Turja Lehtonen

This isn’t a coincidence. Europe is beginning to coalesce around a scheme to tax foreign AI firms in an effort to recoup a fiscal shortfall brought on by AI. It probably won’t work, but it makes sense: - AI tilts the factor share of income away from labor towards capital. Not the whole way, it’s just not 70/30 any more (70 being labor). Maybe it’s 60/40. This should be obvious. This doesn’t mean output falls. Probably output and productivity rise, it’s just that capital captures a larger share. - this fundamentally challenges the way developed states collect tax which is mainly on labor and wages. European nations in particular rely on personal income, payroll taxes and social contributions to fund grossly engorged welfare states. States must make up the lost payroll taxes by capturing the gains accruing to capital. But wait! Capital is a foreign AI firm. The AI firm disrupting domestic labor is probably not domestic in origin (for Europe). So there’s nothing left to tax. - European nations are mainly consumers rather than producers of AI. A producer nation has a similar problem - it must tax capital more aggressively to make up for lost labor income, but this is tractable - but a consumer nation has a much worse problem. Europe will face the substitution of domestic labor for foreign inference which benefits the owners of a largely foreign AI supply chain. When a French professional services firm gets disrupted and loses 70% of its staff due to AI productivity gain, the French government can’t tax Anthropic over in California to make up for the lost payroll and personal income taxes. The laid off French workers will also spend less reducing consumption tax receipts domestically. Some savings will remain in France as consumer surplus via lower prices but that’s not easily taxable. The French firm itself might be more profitable after it replaces staff with AI, and that is captured but that doesn’t make up the shortfall. - Europe has a few options. They will attempt all of them. They can a) regulate away AI disruption by banning AI use in professional fields. They can b) try and capture the tilt towards capital by fostering their own domestic industry of AI firms. They can c) try and extract rents from the foreign AI firms that are disrupting them. A) is the obvious move, make it illegal for an AI model to provide medical, legal, or accounting advice (etc). This will be very unpopular in the end but it will definitely be attempted. This is already underway. It will make these countries less productive and less competitive in the global market. And it wont work. People will find ways to use frontier AI. Diffusion will be slower but not inhibited. This will worsen Europe's fiscal situation overall by making it a worse place to do business and putting a drag on growth. B) is another obvious move – if Anthropic is disrupting French white collar labor, ban Anthropic and support a domestic competitor - the Le Gros Chaton model or whatever. The only problem is that Europe appears incapable of creating a frontier model. They have the talent but not the right regulatory model or incentive to form capital locally. AI could have been invented in Europe, and many of its component parts and researchers are European, but the winning AI firms were largely not capitalized there, because of the exact thing we're talking about - an engorged welfare state and a high tax burden required to support it. Also, Europe has engaged in suicidal deindustrialization so it isn't competitive when it comes to the more fundamental inputs to AI like power and data centers. Thus, Europe will mainly be an importer and consumer of inference rather than a seller. Structurally, Europe will not be able to marshal capital locally which it could then shift the fiscal burden onto. European firms will continue to consume foreign inference. C) is where we land, and this explains Europe's behavior with these new exotic taxes on internet use and AI. Europe will have to contrive a way to try and recoup lost labor taxes by taxing foreign capital. American tech companies tolerate this for now as a nuisance cost of doing business in Europe, but this will eventually reach a fever pitch as Europe continues to raise the stakes. Want access to the European market? Pay us $10b/year in "fines" (taxes). Now pay us $100b a year. At some point, Europe will exhaust American tech companies' ability to pay and they will exit the market. Moreover, this is only a partial measure and depends on a benevolent America tolerating ankle-biting without taking punitive measures. The US has already begun applying pressure to Europe to stop coattail-riding via NATO and this will only accelerate, so Europe will have a very limited ability to extract fines. This won't work in the end, but expect to hear a lot about it in the coming years. In the end, Europe will benefit from AI as productivity gains diffuse throughout society, but AI will further deteriorate its already tenuous fiscal situation. Europe cannot cope with a situation in which domestic labor is outsourced to foreign inference, and it has an extremely limited ability to deal with this. I don't expect total collapse, but a continued erosion in standards of living and relevance, especially if they don't make the hard choices of slashing immigration, massive welfare states, and spending on the elderly.