Digital Taxes Combine Bad Policy With Fatal Legal Flaws

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Even before the pandemic accelerated the process, the digitization of the economy was well underway. This trend has not gone unnoticed by revenue-needy budget planners in other countries, and even some American states. Yet while the coronavirus has slowed international and domestic efforts to enact new taxes that exclusively target digital goods and services, evidence continues to pile up that digital taxes are legally dubious.

One of the first countries to pursue targeted taxation of digital goods was France. After passing a 3 percent tax on digital services revenue collected in the country in July of 2019, the country agreed tosuspend the tax until the end of 2020 in response to threatened American tariffs.

Yet it is not just the usual retaliatory mechanisms that France should fear. A recent analysis from Georgetown University, in partnership with the Tax Foundation and Tradelab, determined that the country’s digital services tax could face serious challenges in three legal areas: bilateral tax treaties, international trade law, and European Union law.

And that’s not the only example of digital taxes suffering from severe legal deficiencies. Here in the U.S., Maryland’s legislature passed a digital advertising tax at the beginning of the year, only for Governor Larry Hogan to wisely veto the law due to concerns about its ability to stand up to legal challenges.

The Maryland law likely would not (or will not, should the legislature override Hogan’s veto) survive legal challenges on multiple counts. The law directly conflicts with the federal Permanent Internet Tax Freedom Act, which prevents states from levying taxes that discriminate against internet commerce — the state does not tax traditional advertising.

In terms of constitutional issues, Maryland’s tax would seem to represent an undue burden on interstate commerce, as it would primarily fall on businesses outside the state. The tax would even face serious First Amendment challenges, as taxes that target a primary revenue source for news outlets could be seen to violate press freedom protections.

Another state that has flirted with digital taxation is New York, a government that never turns down an opportunity to squeeze non-residents for tax revenue (even if they are volunteers helping with the state’s severe coronavirus outbreak). Companion legislation introduced in each of the state legislature’s houses would impose a five percent gross receipts tax on any business that “derives income from the data individuals of this state share with such corporations.”

Such vague wording opens the door to all kinds of businesses being taxed that are not thought of as “digital firms,” as nearly all businesses process consumer data in some form as part of normal business operations. Examples of businesses that could be affected by New York’s proposal include restaurants, businesses with reward programs, insurance companies, and any business that offers free wifi access. Such a broad and significant tax would not only be devastating to New York’s economy, but would also likely violate the dormant Commerce Clause.

It’s not a coincidence that digital taxes often run afoul of the law as they are structured. Though their advocates claim that they address a disparity created by outdated tax laws, this is false — there is no significant difference between effective tax rates paid by digital vs. traditional firms. Rather, digital taxes create the disparity they claim to address by targeting a growing sector of the economy that budget planners view as a potential cash cow.

The temptation to hop on the bandwagon created by countries like France, as well as states like Maryland and New York, certainly exists for state legislators. However, if their concern is a fair and equitable tax code, they will resist this impulse. Not only are digital taxes bad tax policy, but they suffer from fatal legal flaws. 

Andrew Wilford is a policy analyst with the National Taxpayers Union Foundation, a nonprofit dedicated to tax policy research and education at all levels of government. 

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