Superiority of the VAT to Turnover Tax as an Indirect Tax on Digital Services

Countries seeking to address the challenges of taxation in a digitalizing economy have proposed or enacted indirect digital services taxes (DSTs) rather than income taxes in part to attempt to avoid violating international income tax treaty obligations while targeting certain business activity. DSTs are likely to have a similar incidence to the value-added tax (VAT) in raising prices to final consumers; indeed, the DST could be viewed as a special higher rate VAT on digital services. However, the general VAT is superior on efficiency grounds to these targeted turnover taxes (i.e., taxes on gross revenues). Turnover taxes are more likely to distort production decisions by firms and to risk cascading and double taxation. This paper explores possible economic rationales for a special higher rate of indirect tax: taxing leisure complements, taxing items with higher costs of avoidance or evasion, and taxing items that generate negative externalities. It is far from clear that any of these conditions hold in the case of digital services. The administrative and other concerns with implementing a higher rate tax weigh against doing so even if the case could be made. The broader international community continues to seek a consensus-based long-term solution for addressing the tax challenges of the digitalizing economy. The economic analysis here suggests that countries that wish to act in the interim may achieve superior outcomes by continuing efforts to ensure the general VAT system applies effectively to digital services rather than by taxing turnover of digital services.