Digital tax dilemma

How to put in place a global cooperation framework that puts an end to avoidance practices when some countries stand to win and others lose?

The global expansion of the digital economy and digital transformation of the global economy is happening at an ever faster rate. It is reshaping the global economy and posing cross-cutting challenges to the traditional governance architecture. Digital tax, which was designed for online business conglomerates, is already a reality in countries such as France, the United Kingdom, Italy, India and Singapore. The international controversy it has sparked brings the complexity and polarity of the issue into sharp relief. On the other hand, international dialogue platforms such as G20 and the Organization for Economic Cooperation and Development have been making meaningful progress toward putting in place a unified inclusive global digital tax framework, and countries are advancing steadily toward the ambitious goal of reaching an agreement by the end of this year.

As the digital economy has developed rapidly and taken root throughout the world, non-localized operations of digital enterprises and their radical tax avoidance practices have posed a big challenge to traditional tax regimes. Hence, there is an urgent need for a digital tax.

On the one hand, this need has to do with the fact that an increasing number of multinational digital companies have enormous revenues without a local, permanent establishment, and current internet-based businesses whose main sources of revenue are advertising and services rely heavily on user data, which is provided free of charge in exchange for the use of services provided by these companies, but the value generated by local users is not reflected in the taxation right of the government. From the standpoint of decisionmakers, this flaw has translated into much lower tax rates for digital companies compared to what they should be paying. Based on statistics published by the European Union, digital enterprises in the EU are subject to an effective tax rate of only 8.5 percent on average, whereas traditional multinationals are paying 23.2 percent.

On the other hand, a digital tax is necessary because it is very easy for digital multinationals to shift their profits around the globe by making use of intangible assets such as data, intellectual property licenses and copyright through related party transactions. This gives them lawful ways to minimize their tax base, undermining the exercise of taxation rights of countries with higher tax rates. Google is a case in point. In October 2010, Google was believed to have whittled down the applicable tax rate on its overseas (excluding US) revenues to a mere 2.4 percent through related party transactions with its offices in Ireland, the Netherlands and Bermuda, even though most of the countries where Google operates abroad have a prevailing tax rate of over 20 percent on average.

Global governance in tax collection and management is a textbook case of collective action. Although raising taxes means more tax collected for each individual jurisdiction (which is also the optimal outcome for all countries involved), lowering taxes can attract investments by multinationals which may generate more tax revenue in the end. For this reason, collective action in tax collection and management is always dogged by the free rider problem. In other words, countries that opt out of all tax treaties may end up benefiting from keeping tax rates low, while at the same time undermining tax treaty adherents. Reaching global consensus in any way, shape or form will be a herculean task given this challenge in collective action and the rise of the digital economy, which demands a remake of traditional tax regimes.

As early as September 2013, the OECD launched an action plan to curb base erosion and profit shifting (BEPS), with a view to put in place a global cooperation framework that facilitates the exchange of tax-related information and put an end to tax avoidance practices by multinationals. Thanks to years of research, consultation and consensus building, the OECD unveiled a two-pillar proposal for reforming the tax regime to suit the reality of digitalization of the economy. Pillar One seeks to reallocate taxation rights, while Pillar Two aims to enable global cooperation against base erosion. Specifically, Pillar Two prohibits making use of new technology to shift profits to countries with zero or low tax rates. It also defines a minimum tax rate and seeks to balance the tax rates applicable to traditional businesses and digital enterprises.

Even though the OECD has yet to finalize its global governance framework for digital tax, it has brought about promising progress in the global dialogue it has been facilitating (along with the G20). Having said that, this does not mean that we will see global cooperation in digital tax collections any time soon. In fact, extensive controversies within the EU regarding digital tax and individual initiatives on digital taxation in countries like France, Italy and the United Kingdom serve to remind us of the complexity of the matter and the polarized opinion about it. In fact, diverging economic circumstances among European countries mean that the simple act of rolling out digital taxes will benefit some countries to the detriment of others. For example, Ireland's generous tax deductions for intellectual property transactions practically turned it into a tax haven for tech companies. On the other hand, Sweden, Denmark and Finland repeatedly shot down EU proposals on digital tax due to their ambition to attract investment by high-tech companies. With different policy considerations in mind, France spearheaded a push for a EU digital tax but failed to garner consensus. The turn of events points to the heart of the global governance dilemma in digital tax: in the other words, how to share the costs of institutional reform fairly when some stakeholders stand to win and others lose.

In light of this, we can arrive at a basic idea of the complex paradigm of global governance of digital tax. On the one hand, there is still hope for global governance, while on the other, controversies and disputes persist. Debates and disputes over different alternatives will certainly be on the minds of policymakers and researchers for the foreseeable future, and rightly so.

The author is an associate professor with School of Public Administration at University of Electronic Science and Technology of China. The author contributed this article to China Watch, a think tank powered by China Daily. The views do not necessarily reflect those of China Daily.