Digital Ad Taxation: Great In Theory, But Disastrous In Practice

“Laboratories of democracy” is a term U.S. Supreme Court Justice Louis Brandeis popularized to describe how “a single courageous state may, if its citizens choose, serve as a laboratory; and try novel social and economic experiments without risk to the rest of the country.” Brandeis was an Associate Justice of the Supreme Court from 1916 to 1939.

Experimentation at the state level has laid the groundwork for numerous federal laws, including the Affordable Care Act, which borrowed heavily from health care reform enacted in Massachusetts and signed into law by Gov. Mitt Romney. Colorado’s state-level legalization of marijuana, despite the fact that it is illegal federally, is another.

Sean Hetzler, a senior director who leads the corporate tax department at Tegna, explains how digital advertising taxes currently being proposed by numerus states is a recipe for disaster in “A Failed Experiment,” his article in the November/December issue of The Financial Manager, the magazine for members of the Media Financial Management Association, of which I currently serve as chairman of the board. His research and explanation of the topic is impressive, and I’d like to share the most salient points of the piece, particularly as these proposed tax laws may drastically affect those in the same business as my company.

Let’s start with the origins of digital advertising taxes. Nobel prize-winning economist Paul Romer is widely credited as the catalyst of the U.S. movement via a 2019 New York Times opinion piece. Romer argued that Big Tech digital platform companies, including Facebook and Google, are eroding the values and norms precious to democracy by harboring misinformation and hate speech. Given that these companies garner huge profits from collecting and selling user information, he suggested that taxing digital advertising would be the best approach.

With all due respect, Mr. Romer is wrong.

As the pandemic took hold, several states that were seeing their tax revenues plummeting began looking for new tax revenue sources. Other states agreed with Romer about wresting power from Big Tech. States began proposing new digital ad tax structures, based on a new tax on gross revenue from digital advertising or expanding the existing sales tax base to cover digital advertising.

Connecticut, Massachusetts, Maryland and New York decided on the gross revenue approach, adopting proposals similar to what the European Union put into place (and which, as you’ll read in Hetzler’s article, have largely failed):  enacting taxes as a surcharge on digital activity to make sure digital companies pay what their countries believe is appropriate for business the companies do within their borders.

Maryland, where Sinclair Broadcast Group is headquartered, is currently the only state thus far to pass a digital advertising tax, structured as a straight tax on revenue received from digital ad services in the state, but with the added distinction of increasing the percentage of the tax based on the global annual gross revenues of the company. It’s presumed this is a means to ensure the largest global digital ad providers bear a corresponding tax burden.

What Maryland’s law fails to address is how to determine which digital advertising is from the state. Currently, Maryland’s comptroller is charged with clarifying the details. Not surprisingly, less than a week after the law was enacted, four trade associations filed a federal lawsuit to challenge it; lawmakers passed a follow-on bill that delayed implementation of the law for one year and exempted some broadcast and news media organizations. You can be sure of years of contentious litigation to follow.

Other states, including Louisiana, South Dakota, Washington and the District of Columbia, have adopted the sales tax base expansion approach. Rather than taxing the seller of digital advertising, this tax would be imposed on the buyer of the advertising. The seller would still be required to collect the tax from customers and send the funds to the state tax authority, and it would effectively turn into an across-the-board tax increase in all digital advertising within the state.

Hetzler describes the many flaws in this taxation logic, despite lawmakers’ and consumers’ increasing concern over the societal problems that stem from Big Tech. While most of us agree that U.S. social media behemoths wield an inordinate amount of power and influence over consumers — the recent Facebook revelations being a prime example — taxing all companies that sell digital advertising is the wrong approach.

Digital advertising taxes violate a number of principals of sound tax policy, specifically by imposing tax on items businesses must buy to facilitate their operations. A retail store, for example, taxes its customers who purchase its goods, but the store is not taxed by the distributor from whom it buys the goods. If the store was required to pay tax on those goods, it would either have to pass that expense onto its customers or absorb the cost.

If laws are adopted by states, digital advertising is almost certain to become more expensive to purchase, placing additional pressure on small- and medium-size businesses already struggling with finances. It’s also likely to cause a drop in advertising demand, affecting the country’s highly valued local media outlets that depend heavily on ad revenues to fund their news operations.

Next, according to Hetzler, taxing digital advertising violates federal law. He points to the Permanent Internet Tax Freedom Act (PITFA), which bans U.S. states from levying discriminatory taxes on electronic commerce. Because digital advertising taxes only apply to online transactions, they cannot account for print ads — a breach of PIFTA.

Finally, the issue Hetzler says is the most damning is that digital advertising taxes run afoul of the dormant Commerce Clause of the U.S. Constitution. This clause in general requires that a state tax be “externally consistent,” meaning a state can only tax the portion of revenues that “reasonably reflect activity in the state.” In the case of Maryland, which is considering taxing companies based on their annual global gross revenue, it could result in two companies with similar Maryland digital advertising sales having massively different tax burdens, based on foreign sales unrelated to Maryland.

I highly recommend you read Hetzler’s timely article to get the full picture of this experiment that has gone wrong elsewhere, and is poised for disaster in the U.S. Undoubtedly, more states are readying their own digital advertising tax proposals that they plan to roll out in 2022; media companies should be preparing their own arguments around why this taxation concept is good in theory, but potentially disastrous if put into practice.

Dave Bochenek is chairman of the 2021-22 board of directors of the Media Financial Management Association and its BCCA subsidiary, the media industry’s credit association. He is senior vice president/chief accounting officer of Sinclair Broadcast Group, and can be reached at [email protected].