As with the telecommunications, natural gas and airline industries, the electric utility industry is in the midst of a fundamental transformation. Indeed, one no longer can accurately characterize it as solely the utility industry. Wholesale competition is robust today, with dozens of sellers of electricity as a result of the Public Utility Regulatory Policies Act of 1978, the Energy Policy Act of 1992 and the actions of the Federal Energy Regulatory Commission in orders 888 and 889. Retail customers in at least a dozen states will be able to choose their electricity providers as the result of legislation or comprehensive regulatory packages enacted in those states. It is not only utilities that now are selling electricity. Electric companies that operated in the retail electricity sales business as state-regulated monopolies for more than 50 years will face competition not only from each other, but also from other companies that previously sold no retail electricity.

In states that reform their electric industry, utilities no longer will be restricted to service territories in which they operate as monopolies. These utilities—whether they be investor owned, public power systems or rural electric cooperatives—may find themselves in competition with each other and with new electricity providers like power marketers or independent power producers. The utilities may begin to sell electricity across service territories and state boundaries to customers that previously had no choice of electric companies. They also may break from their regulated vertical structure—in which one company owns and coordinates the power generation, transmission, distribution, accounting, and billing and customer service functions—into separate companies. Some may even sell these functions so they can focus on only one business activity. Many mergers already have occurred, both between utilities and between utilities and companies that do not produce electricity. Some electric companies suggest they will not remain electric companies but will offer, for a single price, an array of services to their customers, including Internet access, electricity, telephone and cable service and even security services. In time, the electric utility bill may bear little resemblance to its current appearance.

In many states’ these changes will require a reexamination of the tax system that has been applied to regulated monopoly businesses. The sales tax is likely to be affected by the greater number of interstate electricity sales, new billing options, the combination of electric utilities with other non-electric businesses and other elements of the restructuring of today’s electric utilities.

This paper deals with direct effects of electric industry restructuring on sales tax revenues. If restructuring fulfills the promise of lower rates and greater economic activity, it will lead to economic growth, new investments and a larger sales tax base. These effects on the tax base are difficult to quantify with a useful degree of accuracy and it is not the purpose of this paper to make assertions about the potential benefits of restructuring. This paper should be taken in that context.

In a restructured market, sales tax revenues will increase in some places and decrease in others. The objective of this paper is to give state policymakers the tools to understand the effects of electric industry reform on these taxes. It will aid policymakers to participate in an informed debate and enhance their ability to make decisions with information about the franchise and income tax consequences of electric industry reform.

The sales tax is susceptible to changes in the electric industry as a result of three general factors:

Allowing companies other than the monopoly distribution company to bill for electricity and collect sales taxes may make it more difficult to collect the sales tax. There are, nonetheless, other policy factors aside from the sales tax that have led many states to encourage that billing be done by nonutilities.

Where change is necessary, it will require state legislation; most of the rules that govern revenue departments’ activities can be found in state statute.

A sales tax is imposed on the retail sales price of tangible personal property that is purchased for use or consumption in the taxing state. Sales and use taxes are counterparts. If a sale were subject to the state sales tax, it generally would not be subject to the state use tax and vice versa. State sales and use taxes generate significant tax revenues for states. States may impose their sales and use tax on the sale of electricity. Historically, states have exempted many energy and nonenergy items from state sales and use taxes. Almost every state exempts some form of energy or energy-related equipment.

Electric utilities collect sales taxes from their customers and send their collections to the state or taxing jurisdiction. Electric utilities also pay sales tax on many of their equipment purchases. The sales tax revenues go directly to the state general fund. They are neither returned by a formula to political subdivisions of the state, nor are the revenues from the sales tax generally designated for one purpose, such as school funding. The sales tax often is a very significant part of state or local governments’ tax revenue stream.

Customers of all electricity providers pay the sales tax. The companies that distribute electricity to those customers collect the tax as a part of the electric bill, and remit the tax revenues to the state or political subdivision of the state. State law exempts some state transactions or customers from the sales tax. Many states levy a sales tax on commercial or business customers and exempt residential electricity users. Some states subject only a portion of the bill to a sales tax—for example, only the generation or only the transmission and delivery component of the bill may be subject to a sales tax. Customers of all types of electricity providers pay a sales tax, including power marketers; regulated investor owned utilities, rural electric cooperatives and public power systems. In most states customers pay this tax at the same rate, regardless of the type of company from which they buy their power. Electricity providers of all types sometimes pay a sales tax on purchases of equipment or other property. Many states exempt these purchases from a sales tax. Certain municipal utilities may not pay a sales tax on equipment purchases made within their own municipal boundaries.

The following example illustrates how utilities and others in the electric industry pay sales taxes and how those payments could be affected by restructuring electric industry. The example is a useful tool for explaining the topic. However, it should not be taken as a recommendation to pursue a specific policy. Questions for state policymakers are interspersed with the example. The answers to these questions will help determine how to address this issue in their individual states.

Consider Amalgamated Electric, a hypothetical electricity provider in State A’s newly competitive electric marketplace. Before the restructuring of the electric industry in State A, Amalgamated Electric collected the sales tax from its customers. This sales tax was based on 5 percent of the customer’s electric bill. Embedded in the customers’ electric rate is another sales tax, the one Amalgamated Electric pays its own suppliers for purchases of equipment. The sales tax has been easy to levy and collect, because Amalgamated Electric is a convenient and willing sales tax collector. In addition, it has been easy to ascertain the amount and price of electricity for which its customers have paid.

Since restructuring, Amalgamated Electric separated its company into several smaller ones under a holding company that is still called Amalgamated Electric. Amalgamated Generation only generates electricity, and has become a wholly owned subsidiary of the holding company, Amalgamated Electric. Deregulated Amalgamated Generation now competes for new business with Marketeer Inc. and Western Power, another electricity provider based in State B. Amalgamated Generation, Western Power and the Marketeer Inc. sell electricity at market regulated prices. Each sends power through lines that are owned and operated by Amalgamated Transmission and Distribution (ATD), another member of the Amalgamated Electric family of companies. Amalgamated Transmission and Distribution remains a regulated monopoly.

These electric providers’ customers will probably continue to pay for and receive the same services they received under a regulated industry, and they may still pay for all those services on one bill. After State A allows competition in electricity generation, the bill will be divided among different functions, and payments will go to different entities. Not all elements of the unbundled electric bill will be subject to tax.

These companies’ electric bills appear different, too. Amalgamated Generation, Marketeer Inc. and Western Power break their bills into several parts that might look like figure 2:

State A may not be able to require out-of-state electricity providers—such as State B-based Western Power—to collect its sales tax. If State A allows companies other than Amalgamated Transmission and Distribution to bill customers, it will be more difficult to collect a sales tax. In attempting to require Western Power to collect a sales tax, State A could encounter a nexus problem.

Similar issues of jurisdiction are likely to arise in states that open up their electric industry to competition. A state may have jurisdiction to tax the company that resides within its borders, but not the business transactions that the company performs with out-of-state companies or business transactions performed in the state by an out-of-state company.

During the electric industry restructuring process, some states may choose to allow utilities to recover partially, the prudently incurred, verifiable and non-mitigable uneconomic assets, often referred to as stranded costs. Should state A allow for the recovery of Amalgamated Electric’s stranded costs, the portion of the bill that is earmarked to pay for these costs may not be subject to sales tax. Some argue these funds simply flow to Amalgamated Electric as an additional state assessment on the price of electricity and should therefore not be subject to sales tax.

Some states define the sales tax as one that is levied on sales from a regulated utility. If electricity generation no longer is state-regulated, the Amalgamated Generation, Western Power or Marketeer Inc. portion of the bill may not be subject to sales tax. Instead, the tax might be levied only on the regulated entities’ portion of the bill—that being Amalgamated Transmission and Distribution. In the example above, only $.02 per kWh, would, therefore, be subject to sales tax.

Western Power collects fees that are dedicated to State A’s programs to help preserve energy efficiency, renewable energy or other public benefit programs. State A’s government might operate those programs with the money that these fees provide. If these fees are broken out on the bill and are dedicated to a specific government-administered program, should they then be subject to tax? To the extent that these fees are no longer part of the price of electricity, but are instead an additional charge that the government requires to be levied on the product, they may not be taxable. In the example above, $.003 per kWh might no longer be subject to sales tax.

California, Pennsylvania, Montana and Rhode Island legislatures have let electric utilities securitize some of their costs related to uneconomic assets. If State A allows securitization of part of Amalgamated Electric’s stranded costs, the portion of the electric bill that repays the securitized bonds may not be subject to sales tax.

This securitization would affect the 1.5 cents per kilowatt-hour (kWh) that all customers in State A pay to compensate Amalgamated Electric for its stranded costs. If Amalgamated Electric securitizes 100 percent of its stranded costs, customers instead might pay 1.4 cents per kWh. Now, however, the 1.4 cents is pledged, as a state-legislatively-guaranteed property right, to pay off bonds that either a state authority or Amalgamated Electric issued. State legislation structures these bonds so that they are secure and highly rated. In fact, the 1.4 cents per kWh flows through Amalgamated Electric directly to a third party, a special purpose entity designed especially to pay off these bonds. Amalgamated Electric does not have access to these funds, and legislation has pledged them to pay off specific bonds. Some may argue that these funds simply flow through Amalgamated Electric as an additional state assessment on the price of electricity and, therefore, should not be subject to sales tax.

In a regulated monopoly system, states approve electric rates and utility companies bill their customers for electricity and sales taxes on electricity. Historically, states have had access to information about the price of electricity.

However, in a competitive environment, State A and the federal government might approve only the price of delivering—not generating—electricity. Particularly when out of state retailers like Western Power use Amalgamated Transmission and Distribution’s lines to sell to State A customers, Amalgamated Transmission and Distribution or State A may not know the price that Western Power charges for energy.

Western Power may argue that it should not have to divulge its price to ATD and in fact, Western may argue that ATD’s holding company, Amalgamated Electric, has an unfair benefit because it can gain access to more information about Western Power’s pricing strategies than Western Power can about Amalgamated Electric’s pricing. Knowing what Western Power charges for electricity could give Amalgamated the opportunity to offer Western Power’s customers a price just slightly below that of Western, while Western does not have the equivalent information about Amalgamated’s customers to be able to do the same.

As a result, it is possible that states will have access only to information about the price of delivering electricity, not generating it, and they may not be able to collect a tax on the generation component of the energy bill.

Mergers, New Services and the Price of Electricity

If Amalgamated Generation follows the lead of many electric companies, it later may merge with a natural gas, telephone, internet, cable or even a security services provider. Known as convergence mergers, these mergers will allow customers to work with one company for all services and pay a single bill, as shown in figure 3.

That bill could differ significantly from the electric bill now sent out by Amalgamated Electric. For instance, it might offer a bundle of services at a fixed price. However, it might not express a charge per kilowatt-hour of electricity that the consumer uses. If State A bases its sales tax on a price per kilowatt hour of electricity, new billing techniques that make it difficult, if not impossible, to define an electricity price could also make it difficult to define a sales tax.

Sales tax revenues fluctuate with electricity prices. Because sales taxes are based on a percentage of the price of electricity, a higher electricity price will produce greater sales tax revenues and lower electricity prices will generate lower sales tax revenues. It is unlikely, however, that many people would consider lower prices undesirable simply because they generate less sales tax revenue.