Entertainment

Analysis: Is the taxman eyeing iTunes?

The $0.99 that the iTunes Store charges for individual songs has taken on an almost iconic role in the field of music downloads, becoming what many consider the standard for fair pricing. While the record labels have long lobbied for variable pricing, Apple CEO Steve Jobs has fought them to keep the rate flat across the board. But the price of some customers’ music has already been threatened thanks to an entirely different source: state governments.

This week, a controversial proposal in the California State Assembly that would have extended the state’s sales tax to include digital downloads of media such as books, movies, and music was narrowly defeated in a hearing of that body’s budget committee. Introduced by Assemblyman Charles M. Calderon of the 58th District, Assembly Bill 1956 would have asked the California Board of Equalization, the body responsible for administrating taxes in the state, to draft a regulation to extend the law’s definition of tangible property to include digital property.

While the bill’s demise shelves such plans for now, there’s no guarantee that the issue won’t return in the future. With the steady rise of digital media consumption, the taxation of such material is an area that many states have had to consider.

“It’s going to be a significant test there,” said Phil Leigh, president of market-research firm Inside Digital Media, who thinks that the California proposal could encourage other states to adopt similar measures.

A bite of the Apple

Assemblyman Calderon estimated that the additional taxes from downloads—which would also cover the immensely lucrative digital pornography market—could bring $500 million in annual additional revenue into the state of California, which has suffered from significant budget shortfalls in recent years. That number was contested however: The Board of Equalization itself cited a more modest potential figure of around $114 million per year. Meanwhile, the proposal’s numerous opponents, among them many prominent technology and entertainment companies, argued that the move could actually harm California’s economy by alienating businesses in the tech industry and encouraging them to move to more financially-friendly locations.

“There will be a backlash,” said Leigh, “but it will not change things. Most people recognize that death and taxes are inevitable.”

Last year, Apple was the number two music retailer in the country and in the first two months of this year the company has already climbed to first place. With more than 4 billion songs sold since the store’s inception, digital downloads of music have undeniably hit the mainstream. Assemblyman Calderon estimated that, had the tax been in place last year, California would have taken in $20 million from music downloads in 2007 alone.

Apple and other purveyors are also on the brink of bringing the same popularity to downloading movies and television shows. It’s little surprise that state governments—who have long collected sales tax on physical media, like CDs and DVDs—want a piece of the action on downloads as well.

An Apple spokesperson told Macworld that the company had joined with the AeA (formerly known as the American Electronics Association), a trade group of electronics companies, to oppose the proposal, which it believed would have unfairly punish California companies.

Roxanne Gould, the AeA’s senior vice president for state government affairs, echoed that sentiment. “This is an industry you want to encourage,” she said. “The tech industry could be a huge part of solving the state’s economic woes.” Gould added that the resulting revenue would not likely have an effect on the state’s bottom line, and that the bill could possibly result in litigation, “costing the state more money.”

The taxman

Sales tax is not administered on a federal basis in the U.S. Rather, each state (and, in some cases, county or municipality) determines its own sales tax rate, with a handful of states (among them New Hampshire and Delaware) having no sales tax at all. Sales tax is usually collected by the vendor based on the local rate where the customer makes the purchase; in the case of Internet transactions, the determination is made based on the billing address of the customer. So even if you live in Texas, if you’re on vacation in New York and you buy a track from iTunes, you would be charged for Texas sales tax. Many states also have what is called a use tax, which essentially requires consumers to pay tax directly to the state when an out-of-state vendor does not collect it (for example, if you buy physical goods online at Amazon, and you are not charged sales tax, you are supposed to pay use tax on the purchase).

In California, the state sets a standard rate of 7.25 percent, but special districts may add additional taxes, with resulting rates as high as 8.75 percent in some areas. Taxing downloads from iTunes at that rate would raise prices for California residents as high as $1.08 for a track, $3.25 for a TV show, and $10.86 for a standard album.

Of course, California isn’t the first state to realize the shifting nature of media consumption. In October 2006, New Jersey added a new “Digital Property” section to its existing tax code. The tax covers books, music, movies, ringtones, and “audio and video works and similar products” delivered electronically, but only when the customer is able to use or keep a copy of the work—so, for example, video on demand and broadcast services are not included.

New Jersey and California aren’t alone, either. At present, Alabama, Arizona, Colorado, Hawaii, Idaho, Indiana, Kentucky, Louisiana, Maine, New Jersey, New Mexico, South Dakota, Texas, Utah, Washington, West Virginia, and the District of Columbia all have some sort of tax on digital downloads, though they vary from state to state. Washington’s tax, for example, makes distinctions between when a transaction constitutes a service as opposed to a good; so, while buying music from iTunes would be subject to sales tax, subscribing to an “all-you-can-eat” music service like Rhapsody, would not.

Other states, like Massachusetts and Pennsylvania, don’t currently tax digital media downloads, but do tax other non-tangible items purchased and downloaded over the Internet, such as “pre-written” or “canned” software applications. Pre-written software downloaded over the Internet is not subject to sales tax in California.

Death and taxes

Though AB 1956 would have only applied to customers living in California, the proposal could well influence other states to follow suit. California is the most populous state in the country, accounting for roughly 10 percent of the U.S. population, and it has the largest economy in the U.S. as well.

Some critics of taxing digital downloads have also suggested that increasing the price on digital downloads could make consumers turn instead to piracy, though some disagree with that contention. “My guess is that the customers will be less inclined to turn to piracy,” said Leigh, “because they’re now conditioned to pay.” And, he added, the potential risks involved with piracy also help outweigh the additional cost the taxes will bring.

The AeA’s Gould went further, arguing that time would be better spent focusing on issues like digital piracy instead of taxing those who purchase media legitimately. “If you want to go after revenue, go after the millions in lost revenue from people downloading illegally.”

However, if piracy isn’t an attractive option for customers, there are also legitimate competitors for them to turn to. Amazon.com may trail Apple by a significant margin in the download market, but the California sales tax plan could have worked to Amazon’s advantage, since the company is based out of Washington state. “It could be good for Amazon’s download service,” said Leigh. “The typical iPod owner is not aware that they can even get music from Amazon.” Many of Amazon’s tracks currently sell for just $0.89, meaning that a California sales tax would have widened the margin between it and iTunes even further.

While AB 1956 may have shuffled off this mortal coil, California may well revisit the issue in the future, and with a third of the states already having such a tax in effect, it’s only a matter of time before others consider the revenue implications as well. When it comes to technological progress, said Phil Leigh, “the government will figure out how to tax it.”

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