9

21 In successive subsections, we cover some of the federal laws that restrict the state s autonomy in designing or revising its tax system; the state corporate franchise tax, sales and use tax, 18 and property tax; local franchise fees and utility user taxes; the many surcharges and fees levied on telecommunications; and relevant federal telecommunications taxes. Finally, we calculate the cumulative rates resulting from these federal, state, and local taxes on telecommunications services. Federal Laws and Restrictions on State and Local Taxes This subsection summarizes the primary restrictions imposed at the federal level that are relevant to a discussion of telecommunications taxation and tax reform at the sub-national levels. Constitutional Restrictions Nexus. A nexus is a connection between the business and the state, such that subjecting the business to the state s tax rules is neither unfair to the business nor harmful to interstate commerce. These two requirements stem from the U.S. Constitution from the Due Process Clause and the Commerce Clause, respectively. Sufficient nexus must exist in order for a state to subject a business to tax obligations. Both requirements must be satisfied before a state may impose tax obligations on a business. The Due Process Clause requires some definite link, some minimum connection, between a state and the person, property or transaction it seeks to tax. 19 In particular, the 14th Amendment provides that no State shall make or enforce any law which shall abridge the privileges or immunities of citizens of the United States; nor shall any State deprive any person of life, liberty, or property, without due process of law; nor deny to any person within its jurisdiction the equal protection of the laws. The Due Process Clause addresses fairness. The simple but controlling question is whether the state has given anything for which it can ask return. 20 Unlike the Commerce Clause, the Due Process Clause does not give Congress any power to enact a law that would modify or violate it. The Commerce Clause (Article 1, Section 8) provides that Congress shall have power... to regulate commerce with foreign nations, and among the several States, and with the Indian tribes. Courts often refer to the dormant Commerce Clause because the Commerce Clause does not specifically limit state activities. Instead, it grants power to Congress to regulate commerce. In applying the dormant Commerce Clause, the courts consider the purpose served by the Commerce Clause and whether action taken by state or local authorities unduly threatens the values the Commerce Clause was intended to serve The sales and use tax is referred to as the sales tax when applied to purchases made in California and as the use tax when applied to purchases made outside of California but brought into California for use or consumption. Consumers are legally obligated to pay the use tax on items bought outside California that would be subject to sales tax if purchased in state. 19 Miller Brothers Co. v. Maryland, 347 U.S. 340, 345 (1954). 20 National Bellas Hess, Inc. v. Dept. of Rev., 386 U.S. 756 (1967). 21 Wardair Canada v. Florida Dept. of Revenue, 477 U.S. 1, 7 (1986). 10

22 Whereas the Due Process Clause looks at the effect of a law upon a particular individual or business, the Commerce Clause looks at the effect of the law on interstate commerce in general. Due process centrally concerns the fundamental fairness of governmental activity.... In contrast, the Commerce Clause, and its nexus requirement, is informed not so much by concerns about fairness for the individual defendant as by structural concerns about the effects of state regulation on the national economy. 22 Telecommunications applications. Due to the significance and nature of some telecommunications assets, such as licenses and satellites, issues can arise as to whether a telecommunications company has nexus in a particular state. Two interesting cases involving nexus for a telecommunications or information company are explained below. In Goldberg v. Sweet, 488 U.S. 252 (1989), the U.S. Supreme Court provided guidance on how to apportion tax for an interstate phone call. We believe that only two States have a nexus substantial enough to tax a consumer s purchase of an interstate telephone call. The first is a state that taxes the origination or termination of an interstate telephone call charged to a service address within that state (e.g., Illinois). The second is a state that taxes the origination or termination of an interstate telephone call billed or paid within that State. The Court also noted that while multiple taxation could result if both the originating and terminating state imposed a tax on that activity, the credit mechanism of the Illinois tax prevented such multiple taxation. The Court was impressed by the realistic legislative solution to the technology of the present-day telecommunications industry in Illinois. In America Online, Inc. v. Johnson, Commissioner of Revenue for the State of Tennessee, No III (Chancery Court, Tenn. March 2001), revised and remanded 2002 Tenn. App LEXIS 555 (Tenn Ct App July 2002), the lower court found that AOL did not have nexus in the state and therefore was not obligated to collect sales and use taxes or to pay franchise, excise and business taxes (about $9.6 million over 7 years). In July 2002, the Tennessee Court of Appeals reversed the lower court s grant of summary judgment on the basis that AOL s activities in Tennessee might be significant enough to find that it has nexus in the state. AOL sells online services throughout the United States and its principal place of business is in Virginia. AOL had customers in Tennessee, but no real property, office, place of business, or employees in the state. The phone lines used by AOL were not dedicated ones. AOL used two distinct types of data networks (x.25 and AOL.net) to exchange data between the AOL customers and the AOL Data Center. Two unrelated companies who had customers besides AOL provided the x.25 data network. AOL paid a monthly fee to the x.25 network service providers (NSP). The AOL.net data network used three NSPs, one of which was an AOL subsidiary. The AOL.net NSPs provided a nationwide network that customers besides AOL could use. The dedicated AOL.net modems were leased by AOL, and the number of modems and the calling areas in which the modems were installed were specified by AOL per its agreement with the AOL.net NSPs.... AOL retained no control over the design, operation or maintenance of the AOL.net data network, paying a fixed monthly and/or per-hour charge for each modem leased.... AOL did not sell or market the services of the NSPs separate and apart from AOL s online services. The AOL subsidiary involved in the AOL.net data network maintained an arm s length business 22 Quill Corporation v. North Dakota, 504 U.S. 298 (1992). 11