The Unintended Consequences of Taxing Digital Platforms: A Race to the Top?

The digital advertising tax is an increasingly used policy measure, but its consequences must still be better understood. We develop a theoretical model where two countries compete to tax a digital platform that sets its quality and advertising to maximize profits. While the tax may increase country-level tax revenues, we highlight an unexplored drawback of this policy. The unilateral ability of a country to tax advertising revenues generated in its territories may lead to inefficiently high equilibrium tax rates. A “race to the top”, as opposed to the “race to the bottom” typically observed in tax competition across countries, occurs whenever the digital platform’s quality is sufficiently responsive to an increase in the tax rate and is more decisive than advertising in determining prices and consumer welfare. Our findings emphasize the need for a global initiative on digital platform taxation rather than leaving the decision to individual countries.