The digitalization of the economy has been a key focus of taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. debates in recent years. Political debates have focused on the differences between taxing physical business operations and virtual operations. These debates have intersected with multiple layers of tax policy including consumption and corporate tax policies. Novel policies have also been developed including equalization levies and digital services taxes alongside more common use of gross-based withholdingWithholding is the income an employer takes out of an employee’s paycheck and remits to the federal, state, and/or local government. It is calculated based on the amount of income earned, the taxpayer’s filing status, the number of allowances claimed, and any additional amount of the employee requests. taxes targeted at digital services.
However, in some cases political expediency has outpaced consistent policy designs in line with sound principles of tax policy. As policymakers continue to evaluate the options to tax digital businesses it will be necessary to avoid creating new distortive tax policies driven by political agendas.
This paper reviews a multitude of digital tax policies around the world with a focus on OECD countries and points out the various flaws and benefits associated with the wide set of proposals.
What Are Digital Taxes?
The digital economy means many different things. The same is true for digital taxes. In this paper, digital taxes include policies that specifically target businesses which provide products or services through digital means using a special tax rate or tax baseThe tax base is the total amount of income, property, assets, consumption, transactions, or other economic activity subject to taxation by a tax authority. A narrow tax base is non-neutral and inefficient. A broad tax base reduces tax administration costs and allows more revenue to be raised at lower rates. .
These include policies that extend existing rules to ensure a neutral tax policy toward all businesses, such as when a country extends its Value-added Tax to include digital services. They also include special corporate tax rules designed to identify when a digital company has a permanent establishment even without a physical presence.
This paper reviews and analyzes digital taxes using the following categories:
1. Consumption taxA consumption tax is typically levied on the purchase of goods or services and is paid directly or indirectly by the consumer in the form of retail sales taxes, excise taxes, tariffs, value-added taxes (VAT), or an income tax where all savings is tax-deductible. es
Consumption taxes are Value-added Taxes (VAT) and other taxes on the sale of final goods or services. Countries have been expanding their consumption taxes to include digital goods and services.
2. Digital services taxes
Digital services taxes are gross revenue taxes with a tax base that includes revenues derived from a specific set of digital goods or services or based on the number of digital users within a country.
3. Tax preferences for digital businesses
Tax preferences are policies such as research and development (R&D) credits and patent boxA patent box—also referred to as intellectual property (IP) regime—taxes business income earned from IP at a rate below the statutory corporate income tax rate, aiming to encourage local research and development. Many patent boxes around the world have undergone substantial reforms due to profit shifting concerns. es that reduce the tax burden on digital businesses. Though most preferences are available for any business, some specifically lend themselves to digital business models.
4. Digital permanent establishment rules
These policies include redefining what constitutes a permanent establishment to include digital companies that have no physical presence within a jurisdiction. These virtual or digital permanent establishments are usually defined using specific criteria including engagement with the local market.
5. Gross-based withholding taxes on digital services
Gross-based withholding taxes are used by some countries instead of corporate taxes or consumption taxes to tax revenue of digital firms in connection to transactions within a jurisdiction. As gross income taxes, these policies do not substitute for income or consumption taxation.
The Digital Tax Debate
The growth of the digital economy in recent decades has been paired with policy debates about the taxes that digital companies pay and where they pay them. Many digital business models do not require physical presence in countries where they have sales, reaching customers through remote sales and service platforms.
Business models including social media companies, e-commerce marketplaces, cloud services, and web-based services platforms have all motivated targeted tax policies. In some cases, the policies are extensions of old rules to new players, while other policies are special taxes directed specifically at a business or platform.
Consumption tax policies have shifted to account for the growth of products and services delivered through digital means, often without a business having a taxable presence within the country where the products are consumed. Additionally, policymakers have examined ways to change corporate taxes to capture activity of digital firms in countries.
Preferential tax regimes including shorter depreciationDepreciation is a measurement of the “useful life” of a business asset, such as machinery or a factory, to determine the multiyear period over which the cost of that asset can be deducted from taxable income. Instead of allowing businesses to deduct the cost of investments immediately (i.e., full expensing), depreciation requires deductions to be taken over time, reducing their value and discouraging investment. schedules for intangibles, targeted R&D tax relief, and patent boxes to a certain degree have caused digital firms to benefit from lower taxation. While the arguments behind these preferences are to spur innovation and attract investment in the newest technologies, the lighter tax burden resulting from the incentives has created a gap between the taxation of digital businesses relative to other sectors.
In response to the difference in tax burdens, policymakers have sought new taxation tools targeted (in some cases) at the same businesses that are eligible for the targeted preferences.
Because the major digital companies are multinational businesses, the digital tax discussion has led to the need for an international agreement on whether rules need to change. Without a multilateral agreement, individual country policies are likely to intersect or contradict one another, resulting in double taxationDouble taxation is when taxes are paid twice on the same dollar of income, regardless of whether that’s corporate or individual income. .
Whither Value Creation?
Changing international rules on digital taxation will impact both where and how much tax the impacted digital businesses pay. International norms of corporate income taxA corporate income tax (CIT) is levied by federal and state governments on business profits. Many companies are not subject to the CIT because they are taxed as pass-through businesses, with income reportable under the individual income tax. ation rely on the concept of value creation to decide where a business pays taxes. In the digital tax debate, a new angle to the value creation debate has arisen.
Proponents of digital taxation often argue that digital value creation should take account of the value contributed by users of social media platforms or e-commerce websites because the data provided by user habits are then translated into targeted advertisements or other customized services.
Attributing value to a user that accesses a free service is economically challenging because there is no price signal connected to the single user, and treating a network of users as a value-creating asset comes with similar measurement and valuation challenges. Although network effects are prevalent in some digital business models, such effects are also common throughout other parts of the economy and do not give rise to special tax rules.
Policies that follow the logic of value created by users implies that the location of value creation for tax purposes would necessarily change. Just as the global population is not evenly distributed across countries, recent measures of value created by digital companies are concentrated in certain jurisdictions.
In 2015, a bit more than one-third of global internet users were in East and Southeast Asia, while 20 percent of value created in information industries originated there. Conversely, just 11 percent of internet users in 2015 resided in North America while 37 percent of value created in information industries originated there.
|Regions||Millions of internet users||Share||Information industries (Trade in Value added in Millions of U.S. Dollars)||Share|
|East and Southeast Asia||1,080||34%||625,194||20%|
|South and Central America||206||7%||99,675||3%|
Note: Information industries includes publishing, audiovisual, broadcasting activities, telecommunications, IT, and other information services (industry codes: D58T60, D61, D62T63).
North America includes Canada, Mexico, and the United States; Europe includes Iceland, Norway, Switzerland, Russia, the United Kingdom, and the 27 member countries of the European Union; East and Southeast Asia includes Japan, Korea, Brunei, China, Hong Kong, Indonesia, Cambodia, Malaysia, Philippines, Singapore, Thailand, Chinese Taipei, and Vietnam; Other Regions include Australia, Israel, New Zealand, Turkey, India, Morocco, Saudi Arabia, South Africa, and Tunisia; World includes the remainder from the rest of the world.
Source: “Number of Internet Users by Country,” Our World in Data, accessed May 22, 2020, https://ourworldindata.org/grapher/number-of-internet-users-by-country; and OECD, “Trade in Value Added (TiVA): Principal Indicators,” accessed May 22, 2020, https://stats.oecd.org/Index.aspx?DataSetCode=TIVA_2018_C1.
Multilateralism or Unilateralism?
Because of the mismatch in the current distribution of internet users and the location of digital production, changing tax rules to reflect where users are located would change where businesses owe and pay taxes. This highlights the political challenge of rewriting the rules in ways that impact which countries receive tax revenue from digital businesses. This is where the Organisation for Economic Co-operation and Development (OECD) has stepped in to manage negotiations among more than 130 countries.
The conflicting policies that have arisen unilaterally—such as digital services taxes—require multilateral action to avoid a harmful tax and trade war at the end of 2020. However, the solutions on the table at the OECD already violate sound principles of tax policy. As that work continues, this paper takes stock of existing digital tax measures and highlights the strengths and weaknesses of the various approaches.
The digital tax debate is far from over, and policymakers should seek to follow sound principles in developing, refining, and (in some cases) removing digital tax policies.
In two policy areas, consumption and corporate income taxes (and associated permanent establishment rules), countries are working to extend their existing rules to digital businesses. This presents an opportunity to move toward equal treatment of physical and digital business models, but also real challenges to align standards and implement policies on a multilateral basis. Policies in these areas should meet a high bar for alignment with other jurisdictions, minimize complexity and compliance costs, and avoid differential treatment of targeted business sectors.
In two other policy areas, digital services taxes and gross-based withholding taxes, countries are relying on novel, but distortive and discriminatory, approaches to taxing digital businesses. These policies have the potential to lead to an economically harmful tax and trade war and should be avoided.
Preferences for digitalized businesses should be focused on innovation rather than creating tax windfalls. Research & development tax creditA tax credit is a provision that reduces a taxpayer’s final tax bill, dollar-for-dollar. A tax credit differs from deductions and exemptions, which reduce taxable income, rather than the taxpayer’s tax bill directly. s can be improved to avoid compliance challenges that limit the benefits to businesses that can afford to comply. However, patent boxes create tax windfalls that only provide benefits following innovation and can be used in ways that distort investment and income patterns.
The following recommendations should be used to guide design and implementation of policies meant to address the challenges of taxing digital business models.
The expansion of consumption taxes to include digital services and products can achieve a neutral broadening of the tax base. Because the purpose of consumption taxes is to tax where consumption occurs, broadening tax bases to digital consumption is simply an extension of that principle. However, differences in compliance costs, rates, or registration thresholds can create new distortions or unnecessarily increase compliance costs.
Countries should pursue:
A broad consumption tax base that includes digital services and products and achieves equal treatment between digital and physical businesses.
Alignment with general standards for collecting data on remote sales and digital transactions.
Compliance requirements that are designed to minimize the costs associated with building new systems and identifying the location of a sale or customer.
Countries should avoid:
- Policies targeting digital cross-border transactions with rates that differ from those that would apply to similar, local commerce.
Digital Services Taxes
Digital services taxes should, by and large, be removed to avoid the distortions that taxes on revenues create. Absent repeal, countries should clarify ways that businesses can avoid being taxed twice on digital income.
Countries should pursue:
Clear timelines for removal of digital services taxes to avoid a harmful tax and trade war.
Policies that clearly allow for relief from double taxation.
Countries should avoid:
- Adopting digital services taxes to prevent the distortions that such revenue-based taxes create.
Tax Preferences for Digital Businesses
Preferences for digital businesses create an unlevel playing field and are not in line with the principle of neutral tax policy. Countries should consider how their preferences spur innovation or simply create tax windfalls.
Countries should pursue:
- Neutral treatment of investment in capital assets using either full expensingFull expensing allows businesses to immediately deduct the full cost of certain investments in new or improved technology, equipment, or buildings. It alleviates a bias in the tax code and incentivizes companies to invest more, which, in the long run, raises worker productivity, boosts wages, and creates more jobs. or a neutral cost recoveryCost recovery is the ability of businesses to recover (deduct) the costs of their investments. It plays an important role in defining a business’ tax base and can impact investment decisions. When businesses cannot fully deduct capital expenditures, they spend less on capital, which reduces worker’s productivity and wages. system to avoid distorting investment decisions due to better tax treatment of investment in intangible assets.
Countries should avoid:
- Research & development tax credits with high compliance costs which only benefit firms that can afford to comply.
- Using patent boxes to attract intangible asset income because the policies lead to tax windfalls and distort investment and income patterns.
Digital Permanent Establishment Rules
When developing policies to tax corporate income of digital businesses, some countries are adjusting their definitions of permanent establishments. However, this immediately creates the potential for double taxation.
While disagreements among countries on the allocation of taxable corporate income remain, the challenges associated with some countries attempting to tax digital business income without creating double taxation will continue. Though comprehensive reforms to international taxation would also address the digitalization of the economy, it is likely that countries will remain focused on reforms targeted at digital business models rather than taking up the challenge to broadly adopt fundamental reforms.
Outside of a fundamental reform to the international tax system, countries should recognize that navigating definitions of digital permanent establishments comes with risks.
Countries should pursue:
- Multilateral negotiations when developing new approaches for taxing corporate income of nonresident businesses.
Countries should avoid:
Rules targeted at specific industries or sectors that would create unstable policies in the context of a rapidly changing and digitalizing economy.
Unilateral pursuit of digital permanent establishment regulations that are likely to result in double taxation and harm efforts to coordinate policies.
Gross-based Withholding Taxes on Digital Services
Gross-based withholding taxes on digital services are a poor proxy for corporate income taxes and represent a shortcut to taxing digital companies without considering the challenges of identifying a virtual permanent establishment. Policymakers should avoid relying on gross-based withholding taxes to tax digital businesses that do not have a local presence.
Countries should avoid:
- Relying on policies that are neither efficient nor transparent as rough substitutes for either consumption or income taxes.
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 Though many countries are implementing digital tax policies to improve tax administration, these changes to tax administration are not considered in this paper.
 “Principles,” Tax Foundation, accessed May 18, 2020, https://taxfoundation.org/principles/.
 In many cases policies become known by the business they are targeting because the policy and political rhetoric is directed at those businesses. For example, see Angelique Chrisafis, “France Hits Back at US over Tax on Digital Giants,” The Guardian, July 11, 2019, https://www.theguardian.com/world/2019/jul/11/france-us-tax-big-digital-companies-donald-trump-amazon-facebook.
 Christoph Spengel et al., “Steuerliche Standortattraktivität digitaler Geschäftsmodelle” ZEW, PwC, December 2018, https://www.pwc.de/de/steuern/pwc-studie-steuerlicher-digitalisierungsindex-2018.pdf.
 Though the European Commission and many European politicians incorrectly interpret the cause of the tax gapThe tax gap is the difference between taxes legally owed and taxes collected. The gross tax gap in the U.S. accounts for at least 1 billion in lost revenue each year, according to the latest estimate by the Internal Revenue Service (IRS) (2011 to 2013), suggesting a voluntary taxpayer compliance rate of 83.6 percent. The net tax gap is calculated by subtracting late tax collections from the gross tax gap: from 2011 to 2013, the average net tax gap was around 1 billion. between digital and traditional businesses, this gap was a key motivation for significant tax proposals for the EU. European Commission, “Fair Taxation of the Digital Economy,” Taxation and Customs Union – European Commission, Mar. 21, 2018, https://ec.europa.eu/taxation_customs/business/company-tax/fair-taxation-digital-economy_en.
 OECD, “Programme of Work to Develop a Consensus Solution to the Tax Challenges Arising from the Digitalisation of the Economy,” 2019, https://www.oecd.org/tax/beps/programme-of-work-to-develop-a-consensus-solution-to-the-tax-challenges-arising-from-the-digitalisation-of-the-economy.pdf.
 Gary D. Sprague, “A Critical Look at the European Commission Staff Impact Assessment Relating to the Proposed EU Directives on Taxation of the Digital Economy,” Bloomberg BNA, July 13, 2018.
 Itai Grinberg, “International Taxation in an Era of Digital Disruption: Analyzing the Current Debate,” SSRN Scholarly Paper Rochester, NY: Social Science Research Network, Oct. 29, 2018, https://doi.org/10.2139/ssrn.3275737.
 OECD, “Members of the OECD/G20 Inclusive Framework on BEPS,” December 2019, https://www.oecd.org/tax/beps/inclusive-framework-on-beps-composition.pdf.
 Daniel Bunn, “Chaos to the Left of Me. Chaos to the Right of Me,” Tax Foundation, May 5, 2020, https://taxfoundation.org/pascal-saint-adams-oecd-digital-tax-negotiation-timeline/.
 Fundamental changes include broad adoption of destination-based cash flow taxes or a fundamental global agreement on allocating taxing rights based on a set formula. Both would rearrange taxing rights across the globe more significantly than changes directed at digital business models, meaning that adoption remains unlikely given the political challenges of getting countries to agree to either.Share