As shown in figure 1, residential and small business users often connect to an Internet service provider (ISP) to access the Internet. Well-known ISPs include America Online (AOL) and Comcast. Typically, ISPs market a package of services that provide homes and businesses with a pathway, or “on-ramp,” to the Internet along with services such as e-mail and instant messaging. The ISP sends the user’s Internet traffic forward to a backbone network where the traffic can be connected to other backbone networks and carried over long distances. By contrast, large businesses often maintain their own internal networks and may buy capacity from access providers that connect their networks directly to an Internet backbone network. We are using the term access providers to include ISPs as well as providers who sell access to large businesses and other users. Nonlocal traffic from both large businesses and ISPs connects to a backbone provider’s network at a “point of presence” (POP). Figure 1 depicts two hypothetical and simplified Internet backbone networks that link at interconnection points and take traffic to and from residential units through ISPs and directly from large business users. As public use of the Internet grew from the mid-1990s onward, Internet access and electronic commerce became potential targets for state and local taxation. Ideas for taxation ranged from those that merely extended existing sales or gross receipts taxes to so-called “bit taxes,” which would measure Internet usage and tax in proportion to use. Some state and local governments raised additional tax revenues and applied existing taxes to Internet transactions. Owing to the Internet’s inherently interstate nature and to issues related to taxing Internet-related activities, concern arose in Congress as to what impact state and local taxation might have on the Internet’s growth, and thus, on electronic commerce. Congress addressed this concern when, in 1998, it adopted the Internet Tax Freedom Act, which bars state and local taxes on Internet access, as well as multiple or discriminatory taxes on electronic commerce. Internet usage grew rapidly in the years following 1998, and the technology to access the Internet changed markedly. Today a significant portion of users, including home users, access the Internet over broadband communications services using cable modem, DSL, or wireless technologies. Fewer and fewer users rely on dial-up connections through which they connect to their ISP by dialing a telephone number. By 2004, some state tax authorities were taxing DSL service, which they considered to be a telecommunications service, creating a distinction between DSL and services offered through other technologies, such as cable modem, that were not taxed. Originally designed to postpone the addition of any new taxes while the Advisory Commission on Electronic Commerce studied the tax issue and reported to Congress, the moratorium was extended in 2001 for 2 years and again in 2004, retroactively, to remain in force until November 1, 2007. The 2001 extension made no other changes to the original act, but the 2004 act included clarifying amendments. The 2004 act amended language that had exempted telecommunications services from the moratorium. Recognizing state and local concerns about their ability to tax voice services provided over the Internet, it also contained language allowing taxation of telephone service using Voice over Internet Protocol (VoIP). Although the 2004 amendments extended grandfathered protection generally to November 2007, grandfathering extended only to November 2005 for taxes subject to the new moratorium but not to the original moratorium. To determine the scope of the Internet tax moratorium, we reviewed the language of the moratorium, the legislative history of the 1998 act and the 2004 amendments, and associated legal issues. To determine the impact of the moratorium on state and local revenues, we worked in stages. First, we reviewed studies of revenue impact done by CBO, FTA, and the staff of the Multistate Tax Commission and discussed relevant issues with federal representatives, state and local government and industry associations, and companies providing Internet access services. Then, we used structured interviews to do case studies in eight states that we chose as described earlier. We did not intend the eight states to represent any other states. For each selected state, we focused on specific aspects of its tax system by using our structured interview and collecting relevant documentation. For instance, we reviewed the types and structures of Internet access service taxes, the revenues collected from those taxes, officials’ views of the significance of the moratorium to their government’s financial situation, and their opinions of any implications to their states of the new definition of Internet access. We also learned whether localities within the states were taxing access services. When issues arose, we contacted other states and localities to increase our understanding of these issues. We discussed with state officials how they derived the estimates they gave us of tax dollars collected and how firm these numbers were. We could not verify the estimates, and CBO supplemented estimates that it received from states. Nevertheless, based on other information we obtained, the state estimates appeared to provide a sense of the order of magnitude of the numbers compared to state tax revenues. We did our work from February through December 2005 in accordance with generally accepted government auditing standards. The moratorium bars taxes on the service of providing access, which includes whatever an access provider reasonably bundles in its access offering to consumers. On the other hand, the moratorium does not prohibit taxes on acquired services, referring to goods and services that an access provider acquires to enable it to bundle and provide its access package to its customers. However, some providers and state officials have expressed a different view, believing the moratorium barred taxing acquired services in addition to bundled access services. “a service that enables users to access content, information, electronic mail, or other services offered over the Internet, and may also include access to proprietary content, information, and other services as part of a package of services offered to users. The term ‘Internet access’ does not include telecommunications services, except to the extent such services are purchased, used, or sold by a provider of Internet access to provide Internet access.” (italics provided) As shown in the simplified illustration in figure 2, the items reasonably bundled in a tax-exempt Internet access package may include e-mail, instant messaging, and Internet access itself. Internet access, in turn, includes broadband services, such as cable modem and DSL services, which provide continuous, high-speed access without tying up wireline telephone service. As figure 2 also illustrates, a tax-exempt bundle does not include video, traditional wireline telephone service referred to as “plain old telephone service” (POTS), or VoIP. These services are subject to tax. For simplicity, the figure shows a number of services transmitted over one communications line. In reality, a line to a consumer may support just one service at a time, as is typically the case for POTS, or it may simultaneously support a variety of services, such as television, Internet access, and VoIP. Our reading of the 1998 law and the relevant legislative history indicates that Congress had intended to bar taxes on services bundled with access. However, there were different interpretations about whether DSL service could be taxed under existing law, and some states taxed DSL. The 2004 amendment was aimed at making sure that DSL service bundled with access could not be taxed. See appendix I for further explanation. Figure 3 shows how the nature and tax status of the Internet access services just described differ from the nature and tax status of services that an ISP acquires and uses to deliver access to its customers. An ISP in the middle of figure 3 acquires communications and other services and incidental supplies (shown on the left side of the figure) in order to deliver access services to customers (shown on the right side of the figure). We refer to the acquisitions on the left side as purchases of “acquired services.” For example, acquired services include ISP leases of high-speed communications capacity over wire, cable, or fiber to carry traffic from customers to the Internet backbone. Purchases of acquired services are subject to taxation, depending on state law, because the moratorium does not apply to acquired services. As noted above, the moratorium applies only to taxes imposed on “Internet access,” which is defined in the law as “a service that enables users to access content, information, electronic mail, or other services offered over the Internet.…” In other words, it is the service of providing Internet access to the end user—not the acquisition of capacity to do so—that constitutes “Internet access” subject to the moratorium. Some providers and state officials have construed the moratorium as barring taxation of acquired services, reading the 2004 amendments as making acquired services tax exempt. However, as indicated by the language of the statute, the 2004 amendments did not expand the definition of “Internet access,” but rather amended the exception from the definition to allow certain “telecommunication services” to qualify for the moratorium if they are part of the service of providing Internet access. A tax on acquired services is not a tax directly imposed on the service of providing Internet access. Our view that acquired services are not subject to the moratorium on taxing Internet access is based on the language and structure of the statute, as described further in appendix I. We acknowledge that others have different views about the scope of the moratorium. Congress could, of course, deal with this issue by amending the statute to explicitly address the tax status of acquired services. As noted above, some providers and state officials have construed the moratorium as barring taxation of acquired services. Some provider representatives said that acquired services were not taxable at the time we contacted them and had never been taxable. Others said that acquired services were taxable when we contacted them but would become tax exempt in November 2005 under the 2004 amendments, the date they assumed that taxes on acquired services would no longer be grandfathered.