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Should we worry about tax-revenue?

Here is a popular narrative:

The financing of the welfare state is under increasing pressure due to globalization, digitalization, and tax competition. As economies become more interconnected and digitalized, traditional tax bases—such as corporate profits and labor income—are eroding. Businesses and individuals can shift profits and income across borders more easily than ever before, taking advantage of lower-tax jurisdictions. Some worry that welfare states will face a “race to the bottom,” where countries compete by lowering tax rates to attract firms and investment, ultimately undermining their own fiscal sustainability. Digitalization adds another layer of complexity. Multinational tech companies generate vast revenues in markets where they have little or no physical presence, making it difficult for governments to tax them effectively. Existing tax systems, designed for a brick-and-mortar economy, struggle to capture value in the digital age.

Digitalization adds another layer of complexity. Multinational tech companies generate vast revenues in markets where they have little or no physical presence, making it difficult for governments to tax them effectively. Existing tax systems, designed for a brick-and-mortar economy, struggle to capture value in the digital age.

Worries like these have been raised over and over again, at least since the 1980s. The idea of a race to the bottom triggered by institutional competition can be traced back at least to Gramlich (1982). Hans-Werner Sinn, a prominent German economist, has extensively analyzed the “race to the bottom” phenomenon within the context of global economic integration (1997, 2004).

But what has happened? Let’s pick a year, after the crisis if the early 1990s but before the big rise of the Internet: 1995. (The starting year actually does not matter much). In the OECD, these were the countries with the highest overall taxes (measured as total tax revenue as a share of GDP)

  1. Denmark – 46.6
  2. Sweden – 45.1
  3. Finland – 44.5
  4. Belgium – 42.8
  5. France – 42.7

The five countries had the lowest tax revenues in 1995:

  1. Mexico – 9.6
  2. Colombia – 16.0
  3. Türkiye – 16.4
  4. Chile – 18.2
  5. Korea – 18.8

The average tax ratio in the OECD countries in 1995 was 32 percent. If globalization, digitalization, and tax competition have a negative impact on tax revenue, we should see a falling trend. We do not. In fact, average taxes in OECD-counties have trended upwards. The countries with the highest taxes in 1995, have almost as high taxes in 2022. And the countries with the lowest taxes in 1995 have much higher taxes 2022.

The striking trend in the graph above, is clearly not a race to the bottom. It is convergence. To verify this, the graph below displays the standard deviation for country level tax ratios, yearly from 1995 to 2022. The dispersion has decreased, from 8.9 to 7.3 standard deviations.

In other words: during the era of globalization and digitization, OECD-countries have become more similar, but the main driver has been higher taxes in low-tax countries.

References

Gramlich, Edward M. (1982), ‘An Econometric Examination of the New Federalism’, Brookings Papers on Economic Activity, 2, 327–60.

Sinn, Hans-Werner (2004), ‘The New Systems Competition’, Perspectiven der Wirtschaftspolitik, 5, 23–38

Sinn, Hans-Werner (1997), ‘The Selection Principle and Market Failure in Systems Competition’, Journal of Public Economics, 66, 247–74.

25 January 2025

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VAT on B2C virtual activities

Many activities nowadays are happening in a virtual environment. Various digital artifacts are sold and bought in online games, people are playing in online casinos, take distance educational courses, and use different applications for training and entertainment. Especially after the COVID-19 pandemic, many services traditionally delivered physically are now delivered remotely, such as digital conferences and online fitness classes.

From the VAT perspective, this creates a number of challenges. The first one concerns the jurisdiction to tax remote services. According to the current EU VAT rules, services relating to cultural, sporting, educational and similar activities supplied to non-taxable persons are taxed at the place where these activities actually take place. This rule has been challenged by the digitalization of services resulting in the disruption of the unity of place, time and actors involved in the provision of such services. In Geleen (C-568-17), the Court of Justice had to deal with the imperfection of the VAT Directive’s provisions and decided that live interactive entertainment services should be taxed at the place where their supplier was established. Luckily, in that case this resulted in taxation at the place of consumption since the customers were in the jurisdiction of the supplier.

After this case, the EU legislature changed by virtue of Council Directive 2022/542 the place-of-supply rule for business-to-consumer services relating to cultural and similar activities which are streamed or otherwise made virtually available to be the place where the customer is located. The new rules will apply starting from 1 January 2025. This implies that an organizer of a digital conference or any other virtual event will have to distinguish between business and private customers, and in respect of the latter to pay VAT in the jurisdiction of the customer. To do that, the supplier will have to either register for VAT in all Member States where their private customers are located or, alternatively, register and pay VAT through the one-stop-shop simplification scheme. A task that is far from being easy, considering that the EU VAT legislation does not contain any rules on how to determine the location of the customer in respect of virtual activities. Moreover, the suppliers of services relating to virtual activities are not able to benefit from the simplification for EU small businesses allowing them to pay VAT in the Member State of their establishment subject to EUR 10K annual threshold.

It is common for many events to take place in a hybrid form. For example, a fitness masterclass may be provided at a specifically identified location for a number of participants, whereas some of the participants may enjoy the live-streaming of the event. A hybrid form is quite common for conferences, presentations and other events. As services relating to physical and virtual events will be subject to different place-of-supply rules, the question arises how to determine where to tax services relating to hybrid events. Besides physical and virtual participation options, events may entail different service elements, part of which are provided at a concrete place, while others – virtually. Unfortunately, the current EU VAT legislation does not provide clear rules on how to treat such services, which leads to legal uncertainty and increases compliance burden for taxable persons.

Another issue with the VAT treatment of virtual B2C activities is a thin borderline with the category of electronically supplied services. If provided to non-taxable persons, both will be taxed at the place of the customer’s location. However, these two categories of services may be treated differently for VAT purposes. For example, the VAT Directive contains a number of exemptions relating to sport and physical education, educational and cultural services. These exemptions do not necessarily apply to services falling within the category of electronically supplied services. Likewise, the above-mentioned simplification for small businesses applies to electronically supplied services, but not to virtual activities that do not fall within this category. The electronically supplied services are characterized by being essentially automated and involving minimal human intervention. Virtual activities may also be characterized as electronically supplied services if, for example, pre-recorded. All these classification issues create an additional administrative burden for taxable persons.

Yet another challenge for the EU legislature is that many virtual activities that could potentially constitute a VAT base will most likely remain untaxed. Let us take an example of virtual fitness classes, an industry which is expected to grow to nearly 80 billion by 2026. Nowadays, many digital platforms facilitate the provision of live fitness classes to consumers by providing a virtual space for their live-streaming, as well as related services. The EU VAT legislation does not have an effective mechanism to tax such services. To note, the solution for the platform economy, which has been finally agreed by the Council on 5 November as part of the “VAT in the digital age” package only covers short-time accommodation rentals and passenger transport services. This may result in distortion of competition between untaxed virtual fitness classes and similar services provided by gyms and alike entities.

The segment of diverse services provided in a virtual environment continues to grow, creating a potential broadening for the VAT base. However, the EU VAT rules are not keeping pace with this development, leading to outdated and ambiguous rules or the absence of rules at all. It may be questioned whether the criterion of “essentially automated and requiring the minimum human intervention,” which is a characteristic of electronically supplied services, is still relevant in a digital economy considering the emergence of other remote services, such as virtual events.

Mariya Senyk

Pufendorf Institute

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18 November 2024

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Justifying or Criticizing the Global Tax Deal?

Pufendorf Institute: BLOGG POST

Across most EU Member States, debates on the upcoming year’s budgets are in full swing. In these times of austerity and fiscal constraint, proposals to raise taxes does not come as a surprise. France’s case is particularly noteworthy, as it proposes a significant increase in tax revenue, aiming to generate an additional €60 billion next year. This revenue target means income taxes must exceed current levels. For individual income tax, the French government has introduced a “differential contribution of high incomes,” impacting households already subject to the exceptional contribution on high income (with net income over €250,000 per individual or €500,000 per couple). Those whose average tax rate is below 20% will now need to meet this threshold. Though only 24,300 tax households will be affected, this measure is expected to contribute substantially to the €60 billion target, alongside higher taxes on capital and the cessation of tax exemptions on life insurance payments for inheritance beneficiaries.

Additionally, the 2025 budget proposal suggests doubling the Digital Service Tax (DST) from 3% to 6%. France is not alone in reconsidering DST frameworks; Italy, for example, proposed strengthening its DST in its draft 2025 budget by removing thresholds related to global revenue and domestic sales. Beyond the EU, Australia has also raised similar issues, with a parliamentary committee recommending taxation on large social media platforms to support the country’s news publishers. However, protectionist measures may prompt defensive trade barriers from other countries. In her Tax Notes International article “Looking Past Pillar 1 Through a DST World” dated November 18, Prof Mindy Herzfeld exposes the large retaliation risks from the US side, mentioning section 891 of the IRC,stating that ” if the president finds that, under the laws of any foreign country, citizens or corporations of the United States are being subjected to discriminatory or extraterritorial taxes, the president will proclaim that the rates of tax imposed ( …) for the tax year during which the proclamation is made and for each tax year thereafter, be doubled for each citizen and corporation of that foreign country. ” There is little doubt that the new Trump Administration will hesitate to use this tool.

These targeted initiatives to curb tax base erosion and address national budget shortfalls underscore the need for a global forum, such as the OECD or UN, according to these organizations. The unfit current international tax system to the current economy is a recurring topic in international economic discussions. Rebecca M. Kaysar’s recent article, explores the need to reassess the trade liberalization foundations on which existing laws stand. She references Ruth Mason’s influential article, The Transformation of International Tax (2020), which posits that we are experiencing a shift toward “coordinated unilateralism” driven by the OECD. This new approach in international economic governance reallocates resources to reverse fiscal austerity and address inequality.

As the geopolitical landscape becomes increasingly fragmented, a new global tax agreement seems to be difficult to reach but also necessary to avoid more fragmentation. Short-term unilateral responses like digital service taxes, designed to address tax issues from the digital economy, have instead become entrenched rather than leading to a comprehensive global tax framework like the OECD’s Pillar One proposal. A recent article, Five Years of Digital Services Taxes in Europe: What Have We Learned? (Intertax, Vol. 52, Issue 10), reveals that a significant portion of the tax burden has shifted to SMEs and consumers, with minimal impact on digital giants. For instance, “the overall impact of a 3% revenue tax correlates negatively with corporate profitability. For a company with a low profit margin of 5%, the tax is equivalent to a corporate income tax of 60%, whereas for a company with a high profit margin of 50%, it amounts to only 6%” (ibid, p. 646, M. Bauer).

The “new international economic governance” advocating for a global solution raises questions across disciplines. One key inquiry is how current laws might be adapted to meet today’s costs of welfare financing. Corporate income tax rules currently allocate taxable profits according to bilateral tax treaties embedded in domestic law. Parliaments ratify these treaties, historically under OECD and UN guidance, to prevent double taxation and combat double non-taxation. But what alternatives exist if this system is no longer viable? Are the OECD and UN’s Pillar One and Pillar Two proposals legitimate, and can international tax “technocrats” without direct ties to domestic tax authority truly enact global change?

Ana Paula Dourado, in an editorial for Intertax (Vol. 52, Issue 3, 2024), underscores the importance of legitimacy, noting that legitimate taxation relies on laws that reflect a social contract between citizens and government. Social scientists discuss the input, output, and throughput legitimacy of rules, acknowledging, as legal positivist H.L.A. Hart did, both formally adopted and informally applied rules. Legal scholarship, often focused on the formal validity of rules, recognizes that the OECD’s recommendations to equitably distribute tax responsibilities play a role. Yet criticisms about the OECD’s lack of democratic representation are unlikely to succeed in court (if an international tax law court existed). While this does not exempt the OECD’s proposed regulations from critique, the tools of traditional legal analysis may be insufficient here. 

Thus, for scholars examining the shifts brought by a digitalized economy, it is essential to look beyond legal frameworks and consider insights from other fields on the broader issues of eroding tax bases and the pressures on welfare funding before justifying or criticizing such globally impactful reforms.

Cécile Brokelind

Pufendorf Institute

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18 November 2024

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