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INSIGHT: The Time Has Come for State Digital Taxes

May 29, 2020, 9:01 AM

As Covid-19 forces us to hunker down in our homes, we give thanks for the wonders of technology that allow us to binge-watch our favorite shows way past bedtime, order products to be delivered to our doorstep, and attend business meetings in sweatpants.

Business is booming for tech companies such as Netflix, Amazon, and Zoom, while restaurants, movie theaters, and main street stores suffer. If there was ever a time for digital services taxes, this is it.

Social-distancing and stay-at-home orders under Covid-19 have led to widespread layoffs and a precipitous decline in economic activity—former Federal Reserve Chair Janet Yellen cited estimates of a 30% decline in GDP. States and localities that depend on income and sales taxes are facing a revenue crisis at the same time that residents make unprecedented claims on spending programs such as unemployment insurance and Medicaid that are partially funded by states.

States are already evaluating ways to close their budget gaps, including tax hikes, social service cuts, and lay-offs. But layoffs and service cuts would deepen the recession, taking even more money out of the economy at a time when employees and residents are already at their most vulnerable. As part of a comprehensive response to the fiscal crisis that would ideally include much more federal support for states, digital taxes could help mitigate the revenue crunch.

It’s no surprise that cash-crunched states are looking for new revenue sources during the pandemic, but lawmakers were eyeing digital taxes even before the crisis. Many European countries have proposed or enacted digital taxes. The Maryland legislature recently passed a digital advertising tax proposal, which was introduced by Democrats, although it could be vetoed by Republican Governor Larry Hogan. Maryland estimated that its digital tax would raise $250 million annually. This is substantial revenue and, if combined with other revenue raising tools that made sense before the pandemic, the states could go a long way towards helping themselves at this very difficult time.

Digital services taxes apply to the gross revenues from the provision of certain services. Typical candidates for taxable digital services are advertising, subscriptions to streaming services, sales of user data, and fees collected from buyers or sellers for the provision of a two-sided marketplace, such as eBay. Each state would collect a fixed tax—typically 2% or 3%—on a portion of the company’s relevant turnover. The portion taxable by each state could be determined in various ways. One method would be to determine what proportion of the company’s U.S. users are in the taxing state.

One important open question about digital taxes concerns who would actually pay them—or bear their incidence in economics-speak. If companies respond to digital taxes as they do to sales taxes, then some part of the tax likely will be passed on to consumers in the form of higher prices. This means that Netflix subscriptions and Amazon products could become more expensive. So could products advertised on social media sites. Yet even if part of the tax is passed through to consumers, a digital tax would very likely be more progressive than other state responses to fiscal crises, such as layoffs and benefit cuts.

A further reason digital taxes are so attractive to governments is that companies can’t avoid them by threatening to move jobs out of the state. Companies can’t move their users. Thus, digital taxes have been seen as an efficient way to tax large multinational companies that have been successful at avoiding corporate income tax.

States would have to design their taxes carefully to avoid violating federal and treaty law that prohibits discrimination against interstate and international commerce, and the law passed by Maryland may not pass muster. Most of those problems arise when states try to pick and choose which companies will be subject to digital tax. But a broad-based tax on, say, all advertising whether in print or online, would avoid legal problems. Another way to tax digital ads while avoiding legal questions would be to do what Nebraska proposes: simply add digital advertising to its list of services taxed under the state’s ordinary sales tax. If passed by Nebraska, that simple change to bring in over $43 million next year.

As Covid-19 forces us to shift even more of our economic activity to the virtual world, state tax systems must catch up to the changes in our economy. Digital taxes are not a panacea and will not be sufficient on their own, but, during this pandemic, states must take advantage of all sensible opportunities.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Author Information

Ruth Mason is Edwin S. Cohen Distinguished Professor of Law and Taxation at the University of Virginia School of Law and Darien Shanske is a Professor of Law at the University of California, Davis School of Law. They are participants in Project SAFE.

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