Maryland’s Digital Advertising Levy Sets Off a New Battle Over Taxing E-Commerce

The most interesting tax news these days may not be the tax cuts in the massive pandemic relief bill now awaiting House passage. Rather, it may be the growing efforts of states to tax internet advertising.

These new state taxes, which parallel efforts by several European countries to tax digital services, raise three huge questions: Are they permitted under federal law? Are they good policy? And is it realistic to expect individual states to solve the tax challenges raised by an increasingly virtual world?

The simmering debate boiled over on Feb. 12 when the Maryland legislature, controlled by Democrats, enacted what is effectively a gross receipts tax on digital advertising, overriding a veto by Republican Governor Larry Hogan.

Yet efforts to tax digital ads are not partisan. Nearly identical legislation to impose gross receipts taxes on social media companies was introduced by Republicans in Connecticut by Democrats in New York. Meanwhile, deep red Nebraska and deep blue Washington State are moving ahead on a slightly different path. They’d include digital advertising in their sales tax bases.  

Headed to court

But, for now, the story is shifting to court. Several groups representing the digital industry, as well as the US Chamber of Commerce, immediately filed a federal lawsuit against the Maryland tax.

And critics have some legal ammunition. The first objection is statutory. In 1998, Congress passed the Internet Tax Freedom Act (ITFA) in an effort to protect the then-nascent internet from potentially burdensome state and local taxes. Congress made the law permanent (so now, PITFA) in 2016, when digital commerce was no longer so nascent.

The law prohibits taxes on internet access—those monthly fees your service provider charge. And it prohibits state or local governments from imposing “multiple or discriminatory taxes” on electronic commerce. The original idea: States could not impose a higher tax on e- commerce than on the same product purchased in a brick-and-mortar store. 

PITFA may present a steep legal challenge for the Maryland law, since the state does not tax advertising in, say, newspapers. But Maryland Attorney General Brian Frosh argues that it is “possible” that the new law could withstand legal scrutiny if courts conclude the tax is on the “sale of the advertising services…instead of the transmission of the advertising itself.”

Constitutional claims

Then, there are the constitutional problems: Critics say it violates the commerce, equal protection, and due process clauses of the US Constitution, as well as the First Amendment’s protection of freedom of the press.

The First Amendment claim seems weakest.  In a different context, firms such as Google and Facebook have convinced Congress that they are not  publishers and thus not responsible for, say, libelous content that appears on their sites. But now, to avoid a tax, they  claim they are entitled to First Amendment protections of a publisher.

Their Commerce clause argument may be more productive. Critics of the tax argue that a firm must have some connection—nexus, in legalese– to a state before that state is allowed to tax it. In its 2018 decision in South Dakota v. Wayfair, the Supreme Court allowed states to require online retailers to collect sales tax from residents who buy from them, even if the seller doesn’t have physical presence, like a store or warehouse, in their state. But can a firm be said to be doing business in a state just because someone looked at an ad on a device while located in that state? What if that firm collects or sells data from the user who opened the ad?

Is it good policy?

The courts eventually will sort it all out. The broader question is this one: Even if taxing digital advertising is legal, is it sensible policy?

No doubt digital ads are a tempting source of tax revenue. And in an increasingly digital world, a strong argument can be made that online services should be included in the tax base. PITFA may be a legal impediment. But the law probably should be repealed. It is also a statutory mess and obsolete: Does Congress really think e-commerce still needs a federal crutch in 2021?

Yet a system where each state imposes its own tax, based on its own rules, on pixels that cross state lines in a nanosecond, seems designed for chaos and multiple taxation. It would be, in many ways, exactly like the problem the OECD and the European Union are trying to address as they struggle to design a uniform international system of taxation on digital services.

In the US, states could do the same thing though bodies such as the Multistate Tax Commission. Over the long term, the rise of digital commerce may argue for a broad-based national Value Added Tax (VAT) with revenue rebated to the states. But absent some way to impose uniform taxes on the vast and growing range of digital services that do not know borders, the likely result will either be tax chaos, or an excuse for digital services to avoid tax entirely.