In what should be a larger news story than it is so far, Microsoft on Tuesday announced via its blog that they will suspend construction of their Windows Azure data center and re-locate to another state (right now the prevailing rumor is San Antonio, Texas).

This all stems from the construction of the data centers being ineligible for a state tax credit. Passed in 1985, the manufacturing sales and use tax deferral program was designed to address unemployment and poverty in distressed areas of the state. See the RCW here. The purpose of the program was to promote economic stimulation and employment opportunities by deferring taxes for specified investment projects in rural areas.

Microsoft and Yahoo! (prior to their recent collaboration) both looked at Quincy, loc! ated in Grant County, as a good place to set up data farms. These "farms" are essentially large rooms with thousands of computer servers running 24/7 that are hooked up to the Internet backbone and provides many of online services such as search, travel, email and cloud computing. One of the reasons Quincy was chosen was for its access to inexpensive hydro power -- an essential element in powering the servers and keeping them cool.

Microsoft and Yahoo! both had hoped to take advantage of the tax deferral program. This would have saved the companies from having to pay 7.9% sales tax on the construction of these farms. Obviously, these server farms are not inexpensive to build. The companies would have saved millions.

But Attorney General Rob McKenna's office ruled that construction of these farms did not fit under the RCW's qualification. The ruling, ! from 2007, said that:

"Under this [RCW]! , for an activity to be manufacturing, the activity must result in the production of a substance or article of tangible personal property for sale or commercial or industrial use."

Jumping ahead:

"As we understand [the] inquiry, activities of the Internet companies -- providing customers with access to data bases and search engines -- do not produce tangible personal property for sale to the Internet companies' customers, or for the industrial or commercial use of the Internet companies....These activities do not produce a product which is sold to the companies' customers or used by the Internet companies as consumers or in manufacturing articles, substances or commodities."

This is very interesting turn of events because the legislature this year refused to enact legislation that would have provided a! sales and use tax exemption for 50 percent of the state sales tax on server equipment and infrastructure construction of server farms in rural counties. Partly because of the state's $9 billion budget shortfall, the legislation, which had a fiscal impact of about $20 million over the 2009-2011 biennium, was shot down.

Also notable, is that the legislature, with HB 2075, constituted that the data on many of these server farms sold to customers in digital format (like MP3 albums, iTunes, streaming video, etc.) is non-tangible personal property. I mention this in passing because it would have been contradictory for the Attorney General to issue a ruling saying that the data involved here is "tangible," even though our state's accepted! definition of digital property is "intangible."

Mike M! anos, vice-president for Digital Realty Trust, sums up the age-old problem of the convergence of technology advancement and government policy-making:

"States and governments are currently using their blunt, imprecise instruments of rule (regulations and taxes) to try and regulate something they do not yet understand but know they need to play a part of. Its no secret that technology is advancing faster than our society can gauge its overall impact or its potential effects and the cloud is no different."

The bottom line is that it appears to be too late to change Microsoft's mind. But Yahoo! has been quite on the matter -- although probably not for long. 

What should be done? Some policymakers be tempted to shrug off Microsoft's move ! as a business acting poorly or in its own interest instead of "the greater good." But this is simple economics -- Microsoft has to make a business decision based upon the current and perceived future of the state's tax and regulatory environment. We saw some backlash against Boeing this past session for thinking about relocating its second 787 line to the East Coast. Now we see Microsoft and others rethink the assertion that Quincy is the next "great data center location."

Companies do not make this kind of decision lightly. They are expensive and time-consuming -- not to mention the loss incurred from abandoning projects mid-stream. But this week Microsoft basically told Washington state policymakers that when it comes to data centers, they are betting against us.