Capital Goods - March 2009

The upside of downloads
By Scott Mooneyham

“If you take a walk, I’ll tax your feet ...”

So far, Tar Heels have avoided the fate predicted by The Beatles in their 1966 hit ”Taxman.” But North Carolina might indeed tax your index finger when it clicks a button to get a song off iTunes or an online movie offering. State legislators are considering a proposal that would subject Internet downloads — right down to ring tones on cell phones — to sales taxes.

“It’s reacting to electronic realities,” says Rep. Paul Luebke, the Durham Democrat who co-chairs the powerful House Finance Committee. The reality to which he refers is the increasing appetite of a tech-savvy world for music, movies, electronic books and computer software via Internet download. After all, why drive to a bricks-and-mortar store or even bother to order some old-fashioned disc over the Internet when you can have it now, through cyberspace and the cables leading to the back of your computer?

In 2007, digital sales accounted for 10% of music sold worldwide. By 2014, downloads are expected to account for 40% of the market, according to In-Stat, an online publication that follows digital communications. Here’s the rub: Every time someone downloads software instead of buying a disc that you plug into a computer drive, state and local governments see their sales-tax base erode a few cents. Internet downloads haven’t been considered tangible goods subject to state sales tax.

A “digital tax,” already in place in 17 other states, would change that. If approved by the General Assembly, fiscal analysts estimate, the tax would bring in about $12 million a year, with roughly $4 million going to local governments and $8 million to state government. That’s minuscule compared with annual sales-tax collections totaling $5 billion. But the number will rise as the technology becomes more dominant in the marketplace.

Brooks Raiford, head of the North Carolina Technology Association, says legislators should be aware of unintended consequences as they consider their digital tax. His group, which promotes high-tech businesses, has yet to take a position on the proposal. That’s because the legislation is still a work in progress, he says. Even so, he’s leery of the idea. Taxing downloads, he says, could send a signal that North Carolina isn’t welcoming to the computer-technology industry, something the state can’t afford in a down economy.

“Tax credits and tax breaks are used as an incentive for behavior — marriage, buying a house, having children,” he adds. Why not a tax break for a practice that is environmentally friendly? Downloading a music file leaves a smaller carbon footprint than driving to a store to pick up a CD. “We’d say that is good public policy in general.”

But legislators and staffers push- ing the tax are really attempting to take a small bite out of a pie that is much bigger than downloading a Miley Cyrus song or online version of Turbo Tax. It’s difficult to separate the proposal from a larger policy debate involving not only taxation of Internet purchases but of all kinds of services and bolstering the sales-tax base in a time of rapid change. The erosion of that base hasn’t been so noticeable in an economy mostly vibrant for nearly three decades. But if the current downturn lasts long, this chipping away will take a toll on state and local revenue, and the chorus within government calling for tax reform will get louder.

Tax officials in states across the country have been working more than a decade to put together an agreement to impose sales taxes on all Internet purchases, regardless of where the retailer calls home. So far, the key player in making the agreement work — Congress — has balked. Eight years ago, when North Carolina last faced a down economy and a budget shortfall, a group assembled by then-Gov. Mike Easley began exploring the idea of taxing services, from the labor on car repairs to the divorce papers filed by a lawyer. Easley backed off after hearing from some well-placed opponents.

Now comes a different predicament involving the sales tax that’s really not so different. The question is, will this digital-tax proposal meet the same fate as those others? And if not, if a digital tax does come about, will it set the stage for different outcomes for these older, hotly disputed tax propositions?

Scott Mooneyham is the editor of The Insider,