Is this the end of taxation as we know it?

Offshore financial centres, operating as commercial `flags of convenience', may mean governments cannot tax people or companies effectively.
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The multinational corporation of the future may have offices in several countries, including Britain, with a main e-mail address on a host computer in Malaysia, transacting electronically with every continent. Goods may be held all over the world.

Which country's tax regime will apply? How can governments prevent transactions being nominally conducted from the country with the lowest, or zero-rated, corporation tax?

Individuals, too, will work transnationally. A flexible labour market has been recognised as a reality by governments. Workers operate a portfolio of jobs. Trade unions say this undermines job security. It also creates an opportunity for higher-paid workers to avoid tax altogether.

Workers of the future will work even more at the computer terminal, they may work in different countries from their employers. Whether on staff or self-employed, the prospects for tax avoidance are increased.

Individuals may find themselves working for different employers each day, with each employer based, for tax reasons at least, in a different country. In each of those countries the employee may be below the taxable income threshold, and so be able to avoid tax in each. Taxation authorities may find it impossible to check real earnings of self-employed people, with clients based in many countries.

Tax evasion is most commonly detected not from employers' records, but by observing the spending patterns of illicit high earners. What has been spent must, presumably, have been earned.

The ability of the Inland Revenue to detect untaxed income will be undermined when most products can be purchased internationally, online, away from the prying eyes of tax inspectors.

Another problem for governments is how to control transactions that eschew hard currency. Local exchange and trading schemes have been established in Australia, Canada and Britain, and similar schemes exist in the US, but one of the factors holding them back has been that they typically operate from out-of-date, hard copy directories. Using electronic information could help the exchange of redundant equipment and help people to trade services.

But a system of barter would be difficult to police. While it may theoretically lead to a tax liability, participants may choose not to declare barter income, in all likelihood without penalty. Furthermore, how could a tax authority determine the real value of a simple exchange of redundant equipment? Barter between corporations is now an important factor in US commerce, mostly featuring stocks and services with little book value. The expectation is that in an electronic world, neither taxes on income (whether they be income tax or corporation tax) nor taxes on transactions (such as value added tax) can be reliably collected. It will be impossible to determine a person's or corporation's real income, or what service transactions take place. Effective audits will become more difficult to undertake.

If we cannot verify what activities are taking place, one argument goes, it is better to find an alternative system of taxation that is verifiable. The obvious solution is to tax per parcel of electronic information dispatched, using Internet service providers as an agent of the state to assist with tax collection - the so-called "bit tax" option, examined by both the European Commission and the US government.

But a bit tax is likely to be open to avoidance, through the use of host computer systems based in zero tax or low tax economies operating as new offshore financial centres. Enforcing a cybertax could be as problematic as the taxes it replaced, and it would build additional overheads into activities that governments need to promote to achieve international competitiveness.

The difficulties attached to any form of cybertaxation have been recognised by President Clinton. He accepts that, for now, a bit tax would be unenforceable, and would create perverse incentives for US industry - either driving it away from new technology, or encouraging US corporations to relocate to more fiscally liberal countries. He talks, instead, of the Internet forming the world's largest-ever free trade zone.

A likely result of this is that taxation will concentrate on the least mobile production factors: lower paid workers. They may, in real terms, face the highest rates of tax. Fair taxation would end; we would have the most regressive system of tax imaginable.

Some political analysts argue that governments will simply have to accept that most of their taxation income will dry up in coming years, and learn to spend less. Others just hope that something, in the way of a solution, will come up. The politicians, meanwhile, say nothing to reassure us that they understand the problems, or have any form of answer.

This extract is taken from `Government in the Digital Age', published tomorrow by Bowerdean Publishing (0181-788 0938), price pounds 12.99.