TOPICS: Consumer Behavior, Taxation, Taxes SUMMARY: Taxes are an inevitable part of doing business. What's taxed, how it's taxed and rates affect many different kinds of companies. One issue for digital companies is the increasing push for state and local government who want to tax digital business. Sales tax in the past was applied to tangible goods, but many digital products replaced them. Examples include streaming music replacing CDs, streaming video services replacing DVDs and video games online replacing physical copies of gaming software. This significantly affects state sales tax revenue which nationally dropped from an inflation adjusted growth of 1.5% from 2004 to 2014 from 3.1% in the previous decade. Some states tax some of these items while others are considering legislation to do so. Companies are pushing back saying they provide a service not a product that someone buys with permanent ownership. For consumers, taxes would increase the price of these services. Given consumer preferences for digital instead of tangible goods, it's uncertain whether increasing taxes would reduce demand. CLASSROOM APPLICATION: Companies that provide streaming services face possible changes as state and local governments consider taxing streaming video subscriptions and cloud computing. State and local governments would like to make up revenue they lost now that consumers no longer buy as many tangible goods including CDs, DVDs and video games. Sales of these items are increasingly online or with a streaming service. The shrinking tax base caused by e-commerce initially occurred when individuals bought tangible goods from out-of-state companies. Now there is the additional threat to the tax base caused by shifting consumer behavior from tangibles to streaming services. Companies recognize they need to counter legislation. For example, Netflix fought a proposed Idaho law attempting to tax certain digital items. Companies should always be aware of the political environment that affects their business and customers. As for state and local governments, the issues they face with sales tax reflect how government too is affected by changes in technology and shifts in consumer behavior. QUESTIONS: 1. How would a tax on streaming content and cloud computing affect you financially? 2. What is meant by the term "tangible goods” within the context of music, movies, books and games? 3. Discuss what has been happening to state and local tax bases over time. 4. If one city, like Chicago, or a state like Illinois taxes digital services, how might that affect the overall business climate and economy. 5. Why might demand for streaming services continue even if new taxes raised prices?

States Eye Taxes on Streaming Entertainment and Cloud Computing

Decline in DVD and CD sales has taken a bite out of revenue in recent years

State tax officials are trying to catch up with fans of “Orange Is the New Black” and One Direction.

With sales of DVDs, videogames and traditional packaged software slumping for years, more state and local governments are eyeing technologies, such as streaming video subscriptions and cloud computing, to help make up for hundreds of millions of dollars or more in lost revenue.

Applying age-old sales taxes to the era of new media hasn’t been simple. States have long taxed tangible goods, but the broad array of new digital products often don’t fit the category. Some states are trying to use existing laws, while others are taking on the politically thorny task of rewriting tax rules.

The result is a patchwork of tax policies—and some new laws—for fast-growing slices of consumer and business sales. While taxes on digital entertainment and software represent only a sliver of the $271 billion that states collected in sales taxes last year, the issue highlights the challenge states and localities face as technologies rapidly shift.

“What’s so hard about digital goods is they move so fast there’s not the time for states to grasp them and figure out what to do,” said Diane Yetter, president of Yetter, a Chicago-based sales-tax consultancy.

Last month, Tennessee extended its 7% sales tax to software and digital games that are accessed remotely. Meanwhile, Chicago is one of the first cities to wade into taxing digital goods, requiring in the coming months local taxes on cloud computing and streaming entertainment.

But Alabama lawmakers recently shelved its own “ Netflix tax” after months of study, and Vermont ended an effort to levy taxes on cloud computing after finding the technology was more akin to a service than a tangible good.

The Netflix website is displayed on laptop computers in this arranged photograph in Washington, D.C., last year. Photo: Andrew Harrer/Bloomberg News

States and cities have struggled for decades with shrinking tax bases, often driven by the decades-long decline of manufacturing, but also the more recent rise in e-commerce, which is hard to police when individuals buy goods from out-of-state companies. Nationally, the average, inflation-adjusted growth rate for state sales-tax revenue was 1.5% between 2004 and 2014, down from 3.1% a decade earlier, according to Nelson A. Rockefeller Institute of Government at the State University of New York.

“There’s a concern when you have something that the state as a policy matter has clearly chosen to tax, but it starts not being taxed because of changes in technology,” said David Gerregano, deputy revenue commissioner of Tennessee, which expects to collect $11.3 million in the first year following its tax changes, providing some additional revenue for the state’s multibillion-dollar budget.

States still don’t have a handle on how much revenue they have lost from the decline of physical media, because they typically don’t track tax collections for specific items.

Annual U.S. spending on sales and rentals of DVD and Blu-ray discs have fallen to slightly more than $10 billion from a peak of $20.2 billion less than a decade ago, according to data from Digital Entertainment Group, a trade association. Sales of CDs have seen an even sharper decline, with data from the Recording Industry Association of America showing record-company shipments fell to $1.9 billion last year from $13.2 billion in 2000. Sales of videogames also have fallen steeply in recent years.

States have likely lost hundreds of millions of dollars a year in tax revenue from those three items, perhaps more than $1 billion. Not all states assess sales tax, and in the 45 states that do, rates range from less than 3% to more than 7%, when local taxes aren’t included.

As CD and DVD sales have fallen, first downloads and then streaming subscriptions have notched rapid growth. Netflix Inc., for instance, drew in $2.01 billion in sales in this year’s first half from its U.S. streaming video business. The company says its offerings are currently taxable in roughly half of U.S. states and certain municipalities.

Another fast-growing area that could bolster state coffers is cloud computing, an amorphous term that includes renting online computing storage and using remote Internet-connected servers for number crunching. Gartner Inc. projects the cloud-computing market in the U.S. will reach $115 billion next year, which includes business processing, infrastructure and security.

Idaho has moved cautiously on taxing cloud computing and streaming video. Two years ago, the state decided to exempt most cloud-based software from sales taxes, viewing it as a service. The following year, it exempted downloadable software, while taxing digital music, video, books and games, according to the state tax commission.

Netflix, which determined it had to collect sales taxes on subscriptions under the Idaho law, fought the law at the capitol in Boise. “Netflix unquestionably provides a service, not the sale or rental of digital products,” the company said in comments to the Idaho State Tax Commission.

Earlier this year, Idaho legislators passed a new law specifying that unless the consumer got a permanent right to the content, it wasn’t taxable, which exempts streaming services from the sales tax.

Meanwhile, Chicago is facing pushback from businesses for its effort to drum up about $12 million a year in taxes from various digital offerings. For now, the city has extended the period for businesses to come into compliance on cloud computing to the start of next year, and new exemptions are under discussion.

Asked about Chicago’s move, a Netflix spokeswoman said the company has “no broader policy beyond reviewing situations on a case-by-case basis.”