2024 Overlooked Risk: Digital Service Taxes and International Frameworks a Viable Solution for Expanding the Tax Base?

As the world economy is becoming more digitized, the tax system is facing a growing challenge, but not every country and business has been aware of the curse. Traditional rules governing taxation are only applied to businesses with a physical existence in an economic territory, so digital goods and services which may not have a tangible presence are not necessarily being taxed. This creates a controversy over whether the digital sector is paying a fair share of taxes. Meanwhile, as more economic activities are moving online, the economic importance of the online sphere has grown relative to that of the physical world. Therefore, the current legal loopholes in the tax system have increased states’ vulnerability to tax base erosion, which poses a latent threat to their long-term fiscal stability. 

The digitalization of business models points to a need for a new type of tax in response to the unstoppable trend of digitalization. Some countries like the UK and Turkey have embraced the option called digital services tax (DST), which refers to taxes on gross revenue derived from a variety of digital services. 

While DST can certainly widen the tax base by covering digital commodities that have been ignored by traditional taxes, the introduction of DST can hardly avoid problems. The online world is ultimately a virtual sphere with no clear geographical boundaries, so traditional tax concept jurisdictions of tax revenue may not apply to the digital sphere. Customers from a state with DST may be consuming virtual goods and services provided by companies outside the state. Alternatively, the companies may be collecting data from consumers from other countries to generate profits. Under imperfect information, these companies, despite offering products to foreign customers, may not necessarily be aware that they could be subject to taxation of another state. Such information and compliance issues can put them vulnerable to additional penalties, thus arousing controversies over the jurisdiction of tax revenue. 

In light of the escalating threat of such risks and the uncertainty over the fiscal space, this report aims to explain how the digitalization of the world economy will impact the fiscal stability of both developed and developing countries in the foreseeable future. It also provides several recommendations for both the governments and the market to navigate the risk and prepare for what lies ahead.

In addition to the DSTs in the U.K. and Türkiye, there are other multilateral initiatives which set out to broaden the digital tax base and ensure fair tax is paid by multinational enterprises (MNE).One such initiative, and perhaps one of the most influential of its kind, is the OECD’s Inclusive Framework on Base Erosion and Profit Sharing (IFBEPS). The IFBEPS comprises of two pillars; (i) giving taxing rights to jurisdictions where MNEs conduct business even if MNEs do not have a physical presence in that jurisdiction, and (ii) ensuring that MNEs with over EUR 750mn in revenue pay a minimum tax rate in the jurisdictions where they operate physically even if they do not have business within that jurisdiction. The IFBEPS is due to come into effect across the 137 member countries at some stage later this year.

Although the IFBEPS is in so many ways a crucial initiative to tackle digital tax avoidance, it has two limitations. The first is that the vast majority of member countries are Western democracies, barring some exceptions in Africa and Asia. The second is that the IFBEPS does very little to actually boost bottom-up issues in the digital economy, namely participation. Nevertheless, both of these limits sit largely outside of the IFBEPS’ remit, though both are pertinent observations. For one, it remains to be seen if the adoption of IFBEPS pillars might push MNEs to operate in states that are not signatories to the IFBEPS to limit tax burden although at a potential risk of a reduction in human capital or moving costs. Secondly, a lack of bottom-up approaches means that whilst large multinationals would have more tax exposure plenty of small and medium-sized enterprises (SMEs) may not be impacted as significantly, especially in jurisdictions with large informal economies or tax delinquency rates. For those countries - with large informal economies and tax delinquency - IFBEPS might only increase overall tax revenues marginally without robust bottom-up approaches.

Fortunately there are examples of how such countries can go about increasing bottom-up participation. One such example is South Korea’s ‘Coin-Less’ society which aims to increase card payments and usage. The premise of the programme launched by the Bank of Korea (BoK) is to return change to cash-paying customers to prepaid debit cards through arrangements made between businesses, POS providers and debit card issuers. The logic of the programme is thus to highlight the convenience of card payments with respect to cash.

Figure 1: Bank of Korea ‘Coin-Less’ Scheme, taken from World Cash Report

Of course, a limitation to the implementation of such schemes is that they would probably only be implemented on a voluntary basis. Nevertheless, they could go a long way in promoting digital payments in the long-run in tax jurisdictions with low consumer digital payment usage and informal economies.

Nevertheless, DSTs and the IFBEPS mark a good first step in expanding the tax base to cover digital services but also have the potential to be the foundation for policies similar to the BoK’s ‘Coin-Less’ scheme, which could go a long way in combatting the informal economy by increasing participation in the digital economy. For this reason, the roll-out of the IFBEPS in 2024 will be crucial for expanding global tax bases into the digital space.