How reasonable are the EU’s digital taxation plans?

Stan Veuger

 
The European Commission recently released two proposed directives that relate to the taxation of the digital economy. Both proposals would shift tax revenue from the United States to Europe — and potentially invite retaliation — by taxing activities dominated by American internet and technology firms where their customers are located.

The first proposed directive is meant to provide an answer to the question of how to tax firms that operate online as opposed to only through traditional physical establishments. A firm would be considered to have a significant digital presence — virtual nexus — in a member state if its annual revenue there exceeds €7 million, or if it has more than 100,000 users in the member state, or it has over 3,000 contracts for digital services with businesses in the member state. A proportional share of its profits would then become taxable in the country that it has nexus to.

The second proposed directive is presented as a temporary solution that allows countries to collect taxes on certain digital activities while negotiations regarding the permanent fix take place. This interim tax would apply only to social media operations and online ad sales and only to certain large companies — those with worldwide revenue of at least €750 million and revenue within the European Union of at least €50 million.

The central justification offered by the Commission for these two proposals is that digital activities escape traditional taxation. The implicit contrast here is with brick-and-mortar establishments that add value and sell products in a single location, which is also where its employees and consumers live. These various elements have of course come unbundled before in all types of industries, and it is hard to believe that it was through purely deductive conceptual reasoning that the Commission arrived at these proposals. Instead, the economic activities at issue here — especially those affected by the interim proposal — are ones where the European Union is a net importer, not a net exporter.

The intellectual property of the firms involved is therefore often located outside of the European Union, and most of the value added is created there as well. These companies’ income is therefore mostly not taxed in the EU, but that certainly does not mean that they are not taxed, especially now that the United States has adopted what for all intents and purposes is a global minimum tax. The Commission responds to this by arguing that value in this industry is actually created through “user engagement” and that the location of such engagement should determine where profits are taxed, which is not currently the case. Most economists would probably dispute that this is a unique feature of social media or other digital applications: The food I buy is also useless if I don’t eat it, where eating is a traditional form of user engagement.

This takes us to a second consideration. One can easily envision a system of corporate taxation that is destination-based, i.e., a system that taxes profits where consumers are located. In fact, Republicans in the US House of Representatives proposed precisely such a scheme just last year. What does not necessarily seem reasonable is to apply this type of system, as the Commission proposals do, only to industries where consumers are disproportionately domestic. A switch along these lines also reduces the space available for tax competition both within and with the European Union and subjects firms to the tax jurisdiction and enforcement efforts of ever increasing numbers of countries and subnational units.

Perhaps then this debate is not solely about new challenges posed by new technology. Perhaps the allocation of resources and the power to extract them are, in fact, as controversial as they have always been.

 
Stan Veuger is a resident scholar at the American Enterprise Institute (AEI), where his research is in political economy and public finance. He is also the editor of AEI Economic Perspectives. Dr. Veuger has been a visiting lecturer of economics at Harvard University, and is a fellow at the Center for the Governance of Change at the IE School of International Relations in Madrid.