A 3 percent tax on digital services can balloon to roughly 39 percent of actual income because it applies repeatedly to the same economic activity as payments move through supply chains, according to a new analysis published by the Tax Foundation. The report examines how digital services taxes—now imposed by France and other countries on large tech platforms—cascade through multiple firms in ways that disproportionately harm low-margin businesses and penalize the specialized division of labor that makes internet commerce work.

The report presents a detailed travel booking scenario to show how the tax compounds. When a traveler books a bed-and-breakfast for €200, the online travel agency receives that payment but pays €25 to a search engine for advertising and €20 to a retargeting firm, which in turn pays €15 to a social media platform for ad space. Each firm in this chain pays the 3 percent digital services tax on its gross revenue, not its profit. The online travel agency earns just €10 before tax but pays €6 in digital services tax—60 percent of its income. The retargeting firm has €1 of pre-tax income and pays €0.60 in tax, also 60 percent. Across all the digital firms involved, the total tax reaches €7.80 on combined pre-tax income of €19.75, an effective rate of 39 percent. The same pattern emerges in online goods sales: in one example, a retargeting vendor with €0.36 of pre-tax income pays €0.36 in digital services tax, consuming 100 percent of its earnings. The gross revenue across the chain totals €260 even though the final service is worth only €200, because €60 paid between covered firms gets counted twice.

The report argues that digital services taxes "penalize the specialization needed to make the economy more productive," noting that small sellers can't build their own search engines or advertising exchanges and depend on specialized internet firms to reach customers. According to the authors, "DSTs can operate as taxes on the matching process itself" rather than simply taxing large tech companies as often claimed. The Tax Foundation writes that the burden likely flows beyond the formal taxpayer, with digital firms either absorbing the tax through lower margins or passing costs to consumers through higher prices, potentially reducing transaction volume as consumers substitute away from services that rely on specialized internet infrastructure.

The pyramiding happens because digital services taxes are gross-based levies that don't provide credits for taxes paid earlier in the supply chain, unlike value-added tax systems. The report explains that a VAT "is designed not to tax business inputs repeatedly" because firms deduct VAT paid on their own business purchases, ensuring the final consumer bears the same tax regardless of how many transactions are involved. France's digital services tax applies to firms exceeding €750 million in worldwide revenue and €25 million in France-attributable revenue, covering digital intermediation services and targeted advertising. While France allows firms to deduct digital services taxes against corporate income tax, the report notes this provides limited relief: at a 25 percent corporate rate, deducting €1 of digital services tax is worth only €0.25, leaving the firm to bear €0.75. The tax can also hit the same transaction twice when buyer and seller are in different countries that both assert taxing rights.

The report recommends that governments tax digital consumption through destination-based VAT or goods and services tax systems instead of separate gross-revenue taxes on selected firms. The authors note that the European Union already has infrastructure for cross-border VAT on digital transactions through the One Stop Shop, which lets businesses register once and charge VAT at each customer's country rate. The Tax Foundation concludes that tax policy shouldn't punish the specialization that makes modern commerce work, arguing that a bed-and-breakfast owner, traveler, ceramicist, or cooking enthusiast should be able to use internet services knowing the tax rate will be neutral—no more or less than under any other method.