EconPol Europe: The EC’s Digital Tax Proposals Wiped €52 Billion From Capital Markets - Policy Makers Should Proceed With Caution

The introduction of ring-fencing digital taxes leads to disruptive effects on firm value and, potentially, overall economic wealth, according to a new study from EconPol Europe, University of Mannheim and ZEW Mannheim. The study suggests that while a digital tax on revenues may be an effective measure to prevent profit shifting, the economic effects of reduced investment and growth of digital companies may outweigh any potential benefits.

The study - the first to examine the effects of tax measures on firm values in the digital economy and the European market - analyses investor reaction to the European Commission’s March 2018 proposals on the taxation of digital corporations. It reveals that the market value of digital and innovative corporations decreased by at least €52 billion in excess of the regular market movement during the two days following the announcement of the proposals. Authors Daniel Klein (University of Mannheim), Christopher Ludwig (EconPol Europe, ZEW Mannheim, University of Mannheim) and Christoph Spengel (EconPol Europe, University of Mannheim, ZEW Mannheim) point out that the results provide evidence that investors believe that  digital tax measures have a negative impact on affected firms’ future profitability and competitiveness.

“By examining the stock returns of potentially affected corporations surrounding the draft directives’ release, we found a significant abnormal capital market reaction of -0.692 percentage points,” Ludwig states. “In various cross-sectional analyses, we find that the capital market reaction is, as expected, stronger for firms that can be assumed to engage more actively in tax avoidance and have a higher profit shifting potential.”

Klein adds: “The capital market reaction has further been found to be more pronounced for firms located in the EU, inversely related to firms’ revenues and seems stronger for loss-making firms. Based on the results, we estimate an overall abnormal market value decrease of digital and innovative corporations by at least €52 billion in response to the proposed measures. About 40% of this is attributable to US based corporations.”

The results highlight the distortive nature of the draft directives, substantiate the accusation of being focused on US firms and justify the concern of increased political and economic costs due to potential US countermeasures, the authors say. They add that this suggests some digital firms are currently able to avoid taxation in the EU, but that investors believe that this opportunity would vanish through the introduction of the digital tax package.

The two draft directives of the European Commission on the taxation of the digital economy were published on March 21, 2018. The first draft directive suggests the introduction of an interim tax of three percent on gross revenues from certain digital services on companies that exceed two size thresholds: those with a worldwide company turnover of 750 million euros within a financial year, and with a total amount of taxable revenues within the EU exceeding 50 million euros. The second directive proposes a longer-term solution to the digital tax issue by establishing a new taxable nexus for firms that maintain a non-physical but significant digital presence in one or more-member states of the EU. The study identified a significant reduction in firm value of 222 digital firms which are likely to be affected by the measures.

“Investors on average perceive the introduction of digital tax measures as both a likely event and negative news for firms’ profitability,” Spengel reports. “The observed significant wealth reduction of shareholders may be translated into reduced opportunities for affected firms to invest and grow in the future.”

Spengel warns that with regard to the identified shortcomings in the conception and potentially harmful effects of the draft directives on firms, intergovernmental organizations as well as local governments should carefully evaluate the introduction of ring-fencing digital tax measures.

“Policy makers should proceed with caution before imprudently introducing digital tax measures,” he concludes.

Read the full paper: http://www.econpol.eu/publications/working_paper_36