Individuals and businesses are increasingly generating value in the digital sphere, but governments’ systems of taxation remain rooted firmly in the physical world. At the 2018 Global Government Finance Summit, delegates discussed this existential threat to public sector revenues. Matt Ross reports
Like every other arm of government, taxation authorities can find some powerful tools among today’s digital technologies. But for government’s revenue generators, the social and economic shifts driven by digital innovation also represent a major threat – fostering footloose workforces and elusive value chains that are increasingly difficult for national governments to pin down and tax.
Earlier this year, senior civil service finance professionals from 11 countries debated these issues at the 2018 Global Government Finance Summit – hosted in Berlin by the German government, and supported by EY and Microsoft. “We already have 1% of the world population as digital nomads,” pointed out Dmitri Jegorov, the Deputy Secretary General for Tax and Customs Policy in Estonia’s Ministry of Finance. “They travel the world and no one can claim jurisdiction over their income.”
The growth of remote working, labour mobility and “virtual migration” are, said Microsoft digital architect Harry Tsavdaris, set to leave a growing number of people outside the traditional tax system. “You can have citizens in your country using services, but working and paying taxes in another jurisdiction,” he said. “So you have the burden but not the benefit.”
Digital as a tool
And it’s not, added Tsavdaris, as if tax officials haven’t already got enough on their plate – what with the long fiscal hangover of the 2008 financial crisis, the impact of demographic changes on tax revenue and public spending, and the need to safeguard their vast stockpiles of sensitive personal data. And on top of that, in many countries they’re being asked to use taxation to pursue social or environmental goals. “There’s a saying: ‘culture eats strategy for breakfast’,” Tsavdaris noted. “I could add that taxation can eat culture for breakfast. You can change culture by using the force of tax – it’s a powerful tool.”
As Tsavdaris pointed out, modern technologies can help tax professionals address some of the challenges filling their in-trays. “We can have quicker payments; we can offer new ways to interact with tax administrations; we can improve our operations, optimising workflows and processes,” he said. “We can forecast revenues; protect against fraud; open up our data to show taxpayers where their money is going.”
Estonia is well advanced in its digital services – and Jegorov outlined some of the new services it’s developing for taxpayers. “We’re planning to do financial and business analyses for companies, and display them in their electronic tax interface,” he explained. “We’ll show them how they compare to similar companies in the salaries and tax they pay, and the risk scores that the tax administration has assigned to them – so if their risk score is high in a particular field, they can adjust their behaviour.”
Digital as a danger
Such digital tools have been covered in depth in previous Global Government Finance Summits. But none are currently able to address the threats presented by digital technologies – in particular, the whittling away of both personal and business taxation as economies migrate from the physical to the digital world. Whilst ‘digital nomads’ undermine the income tax base, the growth of digital industries is leaving governments unable to effectively tax growing swathes of business income.
“International tax regulations are based on physical locations and on tangible assets, and none of that’s important for the digital economy: our regulations are out-dated and need to be modernised,” said Jegorov. This isn’t about tax avoidance, he added: the problem is that digital industries often generate much of their value in locations where they have no physical presence or taxable activity.
Some digital businesses may bump up individual users’ tax liabilities, pointed out Tsavdaris, but much of the value they create produces revenues taxed only in faraway countries. “Airbnb and Uber and Bitcoin are deregulated models,” he said. “How will tax administrations be able to regulate and tax these models?”
These changes have far-reaching implications for traditional models of taxation, argued Jegorov. “I believe that we’re witnessing the end of corporate income tax as we know it because of this increasing digitisation,” he said. “You can be an Irish citizen and an Estonian e-resident, with an Estonian-registered company, working with programmers from Ukraine and India to put a service on a cloud – which could be anywhere! – then selling the service to German and Finnish customers. Would someone tell me where the value is created?”
Taken together, said Martti Hetemäki, Permanent Secretary of Finland’s Ministry of Finance, these economic changes present an existential threat to aspects of the global tax settlement. The “pressures on the current system,” he said, raise questions over “whether it’s viable in the long run.”
During Estonia’s presidency of the European Union Council in the second half of 2017, explained Jegorov, the country made “taxation of the digital economy one of the key focal points.” The model of ‘permanent establishment’ – the home of a business for income and VAT purposes – still works “as a central concept for global allocation of taxing rights,” he argued, “but it has to be tweaked a little bit to make room for aligned value creation where profit is taxed.”
A general consensus emerged in the Council, he added: long-term, global solutions are required that keep intact the main body of internationally agreed tax principles. Further, “we all agree that tax must be paid where value is created – but the value creation process is quite complicated, so the real arguments are there.”
As a broad principle, Jegorov continued, “user-generated content and data collection have become core activities for the value creation of digital businesses. So value created by users for these businesses in a particular jurisdiction should be considered as an economically significant function. And when users give data to a platform in exchange for a free service, this part of the transaction should be taxable in your country.”
Finding global agreement on changes to the long-standing arrangements for corporate tax liabilities is, of course, a major enterprise – so some EU leaders are keen to find a short-term remedy that can act as a stepping stone to a final settlement. “The economy is getting digitised day by day, so there’s great pressure to find an interim measure – a temporary one that will give us time to continue negotiations at the OECD to find a global, long-term solution,” commented Jegorov.
In the short-term…
As a result the European Commission has, he said, set out proposals for two directives. There’s a short-term plan for “an indirect tax on turnover of certain digital services”: this involves taxing advertising revenue; the sale of user data; and the “platform revenue” – the fee charged by digital businesses to users such as Airbnb hosts and Uber drivers.
Then there’s “a long-term solution, which is basically a corporate income tax on significant digital presence.” This latter proposal introduces the concept of “virtual permanent establishment: you’re not physically present in the market, but you have a significant digital presence and therefore you must pay a corporate income tax based, in most cases, on user participation.”
The Commission’s goal is, Jegorov explained, to introduce its short-term solution across the EU. “The main idea is to keep the Single Market harmonised and avoid its fragmentation. We know that 11 EU members states have implemented or plan to introduce their own measures if this short-term measure fails, which is a lot out of the 28,” he said.
Only about 120 major businesses, with turnover of over €750m (US$880m) and taxable EU sales of over €50m (US$59m), would be liable for this tax, he added; and it would be deductible from corporate income tax. Nonetheless, charged at about 3%, it should produce about €5bn (US$6bn) of revenue. A single country – designated by each business – would collect the tax, disbursing it to other member states based on the location of user activity.
And in the long-term…
One danger, as Jegorov recognised, is that this ostensibly interim measure morphs gradually into a final settlement. “As we know, there is nothing more permanent than the temporary,” he said. “We need to make sure that the directive states that when there is a global agreement, these measures will lapse.” But those involved are aware that tweaking the existing tax structures in this way will create complexity; and they believe that, as digitisation spreads further through the economy, a more fundamental rethink will be required. The OECD general secretary and countries involved in the process have sped up their work on these long-term plans, he added, “perhaps to make sure that they find a long-term solution that renders the interim solution unnecessary.”
Under the European Commission’s proposals, this long-term solution would involve charging digital business a corporate income tax on their activities in EU states – even when they have no physical presence or staff based there. Companies would become liable for taxation if they have either €7m (US$8m) in sales, 100,000 users, or more than 3000 contracts in a member state; the tax would be imposed on online services deemed impossible to deliver without a digital platform, but exclude online retail.
It would be helpful in agreeing a long-term settlement, Jegorov said, if the EU agrees a common position. “When the US comes to the OECD, they know exactly what they want and they’re frank about it,” he said. “But the majority of EU member states are also members of the OECD and they represent themselves there; I would love to see more European unity. We ought to know better what we want.”
Yet there is also international competition between EU members, noted Hetemäki – pointing to the race to drive down corporation tax rates: “We live in an open world,” he added. “It’s hard to have a purely European solution.” And the USA’s goals are bound to diverge from those of European nations – which are often consumers of the services offered by America’s digital giants: the US houses “a number of the leading companies: the interests of the United States are different,” said one delegate.
In an era when President Trump is championing protectionist policies, commented Torsten Arnswald, Head of the Fiscal Policy Division in Germany’s Federal Ministry of Finance, the EU unilaterally introducing a digital tax could create a negative reaction: “We should not chuck more oil on the fire with this issue of the digital economy: we need the United States to come in.” Clearly, given disparate interests and the America-first instincts of Trump, winning global agreement will not be easy.
Nonetheless, Arnswald continued, “in principle the common interest in the international community finding a proper framework should be clear.” Our current international taxation model was built decades ago in a very different era; and as economies change radically with the introduction of digital technologies, our taxation system must try to keep up. “This is a real case, I think, for international cooperation,” he concluded.
This is part six of our report on the 2018 Global Government Finance Summit. Part one examined the Compact for Africa; part two explored the use of blockchain in public finance management; part three covered Finland’s reforms of health and social care delivery; and part four explored Australia’s use of digital technologies in policymaking and service delivery, whilst part five profiled Singapore’s dramatic advances in digital services and administration. The final part will be published soon.