Two Reasons Digital Services Taxes Are Attractive—and Five Reasons They’re Still Wrong

The United States Trade Representative’s office last week initiated a Section 301 investigation into digital services taxes (DSTs) that have been adopted or are being considered by a number of foreign governments.

Although they may differ from each other in certain respects, DSTs all tax the revenue from a narrow slice of digital services. The taxes only apply to companies that have significant global and domestic earnings. As a result, DSTs mainly affect large U.S. Internet firms. The faulty logic behind DSTs is that most of the value from Internet platforms comes from their users in the countries where they provide services, since without those users there would be no revenues. Therefore, the logic goes, a “fair” proportion of companies’ revenues should be subject to taxation where their users reside.

For countries considering whether to enact them, DSTs offer at least two compelling benefits, especially with other government revenue falling:

1. They target an easy source of money, namely revenue from the largest Internet companies including Amazon, Apple, Facebook, Google, and Microsoft.
2. Because DSTs usually apply only to the largest firms, few of a nation’s domestic firms are hit. This has a double benefit: It reduces domestic political opposition, and it makes it easier for domestic digital firms to compete with American firms.

But just because DSTs may be attractive to individual countries doesn’t make them good policy. In fact, they are bad policy. A central goal of good tax policy should be to treat similar transactions the same way. DSTs violate this principle in a number of ways:

1. DSTs only apply to companies with significant revenues, both globally and in the domestic markets where the taxes are levied. This means that many similar domestic companies pay no DST and that most smaller companies are exempt. This is in contrast to conventional corporate tax policy where all firms, regardless of size or nationality, are subject to the same tax.
2. DSTs fail to deal with the broader issue of digitalization. Industries are increasingly moving economic activity to the Internet and collecting large amounts of data, but DSTs do not apply to the vast majority of this activity.
3. DSTs often apply to ad revenue, but not to subscription fees. So, a free music-streaming site that is entirely ad-supported would pay taxes on all of its revenues. Whereas, a company like Spotify, which also offers a premium subscription service, would not pay taxes on that part of its business. Similarly, a platform such as Amazon Marketplace, which offers products from many third-party providers would be subject to DST. Whereas, a website that only sells products from one vendor would not pay a DST.
4. DSTs are trade barriers that violate international trade agreements. These agreements are premised on the principle that imported goods and services should receive the same treatment as domestic ones. Although on the surface DSTs offer equal treatment to all firms, distinguishing only according to their size and business model, most of the burden falls on a small set of foreign companies, mostly based in the United States. Structurally, the decision to tax these revenues makes the practice equivalent to an ad valorem tax on imports, something that violates WTO rules.
5. DSTs discriminate against less profitable companies. Unlike existing corporate tax regimes, which tax profits, DSTs tax companies based on their revenues. This means that less profitable companies will be much harder hit. A 3 percent tax on revenues equates to a 23 percent tax on profits for a company with a margin of 15 percent, but a 63 percent tax for one with a margin of 5 percent. One could argue that a DST is just a sales tax in disguise, but trade laws forbid those from discriminating against imports—and DSTs are specifically designed to target foreign companies.

To be sure, nations have legitimate concerns about a global tax system that lets many companies legally pay less taxes than they should. But the answer is not to overturn decades of precedent and tradition in corporate tax policy to target a few firms in one industry; it is to reform the broader system.

The Organization for Economic Cooperation and Development’s ongoing negotiations on Base Erosion and Profit Shifting (BEPS) include two pillars. The first focuses on taxing digital companies; the second focuses on eliminating tax havens by establishing some sort of minimum tax rate globally. It looks increasingly like track one is flawed and should either be abandoned or made consistent with long-standing tax principles: Tax profits, and don’t discriminate on the basis of firms’ size, industry, or nationality.