On August 31, New Zealand introduced legislation for a digital services tax (DST). Also last month, Canada issued new draft legislation on its proposed DST.

Countries levy DSTs differently (see Table 1), but generally they are a tax on gross revenues based on user location. As such, DSTs can be considered extraterritorial taxes, meaning that governments tax and collect revenue beyond their territories. The scope of DSTs is also very broad, covering online sales, digital advertising, data usage, streaming and downloads, and more.

The renewed momentum on DSTs is tied to ongoing negotiations at the Organisation for Economic Co‐​operation and Development (OECD) on the Base Erosion and Profit Shifting (BEPS) project. Pillar One of the BEPS project tries to address growing concerns over unilateral DSTs, like Canada and New Zealand’s proposals. However, Pillar One will maintain taxation based on customer location, rather than business activities.

This prong is presenting problems for numerous American businesses (e.g. YouTube) that are unsubtly targeted by DSTs and will be disproportionately impacted by Pillar One. For example, France implemented a 3% DST on revenue from sales of user data, digital advertisements, and online platforms run by companies with more than €750 million in global revenues; and Nigeria’s DST targets non‐​resident businesses with revenue over N25 million from sales of digital content, user data, etc.

As negotiations continue at the OECD, countries with adopted or proposed DSTs agreed to hold off applying the taxes until 2025. Canada is the only country to refuse the “freeze” on unilateral DSTs. What’s even more problematic is that Canada’s proposal contains a retroactivity provision. The 3% tax applies starting January 1, 2024 and is retroactive to January 1, 2022.

Further, the Canadian DST could violate the United States‐​Mexico‐​Canada Agreement (USMCA). In fact, in February 2022, the United States Trade Representative (USTR) stated that if Canada adopts its DST proposal, “USTR would examine all options, including under our trade agreements,” implying it could use enforcement mechanisms outlined in the USMCA.

The uncertainty surrounding the OECD negotiations is made worse by the options the USTR might employ to counter Canada. For example, in 2019 and again in 2021, the Trump administration initiated investigations under Section 301 of the Trade Act of 1974 after a handful of countries implemented DSTs. The Trump administration used Section 301 to ”determine whether an act, policy, or practice of a foreign country is… unreasonable or discriminatory” and burdens or restricts U.S. commerce.

The USTR found that these DSTs were discriminatory against U.S. companies and threatened retaliatory tariffs. If the Biden administration utilized this law and equally threatened retaliatory tariffs, U.S. businesses and consumers would pay for Canada’s misdirected tax policy.

While the OECD seems to have lost its way on promoting global free market economic development, the World Trade Organization (WTO) has spearheaded efforts to reduce taxes on digital products.

Since 1998, members have voted every two years to maintain the moratorium on customs duties on electronic transmissions. These transmissions are commonly understood to include things like digital music, video games, movies, software, text messages, emails, etc. These duties are different from DSTs and more akin to a tariff as they apply to electronic transmissions imports whereas DSTs are technically domestic taxes that could apply to domestic and foreign businesses. DSTs are also a tax on business revenues, while a tariff is usually applied as a fixed fee or ad‐​valorem (a percentage based on the value of the good) to the price of the product.

Unfortunately, the increasing importance of digitalization and, thus, increased opportunity for raising tax revenue, is having repercussions for the moratorium—some members have expressed reservations about foregone revenues and may not vote to extend the moratorium next year. Given the problems at the OECD, it would be prudent for WTO members to make the moratorium permanent.

Politicians capitalizing on digitalization to raise tax revenue is problematic. Customs duties are the same as tariffs and if the moratorium is not extended, consumers will likely bear the brunt of the costs. DST costs will similarly be passed on.

Since DSTs are applied to revenues (not profits), a firm could be required to pay taxes in a jurisdiction it doesn’t actually earn income in. As a result, consumers will likely pay the price or see reduced variety in the market. For example, in the case of the French DST, a study from Deloitte estimated that over half of the tax would be paid by French consumers directly, and 40% by local French businesses that use the taxed digital platforms. For Canada, the Montreal Economic Institute estimates that the tax will cost Canadian consumers between $1.1 billion and $3.3 billion per year.

Extraterritorial taxation, including as currently being negotiated at the OECD, gives distant politicians the power to involve themselves in local affairs. While free trade proponents (like myself) wish for as borderless a world as possible, borders matter. After all, tariffs are taxes and as long as we live in a world with non‐​zero tariffs, it is important that tax competition can exist among countries through sovereignty over trade and tax policy.

The United States should question the direction the OECD has taken and USTR should continue to consider the implications of taxing digital products, whether through a customs duty or a DST, which only serves to empower politicians and impoverish people.