The European Commission (EC) and certain U.S. states are renewing their efforts to expand taxing authority beyond their borders. These efforts will provoke a battle over the proper reach of government tax systems, with wide-ranging consequences for the power and scope of governments at all levels.
In Europe, the EC is seriously considering a “digital-transactions tax” to increase revenue from large multinational technology companies based on the location of their customers. In the U.S., South Dakota—along with 30 other states—is expanding the obligation to report and collect local sales taxes from businesses not physically within the state. The EC and South Dakota claim that the rise of the Internet has fundamentally changed the way taxes should be assessed. In the past, a corporate tax or sales tax could be levied and collected on a business based on their physical location. Their argument, in essence, is that the Internet has rendered physical location an antiquated and economically inefficient standard.
Policymakers in Washington see a European digital-transaction tax and an expansion of domestic sales taxes across state lines as separate issues. However, the two policies have the same principle at their core. Destination-based tax proposals limit tax competition and expand the extraterritorial reach of distant politicians into local affairs. When a government is no longer constrained by its borders, individual liberties are put in jeopardy.
Background on Extraterritorial Taxation
As international trade grew through the 1950s and 1960s, multiple countries claimed taxing rights to the same corporate profits. Countries around the world regularly extended their tax systems beyond their borders to tax profits originating in other countries. Multiple taxing claims resulted in pervasive double taxation of corporate profits, an unfortunate barrier to global trade.
The minimization of international corporate double taxation took concerted efforts and a series of international tax treaties to institutionalize a system that rests on the physical presence of the business. Opposition to extraterritorial taxation has not been universal—with the U.S. itself often enacting extraterritorial policies. Through 2017, the U.S. maintained a worldwide corporate tax system and recently included broad international minimum taxes in the new quasi-territorial regime. However, most developed countries moved to territorial tax systems, and those who still maintained worldwide taxes allowed certain tax liabilities to be deferred and provided credits for taxes paid elsewhere.
Why Europe Should Preserve International Constraints on Taxation
The current international tax system is imperfect. It allows for tax planning and does not tax 100 percent of corporate profits, but, for the most part, these are features, not flaws. The existence of tax havens and a generally porous international tax system has fostered international pressures that keep business taxes relatively low—a boon for economic growth and investment.
Tax competition has facilitated economic growth and international trade with benefits for consumers around the world and with no harm to the ability of nations to generate revenue. Tax competition has forced corporate tax rates among Organization for Economic Co-operation and Development (OECD) countries to fall from above 45 percent to below 25 percent over the past three decades. Lower business tax rates benefit workers through higher wages and help the broader economy through increased investment. The pressures of tax competition have resulted in more tax revenue. Corporate tax revenue as a percentage gross domestic product has increased across the same countries over the same period.
The European Commission Proposal Breaks with the Consensus
The EC’s digital tax proposal is the most recent of numerous projects to break with international consensus on limiting the harms of extraterritorial taxation. The EC proposes a new 3 percent tax on revenues from online advertising, sale of user data, and facilitated user interactions. Revenue-based taxes are economically problematic in their own right because firms could have no net income in the taxing jurisdiction and still be subject to tax. Levying a revenue tax on a destination basis only further compounds the economic inefficiencies of the new tax proposal.
Background on Extraterritorial Taxation in the U.S.
Forty U.S. states are similarly working to overturn limits to their taxing authority. The increasing popularity of catalogue sales in the 1980s presented a challenge for states who wanted to levy sales tax on goods shipped into their state by businesses without a physical presence in the consumer’s state. A series of Supreme Court rulings, most recently Quill v. North Dakota in 1992, prohibit states from compelling out-of-state businesses from collecting and remitting distant sales taxes—a burdensome administrative procedure. Under current precedent, Congress must explicitly authorize extraterritorial state taxes as they are impediments to interstate commerce.
The rise of Internet retail has renewed efforts to expand state taxing powers. States are challenging the ruling in Quill; several congressional proposals are aimed at expanding state governments’ taxing powers beyond their borders. Much like the European efforts to tax digital revenues based on the destination of users, states are attempting to require businesses to collect sales taxes based on customer location—even when the business has no physical presence in the state.
Why the U.S. Should Preserve Limits on Interstate Taxation
Constraining the reaches of governments tend to result in lower taxes and greater economic freedoms. The incentives of individual governments will tend to push for greater authority to tax the desired tax base completely, but allowing such power undermines important pressures that keep taxes from rising.
The current restrictions on states may be keeping state sales taxes relatively low, similar to the pressures of international tax competition. The European Union (EU) levies a similar consumption tax, called a Value Added Tax (VAT), determined on a destination base, and all member countries are compelled to have a similar tax scheme with prescribed minimum taxes. The EU tax cartel and enforceable destination-based tax rules remove certain competitive pressures to keep the tax rate low. The lowest standard VAT rate in the EU is 17 percent. The highest U.S. combined state and local sales tax rate is 10 percent. Lower sales tax rates decrease the tax cost of the goods and services purchased by Americans.
Freedom First, Not Economic Efficiency
The pursuit of economic efficiency is often used to further the case for expanding the reach of tax collectors beyond their borders. In the textbook world of perfect tax policy, taxes are equally applied to a broad consumption base. When taxes are applied unevenly, they create inefficiencies by favoring the untaxed and penalizing the taxed. The proposed digital transaction tax and expanded state sales taxes both seek to connect taxes collected by businesses to the destination of the consumer rather than the locations of the business. In principle, destination sourcing is intended to better capture all transactions and better approximate an evenly applied tax. However, most VAT and state sales taxes are far from textbook consumption taxes. By one measure, state sales taxes only cover about 23 percent of the optimal consumption tax base because most services and many physical goods are exempt. State lawmakers would be better served by first expanding the tax base within their jurisdiction rather than exporting their tax collection duties to out-of-state third parties.
Under the current physical presence-based sales tax regime, about 20 percent of remote sales go untaxed, a loss of less than 1 percent of state tax revenue. This de facto exemption introduces an economic inefficiency with an economic cost. However, these costs must be weighed against the alternative of potentially expanding the base of state sales taxes by 20 percent (without an offsetting rate reduction) and limiting future competitive pressures to keep tax rates from rising. The economic losses from high tax rates are significant and can increase exponentially with the rate. When the state enlists businesses as their tax collectors, the tax collection is best connected to the business location. Divorcing the location of the business from tax collection creates unnecessary administrative burdens, especially for small retailers.
The precise nature of the economic efficiency trade-off between more complete taxation versus higher tax rates and increased revenue is debatable. However, this trade-off should not come at the expense of political protections. Expanded tax powers extend the reach of every state capital and European parliament beyond their natural political borders. The freedom of a small e-retailer in sales-tax-free Oregon from California sales tax collection requirements cannot be directly weighed against the potential economic efficiency of a 50-state sales tax cartel, enforced by the federal government. Limits on state power must be a bedrock principle, even in the face of claims for economic efficiency. Although economists can provide convenient cover for expanding taxes, the political motivations are driven by government’s desire for additional revenue.
When governments are constrained by their borders, individual liberties are best able to flourish. Government taxing authority is the most straightforward case for limited state powers, even at the cost of some revenue loss and possible small economic inefficiencies. Indeed, the economic inefficiencies created by gaps in tax codes are the engine that drives tax competition, keeps political pressures from raising taxes, and keeps the goods and services we buy from including larger tax costs.
The international campaign to roll back the natural limits to government taxing authority is gaining steam in the U.S. and across Europe. Secretary of the Treasury Steven Mnuchin has stated that the “U.S. firmly opposes proposals by any country to single out digital companies.” The Administration and Congress should uniformly apply their skepticism to similar state efforts to tax interstate transactions—a policy that the White House supports.
The limits on state tax systems and the international tax norms that prevail will have ramifications beyond what the revenue governments can collect. A more broadly applied U.S. sales tax or a European digital-transactions tax will irreversibly expand the scope and power of governments at all levels.
—Adam N. Michel is Policy Analyst in the Thomas A. Roe Institute for Economic Policy Studies, of the Institute for Economic Freedom, at The Heritage Foundation.