Neither trade nor tax are new issues. What is new are the types of challenges that digital trade poses to revenue collection. As the digital economy has grown significantly, governments have watched with increasing dismay as taxes have not been collected from a steeply growing volume of transactions. Fiscal pressures in the wake of pandemic spending have accelerated the quest to appropriately tax companies and purchases made in the digital or online environment.
Until recently, trade experts could avoid most discussions about tax and tax experts could overlook trade implications of tax policies. Trade has typically been handled by trade and commerce ministries while tax is managed by finance ministries or central banks. Communication between the two sides, even in a domestic setting, can be limited. International opportunities for conversations between tax and trade are even more rare. The growing strength of the digital economy and new types of cross-border trade activities have eroded this previous division of labor. Increasingly, trade policies need to reflect changes in tax policies and vice versa.
The rise of the digital economy has complicated the traditional tax environment. Firms can be located anywhere and provide goods and services online to suppliers, vendors and customers without any need for a physical presence. The digital economy allows firms to scale up substantially at often minimal direct costs, creating a small set of super firms generating outsized profits. Such technology or digital firms present tempting targets for cash- strapped governments looking for revenue.
However, it is not just large firms that can take advantage of new ways to find customers. A vital aspect of the digital economy is how it enables even the smallest companies to engage in cross-border trade. Firms that might never have been tempted to trade outside their own villages are increasingly finding key markets halfway around the globe.
In short, there are at least three important ways that the digital economy has affected traditional tax systems: by allowing firms to compete in markets without a physical presence; by the proliferation of approaches, mostly used by large firms, to more carefully manage tax; and by the participation in cross- border trade by companies previously not engaged in such transactions.
Changes in tax policy to address these challenges run a significant risk of upending cross-border trade opportunities and burdening firms of all sizes with substantial new compliance costs. As tax and trade have been considered largely in silos, unintended consequences are likely to rise.
Absent global cooperation on the range of direct and indirect tax issues, an increasing number of governments are opting for domestic solutions that increase regulatory costs to trade.
This paper does not examine every element of cross-border tax policies. Instead, it highlights a range of direct and indirect tax applications to the digital economy that are important for trade. Absent global cooperation on the range of direct and indirect tax issues, an increasing number of governments are opting for domestic solutions that increase regulatory costs to trade.
While there have been important recent steps to move towards some more harmonized tax approaches, especially as part of the Inclusive Framework and OECD activities described more fully below, the implementation of coordinated tax changes has yet to begin. Furthermore, global consistency for some aspects of direct tax has not resolved continuing challenges in the indirect tax environment.
Governments have used a variety of tax policies as a tool in their arsenal of options to attract more foreign investment or to provide additional support to local firms. As yet, there are limited institutional mechanisms to address gaps in coverage and avoid duplication of efforts.
This paper highlights some of the current and upcoming issues of digital tax under both direct and indirect tax collection schemes. These tax frameworks have the potential to dramatically upend the expansion of digital trade around the world. Firms will have to navigate an increasingly complex environment that requires adherence to specific trade rules and regulations, and mastery of complicated tax regime requirements that may include VATs, customs duties, DSTs, withholding taxes, extra-territorial application of taxes on intangible assets, and transfer pricing mechanisms.
What may change is not only the payment of tax. Even the requirements for tax reporting could transform and lead to more regulatory divergence. The challenges for companies are significant. Much of this reporting burden is likely to land on firms that are intermediaries. While many digital intermediaries are large firms with resources to address compliance concerns, smaller firms play similar functions but with less capacity. Many MSMEs do not even realize that their businesses will be affected by such international tax policy changes, leaving them unable to respond or play a proactive role in shaping debates or to prepare themselves to manage growing complexity. Increasingly, firms will be asked to submit, on behalf of customers or clients, a wide and growing range of tax-related information on business sales to tax authorities.
As always, the burden of managing such complexity will be substantial for the smallest firms who lack capacity and resources. While many of the tax changes noted in this paper may not directly apply to small firms, the indirect implications and trade changes are likely to continue to disproportionally affect MSMEs. The largest digital firms that currently support MSMEs may opt to make changes that can destroy the value of many smaller firms overnight. This will upend previous business models and could limit the ability of MSMEs to find overseas markets and customers.Trade & Tax in a digital world(Deborah Elms) - Hinrich Foundaton
To read the full report from the Asian Trade Centre and The Hinrich Foundation, please click here.