Taxing financial services: a future with options

VAT is a key part of the fiscal revenue of many countries. Yet financial services are exempt from it. Why? And what are the economic implications of this exemption and the options open to governments in their attempt to prevent market distortions?

Value added tax (VAT) is a broad-based tax on household consumption. With the exception of Australia 1 and the United States, all OECD countries levy VAT, or a similar tax, on consumer expenditure.

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Over the years the importance of VAT as a source of revenue has been on the increase. In some countries, such as France and Turkey, the revenue yield from VAT exceeds that from personal income tax. VAT is a broad-based tax on consumer spending, but some services are VAT exempt, including most financial services. This state of affairs may seem puzzling to some, especially given the significance of that sector and the size of its value-added in today’s world economy.

The reason why financial services should typically be exempt from VAT is a practical one. No country has found an entirely suitable and straightforward way to tax them. New Zealand, for example, examined the idea when they introduced VAT in 1986, but quickly abandoned the attempt.

On close study it proves hard to determine the tax base, in part because of uncertainty over the true nature of the service provided. Also, there is a question about whether it is reasonable to charge a consumption tax on transactions which are often directly related to household saving. Another problem is that subjecting those services to VAT might, by extension, require smaller non-finance sector companies to charge and collect tax in respect of money they have deposited with banks, since those deposits are effectively loans.

Such considerations have led to the introduction of various special consumption taxes on financial services, such as the insurance premium taxes paid by the policyholders. It should be noted that businesses which provide VAT exempt services must pay VAT on such expenses as computer services and stationery.

Services which are exempt from VAT include medical, housing and financial services. The latter involve mainly banking services, dealing in shares, insurance and related brokerage services. Providers of exempted services charge no VAT to consumers. Enterprises providing exempted services, however, cannot recover the VAT included in prices of goods and services they buy from their suppliers, such as computer, accounting and legal services.

This VAT, sometimes referred to as ‘hidden’ or ‘sticking’ tax, ends up by being included in the cost of services sold by banks, insurers and other providers of financial services. It is in this sense that the exempt financial institutions incur VAT costs.

To remove any distortion a feasible method of taxing financial services has to be found. If the current exemption were eliminated, banks and insurers could claim all prepaid VAT and such distortions would no longer occur. The financial institutions would, however, be required to charge VAT on their services.

The calculation of the taxable amount may not be so difficult for relatively straightforward services, such as the operation of a bank account where the amount of value added can be calculated, or share-dealing services where a fee is charged. But financial service businesses engage in a vast range of transactions, such as institutional investments, which may seem far removed from customer services, but which are nonetheless related to the provision of services to clients.

Arrangements for a comprehensive system of taxation have therefore proved problematic. Moreover, the cost of system changes and on-going administration for banks and revenue authorities leads to questions about the relative merits of any reform.