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No-one likes to pay tax and few like to even think about tax. Perhaps this is why there has been so little radical tax reform for over a generation despite profound changes to how our economy works. As a result, the tax system has become one of the main drivers of the “winner takes all” digital economy, with dominant firms still paying little if any tax. Since demands on government spending have escalated, this has meant a bigger tax burden on everyone else.

Europe has belatedly started introducing modest digital services taxes, though these are caught up in arguments with the US (since they mainly hit US firms). These target overall sales, but there are strong arguments for a more sophisticated approach.

The challenge of tax design is to tax fairly without inhibiting productive and creative activity

The challenge of tax design is to tax fairly without inhibiting productive and creative activity. Here economic theory is helpful. Firstly, it tells us that industries with close to zero marginal costs and network effects will tend to become very concentrated (as has happened with Google for search), and secondly that it is possible to levy quite high taxes on marginal revenues without disincentivising investment (the UK’s “Eady levy” on film distribution is a case in point here).

This is the argument for what I call “Proportional Marginal Revenue Taxes” which do what they say on the tin—tax marginal revenues, whether for Hollywood films and Netflix series or digital platforms like Meta. The logic of such taxes is that once a film, piece of software or operating system has covered its costs, new revenue from a new customer is essentially a windfall: marginal revenue with almost no marginal cost, that then becomes surplus for the owners.

Proportional Marginal Revenue taxes can begin quite low, for example at 25%, and should only kick in over specified levels of demand or market share, so as not to hit start-ups or stifle innovation. But designed well, they could raise a lot of money without distorting effects on behaviour.

Moreover, they are simpler to implement than structural separations and demergers—helping us all to benefit from network effects while also encouraging competition (since they would stem the flows of cash enabling so many dominant incumbents to buy potential competitors).

This article was originally published as part of Minister for the Future in partnership with Prospect. Illustrations by Ian Morris. You can read the original feature on the Prospect website.