The Economist says AI could force governments towards consumption taxes.
But replacing domestic workers with foreign AI creates a harder tax problem
The Economist has warned that AI could blow a hole in government finances. Labour taxes provide around half of revenues across the OECD. If AI replaces workers while increasing corporate profits, that tax base starts to shrink.
Its answer includes shifting the burden away from labour, reforming capital gains taxes and taxing consumption more heavily, including through broader VAT bases.
The cross-border hitch
There is a problem: the shift from labour to capital may also be a cross-border one.
Consider a European business replacing domestic employees with AI services supplied by a US technology company. The government loses some income tax and social security revenues. But much of the resulting profit may accrue overseas.
Increasing VAT does not tax those profits. It raises more revenue from consumption at home.
VAT can follow consumption
VAT does have an important advantage. Destination rules increasingly bring foreign digital suppliers into the local VAT net even without employees or an establishment there. This is one reason I have previously argued that VAT could become increasingly important as AI changes the tax mix.
But VAT only taxes consumption. It cannot capture all the profits or capital gains created as AI substitutes for labour.
Governments have tried taxing foreign digital businesses more directly through digital services taxes. That has proved politically difficult, particularly given US threats of retaliatory tariffs.
Labour is local. Capital isn’t.
This leaves an awkward fiscal problem: Labour is taxed where people work. AI capital can earn its returns somewhere else.
Governments may therefore find themselves losing taxes on domestic employment while having limited ability to tax the foreign capital replacing it.
VAT can recover some of the difference. But asking domestic consumers to make up the shortfall is not quite the same thing as taxing the winners from AI.
