EconPol Europe: Tech Giants Should be Subject to Digital Services Tax, but Definition Needs Tightening

A new study from EconPol Europe has analyzed the proposals and international implications around taxing digital platforms and concludes that the European Commission’s proposed digital services tax (DST) addresses the concerns shared by policy makers. However, there should be a more stringent definition of the digital platforms that are subjected to such a tax.

The analysis, says author Marko Köthenbürger (EconPol Europe, ETH Zurich) “provides a foundation for the approach laid down by the EU.”

The significant advertising income generated by tech giants such as Google and Facebook, mainly reported in low-tax countries, is the subject of much policy discussion around how to realign the location of value in creation and taxation. The traditional methods of corporate taxation – profits taxed at the location they are created - are difficult to sustain when firms can shift profits to low tax jurisdictions

“Digital platforms require a sufficiently large amount of indirect network effects to exist, and so operate in many countries,” says Köthenbürger. “The international dimension of this indirect network effect that the digital platforms rely on for their success – charging advertisers for access to users – makes it difficult to determine the exact location where value is created for tax purposes.”

In the case of markets with two distinct user groups (or two-sided platforms) such as Google and Facebook, advertising contracts are directly located in low-tax countries and the users in various countries are exposed to the advertising that follows from the contract. The strategic location of contracts, and thereby advertising income, leaves almost no reported income in other countries where users are located.

“Identifying the location of advertising income is at the core of the policy discussion around digital platforms,” continues Köthenbürger. “In general, the location of servers, the creation of software, the location of intellectual property right and the usage of it might be used as the location where the value is created. However, these locations typically fall apart and, in many cases, are easily adjustable to save on taxes via profit shifting in a source-based corporate tax system.”

“The success of the business model of these digital platforms relies on the existence of indirect network effects, which are the prime reason why platforms exist and generate advertising income,” says Köthenbürger. “To account for these effects, conventional tax policy needs to be adjusted. This includes an adjusted concept of nexus that should rely on the location of users, which generate the relevant indirect network effects.”

The digital services tax proposed by the European Commission in 2018 – a tax on sales that result from active user participation – follows a similar model. Implementation has stalled due to disagreement on its effectiveness among member states. However, those states which support the idea have unilaterally imposed such a tax.

“This DST option will address the issue of how to tax income of digital platforms in a source-based tax system,” concludes Köthenbürger. However, he warns, it is important to note the critical feature that makes two-sided platforms such as Facebook and Google different for policy analysis.

“Digital platforms such as ebay or Airbnb do not pass the test of two-sidedness,” he explains. “They act as intermediaries between buyers and sellers, whereas there are no direct negotiations between users of Google and Facebook and firms that place advertisements.”

Read the full report: https://www.econpol.eu/publications/working_paper_41