Negotiations about how digital giants — Google, Apple, Facebook, and Amazon — pay local taxes to foreign governments have been derailed by the Covid-19 pandemic. The timing couldn’t be worse: Governments are facing historic shortfalls and digital companies are doing exceedingly well. This all sets the stage for a global trade war. The authors explain how we got here, and what type of cooperation will get us through it.
Pre-pandemic, you might remember, the U.S. government threatened to impose 100% tariffs on French goods, including champagne and cheese, in retaliation for France’s planned 3% tax on revenues generated by large digital companies in its territory. France agreed to postpone these taxes until the end of 2020 to avoid a trade war, while hoping that the Organization for Economic Co-operation and Development (OECD) would come up with a multilateral solution by then.
They haven’t. Instead, the world has grown rapidly more complex. An international trade war now seems inevitable, as governments worldwide undertake massive Covid-19 rescue efforts while facing a large shortfall in tax collections. If finding common ground was difficult before, it likely feels impossible now. The only way it can be solved is through historic collaboration.
How we got here
The World Bank estimates a 5.2% contraction in global GDP in 2020, which will be the deepest recession the world has seen in decades. Covid-19 will further negatively impact national incomes in the following years because of lower investment, an erosion of human capital through lost work and schooling, and fragmentation of global trade and supply linkages. Governments will have to make extraordinary efforts to mitigate the downturn and offer fiscal and monetary policy support to their citizens and corporations.
For a long time now, digital giants such as Google, Apple, Facebook, and Amazon (GAFA) have found innovative ways to reduce tax payments to foreign governments, a possible factor in foreign governments’ lowered tax collections. Unlike the local physical companies, digital giants don’t need physical infrastructure, factories, or warehouses to do business. Their lack of a “permanent establishment” makes it difficult for any government to ring fence or identify their economic activity in any region — forget calculation of profits and collection of taxes. In addition, the main cost of a digital company is developing intellectual property, not labor, raw material, or energy. It can easily shift its costs — and thus profits — from a high-tax country to a low-tax country by relocating its intellectual property and imposing large royalty payments. As a result, digital giants are currently one of the largest users of innovative transfer pricing and income shifting schemes.
This shift in economic activity and tax base from local companies to digital giants has been going for more than a decade; Covid accelerated it. The irony is that during Covid-19, while countries are hurting, digital giants have further captured the market and revenue shares from local companies. They are doing really well in this crisis, accelerating the global tax transformation. For example, Amazon took over a large part of profits that would have otherwise accrued to local retailers, who would then pay the taxes to the local governments. Covid has also had a devastating impact on local newspapers and their advertising revenues, which is now shifted to giants like Facebook and Google. Governments thus face one-two punch: fund local recovery and welfare, while not getting enough taxes from digital giants who have usurped their tax base. They have no choice but to look towards digital giants to meet at least a part of their budgetary deficits.
Similarly, discussions about how to more fairly tax digital giants have also been going on for more than a decade; Covid created a new sense of urgency. Roughly 137 countries have been working diligently with European Union (EU) and OECD to find a collective solution. The solution revolves around a revenue-based tax on digital giants, that is, a fixed percentage of gross revenues remitted by local companies to digital giants. This system has two advantages. First, it eliminates the need to calculate profits, which can be reduced by transfer pricing schemes. Second, the burden of deducting tax and remitting to the local tax authority is placed on the local person or company, eliminating the need for a foreign government to run after a company that is beyond its administrative control. The U.S. participated in these negotiations and discussions until June, when they withdrew.
Without U.S. cooperation and with Covid raging around the world, many countries have implemented their own unilateral solutions, worsening the risk of tax disputes and trade tensions. For example, Austria recently implemented a 5% tax on digital advertising revenues. India and the United Kingdom have enacted a 2% tax with retrospective effect. Spain is halfway through legislating a 3% tax. Canada is considering a 3% tax. And Italy has enacted a 3% tax with retrospective effect.
Since the burden of new revenue-based taxes falls disproportionately on digital giants that are U.S. corporations, the U.S. government threatened to retaliate against those countries with its own trade restrictions and tariffs. It has launched a series of trade investigations — whether these actions amount to an unfair trade practice. The affected countries include: Austria, Brazil, Czech Republic, India, Indonesia, Italy, Spain, and Turkey, as well as the European Union. If the French incident is any guide, then the U.S. inquiry promises to be an aggressive trade war. Note that when the U.S. imposed tariffs on France, it also affected U.S. consumers and restaurants who buy French cheese and wines. So, any tariffs imposed by the U.S. not only affects companies, they also affect U.S. consumers and companies that obtain goods and services from foreign countries. Those countries in response could impose their own tariffs and measures affecting U.S. exporters.
What Happens Next
Such a trade war is harmful to global economic stability and progress at any time; it is especially harmful when the world needs recovery from Covid-driven historical downturn. The world economy is already facing a U.S.-China cold war and Covid-driven fragmentation of global trade and supply linkages. Moreover, a confrontational approach would impede technological progress around the world. Foreign governments can raise unfounded fears, withhold the expansion of digital services, and enact protective legislations. That approach would not only harm economic recovery but could make digital giants miss out on potential revenues and market growth.
It is clearly a time for calmer heads to prevail. The U.S. must resume participation and play a meaningful role in OECD’s multilateral discussion, instead of just threatening to derail the process while sitting on the sidelines. Foreign countries must also be more patient and postpone their implementation at least until the end of this year, by which time, OECD has promised a more general solution. And digital giants must become more willing to contribute to the world’s economic well being, which is so essential for their own growth and profits. After all, the shareholders of digital corporations have received tremendous returns on their investments during Covid-19 times. Mark Zuckerberg recently expressed willingness to support tax reforms in Europe, and concedes that Facebook “may have to pay more.” A more collaborative approach would be a win-win solution for all.
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