This weekend, the finance ministers from G20 countries gather in Italy. High on the agenda is an endorsement of the recent breakthrough on managing tax which was spearheaded by the OECD and supported by 130 members of the Inclusive Framework.
Movement on this agenda represents an important step forward on a path to addressing inconsistent global tax policies. As a result, the process has been closely watched by tax experts.
It has most not been followed with such attention by the trade community. This is a mistake. While trade has had the luxury of largely ignoring what tax folks are doing, it is no longer possible. Tax policy changes have trade implications, especially in a digital world.
Direct tax policies, like those to be discussed in Italy this weekend, have grabbed most of the headlines. It is important that the trade community starts to pay attention, as some of these changes will matter.
But direct tax is not the only set of taxation policies with trade implications—a wide range of indirect taxes are also increasingly applied to cross-border settings. Changes in collection of indirect tax will certainly affect trade flows, with significant challenges ahead for smaller firms.
One complication in unravelling the connections between tax and trade has been definitional. Too many varieties of “tax” are frequently bundled together, especially by the trade community, with terms used interchangeably despite significant differences. The bundling together of both direct and indirect types of taxation is particularly problematic. Each may have trade implications but the impact may vary. Loose definitions complicate rather than clarify the discussion.
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
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 in places 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 four 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; companies that can operate with no or minimal presence; and by the participation in cross-border trade by companies previously not engaged in such transactions.
Our latest paper, published this week with the Hinrich Foundation as part of the ongoing series on digital trade issues in Asia, highlights some of the current and upcoming issues of digital tax under both direct and indirect tax collection schemes.
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 require 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 may also play similar functions with less capacity.
Many MSMEs do not even realize that their businesses will be affected by such international tax policy changes at all, leaving them unable to respond or play a proactive role in shaping debates or becoming more internally prepared 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 ahead 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.
Absent sustained dialogue and discussions between governments and the private sector, many proposed and planned changes in the tax landscape may have severe unintended consequences. Allowing tax and trade issues to be addressed in a holistic manner can help ensure the delivery of rules and regulations that work better for all stakeholders.
The trade community can no longer ignore tax or assume that tax departments need not be concerned with the trade implications of various types of changes ahead in the tax landscape. The rapid evolution of trade and tax in the digital world requires attention from us all.
***This Talking Trade was based on our recent paper, “Trade and Tax in a Digital World,” sponsored by the Hinrich Foundation. Click here to download your copy. Stay tuned for a webinar on the topic coming in mid-August. The next paper in the series will address digital sovereignty. Past papers include electronic payments and a review of digital trade issues of increasing importance in Asia. ***