Taxation in digital media markets

• DOI: http://doi.org/10.1111/jpet.12257
• Published date: 01 February 2018
• Author: Hans Jarle Kind,Marko Koethenbuerger
• Date: 01 February 2018

Received: 2 May2016 Accepted: 16 April 2017

DOI: 10.1111/jpet.12257

ARTICLE

Taxation in digital media markets

Hans Jarle Kind1Marko Koethenbuerger2

1NorwegianSchool of Economics

2ETHZurich

Weare grateful for helpful comments by two

anonymousreviewers. The usual disclaimer

applies.

HansJarle Kind, Norwegian School of

Economics,Helleveien 30, 5045 Bergen,

Norway(hans.kind@nhh.no).

MarkoKoethenbuerger, ETH Zurich,

Leonhardstrasse21, 8092 Zurich, Switzerland

(koethenbuerger@kof.ethz.ch).

Digital media goods and digital media platforms exhibit cost struc-

tures and network effects that might imply that price and quantity

effects of consumption taxes are qualitativelydifferent compared to

what we typically find for physical goods. Forinstance, in most Euro-

pean countries and U.S. states, printed newspapers and books face

favorable value added taxes (VATs) or sales taxes. This has proba-

bly increased their circulation. In contrast, reducing the VATrate on

digital newspapers has the opposite effects; it increases prices and

leads to lower sales. This is not true for ebooks, but a low-tax policy

is still ineffective if the aim is to reduce prices. The primary effect of

exemptingebooks from VATsis to increase profits for publishers.

1INTRODUCTION

The purpose of this paper is to explore how the digitalization process affects optimal taxation policies, and our main

focus is on value added taxes (VATs). VAT in general extendsto transactions that involve digital goods and services

that are traded via digital platforms. The increasing importance of services provided by digital platforms like Google,

Facebook, and YouTube exemplifies the value that digitalization creates in the economy.Similarly, the sale of digital and

nondigital goods via platforms like Amazon and Apple has experiencedtremendous growth over the last decade.

The provision of digital products and the use of digital platforms have certain characteristics that set them apart

from conventional transactions.First, the c ost of producingthe first unit of a digital good might be substantial, but the

creationof an additional copy of digital newspapers or ebooks does not incur any costs. The marginal cost of production

anddistribution is zero. Second, the point of sale of digital products isgeographically highly mobile. Platform infrastruc-

ture can be moved across jurisdictions at low cost, akin to a footloose industry.Third, digital platforms are frequently

two-sided in nature. Their revenuescritically depend on the extent to which they can successfully link different groups

of customers. Forinstance, Google links Internet users with advertisers. Users consume the Google search service, and

advertisers contact these users through ads for which Google charges a price. The critical aspect of the business model

is to manage intergroup network effects. In the context of Google, the price advertisers arewilling to pay is increasing

in the number of users, while users might well perceive more advertising as a nuisance and shy awaywhen advertising

becomes excessive.

Albeit these characteristics appear to be a conventional description of the digital economy,they might have quite

nonconventionalimplications for the evaluation of taxes and the design of optimal tax policies. In this paper, we discuss

these implications and relate them to actual as well as proposed tax policies in the European Union (EU) and the United

States. We start out by analyzing the book market, accounting for the interdependence between digital and printed

books. Interestingly, printed books enjoy a preferential tax treatment in most countries. The same does not hold for

Journal of Public Economic Theory.2018;20:22–39. wileyonlinelibrary.com/journal/jpet c

2017 Wiley Periodicals,Inc. 22

KIND AND KOETHENBUERGER 23

ebooks. Although the asymmetric treatment might be argued to put ebooks at a disadvantage, it is not necessarily

optimal to reduce the tax rate.1Given the innate characteristic of ebooks that their marginal cost is zero, alower VAT

rate on ebooks generates windfall revenues to the publishers, with little effect on prices and output. That would be

close to prescription of an ineffective tax policy if politicians want lower book prices. As far as we know, this has not

been formally analyzed previously.

Wealso look at the tax treatment of goods sold by digital two-sided platforms. As argued above, these platforms are

central to the digital economy,and they feature intergroup network externalities. In unraveling the different channels

through which these externalities operateand influence tax policy, we also revisit models of a two-sided platform that

analyze the effects of both VATand specific taxes. One central finding is that lowering VATs might have the rather sur-

prising effect of reducing output. This has implications for the question of whether newspapers on the web and other

digital media products (like TV programs)should enjoy preferential tax treatment. A tax reduction has the presumably

unintended effect of decreasing circulation. Thus, the current initiative in some EU countries to set the VATrate on

digital newspapers equal to zero is counterproductive if politicians aim at increasing newspaper circulation.

With the rise of digital platforms and the extended use of personalized advertising,advertising income has become

the dominant source of income for many platforms. Digital platforms are highly mobile and platforms such as Google

are recurrently accused of tax aggressiveness by locating advertising income in low-tax jurisdictions. A higher source-

based tax on advertising income (frequently referred to as a Google tax) might be advocated on grounds that such a

tax increases welfare in the country in which the tax is levied. Against the background of our model, such a conclusion

appears dubious. A higher tax on advertising income not only shifts tax revenues across jurisdictions, but might also

reduce consumer surplus in the jurisdiction in which the tax is levied.

All in all, the innate characteristics of digital products and digital platforms (such as zero marginal cost and inter-

group network externalities) modify the effects and the optimal design of taxes in potentially unexpected ways. The

issue of taxation in the digital economy is frequently discussed in the policy sphere, however,without explicitly taking

these features into account.2Differently,the peculiarities of digital multisided platforms are well analyzed in the schol-

arly literature (see Anderson & Coate, 2005; Armstrong, 2006; Caillaud & Jullien, 2003; and Rochet & Tirole, 2006,for

instance). Contributions by Kind, Koethenbuerger,and Schjelderup (2008, 2009b, 2010) analyze the role of taxes in

two-sided markets.3In this paper,we recapitulate the results from this literature, and we offer some new insight. To

this end, we first provide a detailed treatment of unconventional quantity responses that arise when the taxed good

generates negative intergroup spillovers,such as advertising. We also extend the existing literature to show that even

if consumers dislike ads, they might be negativelyaffected by a tax that reduces ad levels. Subsequently, we relate the

extended set of insights to actual policy discussions. We contrast the discussions with results on the incidence of the

tax and with policy recommendations on how to choose tax policy from an efficiency perspective. These recommenda-

tionsapply to national tax policies as well as to issues of how to tax digital goods and digital platforms in an international

context, as being high on the agenda in the EU and the United States.

The paper proceeds as follows. In the first part, we set up a model of an ebook market and analyze the role of taxes

both when an ebook supplier competes with a supplier of printed books and when one firm supplies both book formats.

We then turn to an analysis of taxes in two-sided platforms. We illustrate the findings in the context of a two-sided

media platform and relate them to current discussions on the tax treatment of newspapers and advertising income in

various countries, including the issue of taxing digital platforms such as Google in fiscal competition.

1The differential tax treatment is argued to be conducive to the low marketshare ebooks have in many countries. See Wischenbart and Celaya (2014) for a

documentationof the evolution of the ebook market.

2Forinstance, Goldfarb, Greenstein, and Tucker(2015) discuss economic issues of the digital economy including government policy, but leave tax policy issues

aside.Differently, the report of the European Commission expert group on taxation of the digital economy (European Commission, 2014) particularly empha-

sizes the international dimensions of taxation, but leaves,e.g., network externalities and cost implications unaddressed. Also, in discussions of extending the

preferentialtax treatment to digital news services in Norway, the specific features of digital products are not accounted for which leads to policy views on the

effects of taxesthat are difficult to reconcile with our analysis (see EFTA Surveillance Authority, 2016). We relegate a more in depth discussion of this report

toSection 3.

3Issues of tax enforcement that existwith digital sales or, more generally, with e-commerce are discussed in, e.g., Agrawal and Fox (2016) and remain unad-

dressedin this paper. See also Foros, Kind, and Shaffer (2014) for a broader discussion of provision of digital goods.