Research Notes

Facebook: A Growing Threat to National Sovereignty – Negative network effects and lost tax revenue


•   On January 24, 2012 Deloitte published a report entitled “Measuring Facebook’s economic impact in Europe”. The report asserts that Facebook makes a significant contribution to Europe both through its direct operations with employees and supplies as well as the indirect impact as people use Facebook.

•   The report notes that in 2011 in the European Union and Switzerland, Facebook enabled €32 billion in gross revenue, a€15.3 billion in economic impact and supported 232,000 jobs.

First Response to Deloitte’s study “Measuring Facebook’s Economic Impact in Europe”

The report is not based upon actual data from Facebook’s accounting and customers, but rather a number of indicators and multipliers. It’s possible that the actual data would confirm the report, but it is also possible that the real data would indicate a lower impact. While macroeconomists use indicators and multipliers in their assessment, this methodology is not revealed unless one reads the report very closely.  The reality is that some customers of Facebook do well with their advertising and others do poorly. The data provided is not precise enough to tell.

Facebook is still a private company and does not publish its income statement. 
However, Facebook’s 2011 gross revenue has been estimated by a series of insiders at $4 billion.  If we assume that Facebook generates one quarter of its revenue in Europe (where one quarter of its users are based and about 20% of its employees), Facebook should pay taxes on revenue at about 25-35% of profits, depending on the tax rate of the country.  If Facebook paid taxes like a European company, its direct contribution should be about €195 million – 265 million to government coffers, in addition to the €214 million operating expenses noted in the report. Therefore, if Facebook paid taxes like a European firm, its direct contribution to European society should be more than the report states. However, one can recognize that Facebook uses the tax haven of Ireland as a business strategy, and if it paid taxes like a European firm it would likely lessen operations, and therefore earnings in Europe.

Based on the report, Facebook spends about €1 on each European user. The investment a typical mobile operator makes per user is much higher and tax revenue from their services are returned to the government.

Facebook’s success represents the exploitation of network effects, serving a large user base at a low cost while extracting disproportionate revenue from European countries and paying no taxes, unlike its competitors. 

Facebook has direct operations in just 9 countries of the 28 European countries. Of this the more than 90% of the activity occurs in just Ireland (at least 75%) and UK (less than 25%). The differences in European countries allows Facebook an opportunity for arbitrage that few companies can take advantage.

Facebook is a marketing communication channel.  Similarly such studies of the impact of television, mobile communications, email and word of mouth can also show a positive impact to the economy.  Criticism of Deloitte’s Analysis and Facebook’s Assessment

With the financial crisis, European news is all gloom and doom these days. It comes as little surprise that as Facebook is coming under increasing scrutiny and pressure from European authorities that it is looking for ways to justify itself as an good corporate citizen. Hiring the accounting firm Deloitte to prepare such a study gives the story a “veneer” of objectivity.  While reading the report provides a glittering assessment of what the company does for the European economy, critical readers should question the results when they review the study’s methodology.
The report describes what it calls the “narrow” and “broad” effects of Facebook’s impact to the European economy. The narrow impacts are Facebook’s direct operations (employees, suppliers) and the broad effects are the indirect operations (economic impact generated from users and advertisers on Facebook).  Both sets of figures in the report are based on estimates, not actual numbers.  As noted in the footnotes, salary calculations of Facebook’s employees (housed in Ireland for example) come from Eurostat, and the other calculation come from standard economic multipliers for the technology industry.  The resulting numbers have been further adjusted 10% downward to avoid overstatement. 

In short, Facebook’s success reflects a company that has been able to monetize the demise of newspapers. Ad spending has shifted from print media to digital.  There are two main differences from today compared to the past. Today just a few firms (Facebook, Google) collect digital ad revenue whereas before, distributed firms (newspapers) collected print ad revenue.  Furthermore, those smaller entities paid taxes in the communities where they were located, but Facebook pays taxes from its headquarters and employs tax-advantage schemes such as placing its European ad team in Ireland.

The report discusses Facebook’s “direct effect” with spending on its employees and taxes.  Of Facebook’s 3000 employees, there  are 600 in the European Union, most are in Ireland for tax reasons.  Some countries such as Denmark have just one employee. The majority of Facebook’s employees are in their Palo Alto office, and it pays most of its taxes are in the United States.

More specifically the reports notes that Facebook generates €124 million to EU by supporting 600 jobs. Its direct vendor relationships amount to €90 million and 2500 jobs. In the report’s footnotes, it states that Facebook does not have direct economic activity in 17 of the 28 European countries, and that its employee valuations are only estimates, not actuals.  Therefore it is possible that Facebook could have overstated its employee salary valuation.  It is not unusual that such hot companies can attract high quality labor for a lower wage.

Facebook has about 224 million users in Europe, about a quarter of its user base. Facebook is not yet a public company, so it does not disclose its revenue for the region, so it is not clear whether it generates 25% of its revenue in Europe. In any case, its direct inputs to the European economy, about €214 million, is less than 1 € per European user. Considering the scope of Facebook, this operating budget is small, just 5% of total revenue.  Given that the taxes it pays in Europe are even less, one should argue that Facebook’s investment is small in Europe, but  naturally digital firms exploit network efforts as their business model. 

The report also discusses the “indirect effect” in supply-chain as well as the induced effect which “enabled broader economic activity”.  It is true that many European companies have created Facebook pages and even Facebook advertising.  However these companies struggle with measuring the impact of Facebook to their bottom line.   With analytics enabled, one can see that Facebook is just one of a variety of channels that supports leads and sales.  Interesting, we can look at definitive studies from a variety of agencies that show that the cost-per-lead and cost-per-acquisition is higher in Facebook than in other channels.  It is for that reason that Facebook no longer allows its analytics data to be shown in APIs that also show Google AdWords and other ad competitors. In general, Google advertising is more cost effective than Facebook.  Marketers know that Facebook advertising works better for customer retention and customer “engagement”, not direct leads and sales.  What is important to note, however, is that companies have not created new budget to advertise in Facebook. They have simply shifted their spending.  2011 marks the first year in which advertisers have spent more on digital than on print.  So the real story about Facebook’s “enablement” is that it has simply help put the nail in the coffin of the already dead newspaper industry.

Facebook makes a dubious claim that is “supports” 232,000 jobs.  With the exception of certain fast moving consumer goods companies with billions of euros in marketing budget that have large teams for marketing and assign a team for social media,  the social media manager is typically a new graduate.  This is an entry level job for which one gets experience.  The goal is to get experience and to move to a job with more “responsibility” and pay.   In other cases, marketing managers have a variety of responsibilities, and Facebook is just one channel to manage. Remember why companies need to use social media in the first place–they fired our outsourced their customer service and support departments!  So in this regard, we might say Facebook replaced something that consumers valued.  Danske Bank is a great example.  When it moved its banking operations online (cutting costs in a big way), customers complained. It used social media to respond and win its customer loyalty again.

As for the support services, a number of agencies offer consulting and development for Facebook, but typically they offer other services as well. So before they were in the business of websites, and now they also build Facebook pages.  Certainly agencies appreciate that Facebook has created a new business line for them, but very few firms can exist entirely on offering Facebook services.

The report also notes Facebook’s ability to help business “raise awareness of their products and generate new sales”, particularly with “Likes” and paid advertising. Companies are in an absolute mania in an attempt to collect likes, but there is no relationship betweenthe number of likes of a company’s Facebook page and a company’s profitability.  In fact, marketers are very smart at creating campaigns simply to generate fans, for example free giveaways.  What companies buy essentially is the “permission” to market to the user in the future. This is a standard tactic in Facebook.

The report notes that Facebook’s platform and its APIs create network effects and allow large and more frequent activities among users. This is certainly true, and Facebook’s applications are incredibly simple to use. At the same point, their market power crowds out innovation and mindshare for entrepreneurs who want to innovate outside of the Facebook’s corporate environment. Facebook highlights a few of its success stories, but they pale in comparison to the wasteland of hundreds of thousands of failed corporate campaigns and millions of users who are ever more alienated in spite of their supposed Facebook “Friends”.  In a platform with so many players, the biggest brands get the most mindshare, largely in proportion to their market share (McDonalds, Carlsberg, Manchester United etc).

The report also notes that Facebook has supported the development of the App Economy in Europe.  While certainly a few companies have monetized their apps (namely the major game developers Zynga, Playfish), the supposed gold rush to Facebook leaves most developers empty handed.  At the risk of making value judgements, many apps on Facebook are just for entertainment.  Facebook is hard-pressed to prove the development of real science, innovation in medicine, the alleviation of poverty and other such lofty goals as they purport to reach.

Other discussions int the report include how Facebook helps the fundraising field, but the example given of a non-profit raising a few thousand pounds is small compared to the serious business for fundraising being conducted in all media channel. The report even mentions employee recruiting but only mentions how firms use “social media” for hiring, not explicitly Facebook.  It notes that “Facebook has been estimated as accounting for only 1 per cent of total company hires, although this requires further verification.”

Finally the report notes that Facebook increases technology sales by increasing demand for sale of devices and broadband connections.  The report includes a chart of the number of users who access Facebook with a mobile device. It is impressive, but not the whole story.  Phone manufacturers benefits with device sales, but not necessarily mobile operators. We know that mobile operators make no profit on the iPhone, for example, as the markup is too high.  The situation with broadband varies from country to country, and the effect of Facebook can be positive on one side and negative on the other.  So while some operators have experienced increased revenue for broadband, others lose revenue for their SMS services. Danish telecoms, for example, have experienced a 20% decrease in their SMS traffic and revenue because users opt to use the “free SMS” within the Facebook environment. The issue of broadband is rather tricky, because Facebook does not invest in infrastructure. It relies on telecoms to make costly investments even when more are increasingly going to Facebook and not other sites.

The European Union, unlike the United States, has been in the forefront of questioning the role of global digital platforms. There are questions and challenges that Facebook poses.  Is it right that Facebook should have such a large user and customer base in Europe and not pay a proportionate tax? Does Facebook crowd out local competition? Does Facebook crowd out other innovators? This network effect externality results when a number of people use a given network.  Similar to telecom, global platforms such as Google, Facebook, Amazon, and LinkedIn increase in value and benefit to their users as the number of users increases.  While we can note a number of benefits to users on these platforms, their dominance poses importance questions without ready answers. The rapid adoption of global platforms has been coupled with disproportionate market power to just a few firms.  These firms transcend and exploit national boundaries and sovereignty by providing services in one country but being taxed in another.  They crowd out the local country competitors and lessen tax revenues.  As commerce increasingly becomes digital and is transacted through fewer and larger firms, the tax picture becomes distorted.  Nordic countries which are highly digital with citizens who are power uses of digital platforms, yet they do not receive the proportionate tax based upon the economic activity conducted on those platforms.   

Upon the release of the report in the UK, Facebook executives noted that the future information economy demands more high tech workers and that the Britain has fallen behind in providing the scientists, engineers and mathematicians needed. It may be an irony for Facebook to make such a claim because it hires its workers from the very public education system it succeeds to escape supporting.

There is no denying that Facebook is a tremendous phenomenon that has captured everyone’s attention.  Indeed many users think Facebook is the internet!  At the same point, it is important to remember that Facebook is a private, for-profit company in process of making an initial public offering.  Any ideas that it is somehow interested in promoting friendship and society needs to be tempered against the reality that it is in the business of advertising.  In 2011, it made  $4 billion selling advertisements.  Advertisers are its customers.  Users are its product.
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