When are digital services taxes optimal? Output taxes and profit shifting

Abstract

Abstract Motivated by the introduction of digital services taxes (DSTs) in several European countries and the widespread use of revenue-based taxes where profit taxation is imperfect, this paper studies whether targeted output or commodity taxes can serve as surrogate profit taxes when firms avoid corporate taxation – such as by shifting profits to low-tax jurisdictions. The answer is a qualified yes. Output taxation of tax-avoiding firms is optimal when the resulting reduction in output mitigates tax avoidance. I derive an augmented inverse-elasticity rule showing that the optimal output tax decreases with the demand elasticity (as in the classic Ramsey rule) but increases with the output elasticity of profit shifting and the degree of foreign firm ownership. When nonlinear labor income taxation is available, zero output taxation arises only under restrictive ownership conditions – namely, identical ownership shares across household types and full domestic ownership of firms – which are unlikely to hold in practice, particularly in open European economies. In these cases, the optimal tax system combines distortionary profit taxes with non-uniform output taxes. Finally, I establish a complementarity theorem: Whenever the optimal tax system includes a distortionary profit tax, output taxes are also part of the optimal policy mix. These results provide a welfare-based perspective on the role of DSTs as second-best instruments in environments characterized by profit shifting and international ownership.