How States Can Gird for the Coming Fights Over Taxing Digital Ads

Maryland is leading the way, but its new levy faces plenty of pushback in the courts and Congress. States that want to follow suit should act quickly to craft viable uniform model legislation.

Maryland's state flag
Maryland's state flag. (Belyay/Shutterstock)
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Maryland’s Legislature recently overrode a gubernatorial veto and enacted a new tax on digital advertising — the first of its kind among the states. It was inevitable that somebody would break the ice. Last August, I explored the revenue implications for states and localities of a federal tax on interstate digital commerce. Globally, the COVID-19 pandemic has accelerated business migration to Internet platforms, making this the new frontier for tax policy.

Maryland legislators deserve credit for planting their semi-checkered state flag first, to stake their claim, but they are still far from the finish line. Anti-tax wonks point to a host of possible legal snags that could tie up the Maryland tax for some time. They complain that it’s unduly vague, imprecisely crafted, and invites double taxation. The social media goliaths are already protesting that it’s unconstitutional under the commerce clause, which gives Congress supreme authority to regulate interstate business. To salvage its tax, Maryland may find it necessary to make defensible amendments that can withstand judicial scrutiny. But rather than going it alone, the state could use some help from its peers eyeing digital ad taxes of their own.

States have been called the laboratories of democracy, and rightfully so. However, when it comes to national and international commercial activity that sweeps across state lines through complex multi-party transactions, let’s face it: Heterogeneity and administrative complexity are not desirable outcomes. Fifty separate labs tinkering with different tax formulas will drive companies nuts.

The elephant in the room now is whether a patchwork of disparate state tax laws and competing enforcement activities make economic sense, even if they stand up in court. Imagine a future in which every state allows inexperienced legislators pandering to local lobbyists to craft a hodgepodge of rival, untested and idiosyncratic digital-tax rules. That’s a dream come true for litigators and CPA firms, but a nightmare for advertisers’ compliance departments. Such a lack of uniformity invites Congress to eventually trump the rights of states with a national tax, ostensibly to reduce complexity and friction.

In light of the global race to tax multi-national activities, it is hard to see a long-term future for uncoordinated, piecemeal, competing and overlapping subnational taxes on digital advertising. Treasury Secretary Janet Yellen has now weighed in by advocating a global minimum corporate tax structure, which eventually could include digital commerce as one of its groundbreaking elements.

This is a job for the skilled folks who base operations at the Hall of the States on Capitol Hill, and they should act quickly. The national associations of governors, state treasurers, state tax administrators and state legislatures need to organize themselves quickly to develop a model tax law that provides the template for coordinated revenue levies and administration in the digital ad space. Failure to act promptly could invite an avalanche of losing court battles and pre-emptive intervention by Congress.

Just as the Supreme Court’s 1988 ruling in South Carolina v. Baker
dealt a crippling blow to municipal bonds’ historical premises for federal income-tax exemption, a group-grope approach to taxing digital ads could set the states back forever in their efforts to keep pace with future business innovations. Nature hates a void, and the longer these groups wait, the more likely it becomes that Capitol Hill or the G-7 nations will approve an over-arching tax law or international treaty that trumps the labyrinthine rules of 50 states ruling by chaos theory instead of mutual interests wisely managed.

Here are five guiding principles for model state legislation to promote maximum uniformity in multistate digital advertising taxes and strengthen the case for state — not federal — authority:

A common tax base: As the Japanese adage goes, “the nail that stands out gets pounded down,” and that applies aptly to eccentric single-state tax features. A uniform tax system should apply the levy consistently to the same and similar businesses, at the same level, in all participating states. This framework minimizes administrative burdens on businesses and removes the “disparate treatment” objection. For starters, most legislatures will likely seek to avoid taxing small local businesses, instead focusing their taxes on the Big Tech companies. But that is just the first step. Digital advertising has many facets, including content creation, promotion, representation, financing, distribution and analytics, so those that are to be included and excluded from a subsector-specific tax must be specified. To minimize second-guessing by the courts, the principles and research to support those distinctions should be included in preambles and legislative findings. There will be comfort in the herd and strength in the pack.

Efficiency:
Digital ad industry taxes should be straightforward to administer, with the lowest achievable standardized costs of calculation, collection and enforcement. A gross receipts tax is simplest, but states will struggle to establish the relevant taxable nexus for myriad transactions that cross state lines.

Clarity: The legislation should be clear to all parties with respect to “incidence” — where and to whom the tax applies — and administration. The anti-tax wonks’ complaints and industry legal arguments against the Maryland laws are the obvious hot buttons to avoid.

A fair rate: A revered rule of taxation is attributed to France’s Jean-Baptiste Colbert, the finance minister under Louis XIV: “The art of taxation consists in so plucking the goose as to procure the greatest amount of feathers with the smallest amount of hissing.” Predictably, the Internet goliaths have learned to hiss at any and all taxes. There is no reason for digital advertising to enjoy a lower tax rate than those which prevail in other highly profitable businesses. This is true especially of the global giants, which otherwise enjoy massive write-offs and offshore havens to shield their taxable income. If advertising subsectors such as agencies are to be taxed in addition to business income taxes on their profits, a lower separate tax rate (or a countervailing credit similar to a value-added-tax offset) may be justified — and more defensible both legally and politically.

Constitutionality: In the drafting, every precaution should be taken to minimize the litigation risk that model legislation invites the digital advertising industry giants to lobby Congress for relief under the commerce clause. The Maryland plaintiffs who oppose that state’s initiative are already asserting that claim, and the ugliest scenario for states would be if Capitol Hill enacts pre-emptive legislation. Congress has a clear right — but not an obligation — to regulate commerce, while its failure to do so gives credence to the rights of states to tax economic activity within their jurisdictions. Some of the precedents in South Dakota v. Wayfair, the 2018 Supreme Court ruling that cleared the way for states to collect taxes on online sales, can help shed light on legislative designs that are most likely to succeed in federal courts.

Some sound advice to the states is that their policy associations will be wise to confer with litigators and expert economists whose advice can be baked into a model bill, so that expert testimony can be presented reliably in the inevitable congressional and multi-level court battles that lie ahead. States looking with an envious eye at Maryland’s foray into this new taxation frontier would do well to turn up a few modern-day Jean-Baptiste Colberts of their own.


Governing’s opinion columns reflect the views of their authors and not necessarily those of Governing’s editors or management.

The finance columnist for Governing. He can be reached at millergirard@yahoo.com.