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Copenhagen Economics Discussion note
VAT on financial ServicesWhy, how and what revenues?
Helge Sigurd Nss-SchmidtWorkshop Copenhagen Economics9/25/2013
The EU exemption of VAT on financial services creates a number of distortions, including bias against the use
of subcontractors in financial intermediation, higher costs for non-financial enterprises, indirect subsidisation of
household lending as well as creating compliance costs and internal market problems. Traditionally,
implementation of a standard VAT system has been seen as resulting in too high compliance costs exceeding
the welfare benefits from reducing distortions. To circumvent these issues the Tax Calculation Account (TCA)
system has its advantages, when only taxing the gross interest charged on B2C transactions while zero-rating
B2B transactions. However, the merits of implementing such modified VAT systems for the financial sector
have so far notconvinced policy-makers. A possible factor might be that existing studies still show a wide rangeof effects from such reforms, including on net revenue effects, suggesting that a renewed review of pros and
benefits is warranted.
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VAT on financialServicesWhy, how and what revenues?
Introduction
The economic crisis, in particular the combination of
budget deficits and the perception that financial
sector shall pay for its perceived role in creating it,
has triggered increasing interest in getting more tax
revenues from the financial sector. International
institutions, in particular the IMF and EU Commission,
have been frontrunners while a number of moreacademic papers have also contributed to this debate.
This discussion note focuses on the practicalmerits of
introducing a VAT on financial services, focusing on
three issues:
The Why: Recapping the basic distortions arisingfrom the VAT exemption in the EU VAT system.
The How: If a VAT on Financial services were tobe implemented, how should it be constructed
in practice?
What effects on revenues and welfare: what doreally know from existing studies?
The Why
The VAT system is essentially a tax on goods and
services in the country where they are supposed to
be consumed.
From a conventional economic viewpoint all goods
and services, leaving aside such issues as externalities,
should be taxed at the same rate to circumvent
distortion of consumer choice.
In the EU VAT system, financial services are in
principle exempted. The value added not taxed is
essentially the difference between the lending rate
and the deposit interest rate (the interest rate
margin). However, financial institutions also obtain
revenues from charges on specific services, e.g.
provision of payments. Such services are also tax
exempt.
The VAT exemption creates a number of distortions,
well identified in the long literature on the issue:
Bias against outsourcing: as no VAT isimposed on the value added created internally,
VAT exempt firms have an incentive to produce
goods and services themselves rather than buying
from subcontractors. This incentive simply
emerges because it reduces VAT expenses not
because it is economically cost efficient.
Higher costs for non-financialenterprises : VAT registered buyers of financial
services derive no benefits from the VAT-
exemption on the value added within financial
firms. The input deduction mechanism in theVAT system implies that VAT registered
enterprises could have claimed the value added
within financial firms as input VAT which is
deductible against their own output VAT. By
contrast, they suffer from the fact that upstream
VAT on financial institutions inputs cannot be
deducted against output VAT. In countries with
relatively high VAT rates, it also represents a
cost-disadvantage vis--vis foreign competitors.
All other things equal, this reduces business
demand for financial services relative to a full
taxation model.
Lower costs for consumers : the VATexemption implies that a range of services
provided by financial institutions such as payment
services as well as the actual cost of providing a
loan are not subject to VAT. This represents a
subsidy towards consumption of financial services
(payment services, taking out loans etc.)
Compliance costs: The VAT directive defineswhich financial services that are VAT except and
which are not. As many financial institutions
provide both service types, they constantly facetwo types of problems:
a) is the service exempt or not?b) how to distribute input VAT on taxed
services where they can be reclaimed and on
VAT exempt services with no opportunity of
reclaiming?
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Moreover, problems arise in so-called mixed
supply situations where a tax exempt financial
service is delivered alongside a taxed service: this
always provides incentives to shift the tax base
towards the VAT exempt part of the service.
Increasing distortions between exemptand non-exempt firms: Competition in
services such as payment provision has been
increasing between traditional providers of
financial services, such as banks, and other firms.
In principle such distortions are not necessarily
an implication of VAT exemption as the
exemption is merely meant to target a service
provided and not institutions. However, this
principle is not upheld in member states
practices despite ECJ rulings which attempt toprovide some clarity on the issue. The EU
Commission has, at least since 2008, fought a
battle to get more clarity on such rules to
enforce a common practice within EU. So far,
this battle has provided little results as member
states have proved resistant to change.
The How
The traditional argument against imposing VAT on
financial services is arguably a practical one: It is too
difficult to implement in practice. Hence, it might leadan increase in compliance burdens which exceed the
welfare benefits from reduction of distortions.
Thus, when reviewing alternative methods to
replicate the functioning of a standard VAT on
financial services, it is important to hold these two
objectives up as the success criteria: The reduction of
welfare distortions should exceed the resulting
compliance costs.
The perfect model for imposing VAT on financial
services the cash flow model appears simple onpaper1. For financial institutions, all lending would be
seen as a sale while all borrowing as a purchase.
Simplified a bank gets a deposit of 100 and pays a 2
1The description of the models is mostly based onErnst & Young(2009) but evaluations of pros and consare similar in some of the other background studiesin the reference lists.
per cent return. It then lends out the same 100 for
which it receives a 7 per cent return. Let us say the
VAT rate is 20 per cent. So the 102 is considered the
incoming VAT base, giving rise to income VAT of 20
per cent multiplied by 102 while the outgoing VAT is
equal to 20 per cent multiplied by 107. Hence, the
net VAT due is equal to the interest multiplied by the
VAT rate.
However, the vast majority of literature sees this as a
complicated approach due to the need for
transaction-by-transaction accounting, introduction
problems (how to open balances), and shift of VAT
rates over time.
Another approach is the so-called Tax Calculation
Account (TCA) system. Instead of including deposits
and withdrawals as part of the tax base, only gross
interest charged and paid is included in the tax base.
This solution solves the problems related to
introduction of the tax and shifts in tax rates over
time by directly taxing the interest margin in a given
year, leaving aside payments in previous or following
tax periods.
The TCA was tested back in 1995-1996 with ten
large EU institutions and was found to be robust.
Yet, market participants felt uncomfortable about
providing information about their margins on B2B
loans, reflecting issues related to competition.
Hence, the preferred model in several studies is the
TCA with zero VAT on B2B transactions while B2C
is taxed on portfolio basis. This model has clear
attractions:
Zero-rating of B2B instead of exemption allowstwo things: 1)It reduces compliance costs and 2)
it avoids providing information about B2B margin
spreads while allowing registered VAT customers
to get a de facto VAT input deduction. By
contrast, zero VAT on value added inside
financial institutions has in itself no effect on net
revenues as any outgoing tax paid by financial
institutions on their own value added would be
offset by a similar deduction for customers.
Imposition of VAT to non-registered traders ona portfolio basis allows two things: 1) It reduces
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complexity while 2) it also removes the
distortion of not taxing householdsconsumption
of financial services.
While the simplified TCA system is the proposal seen
as the least cumbersome while delivering on many
scores, it would be wrong to say that it receives
widespread political support. To go further, an impact
assessment is probably required.
Yet, the appropriate benchmark for evaluating an
action along the lines of a simplified TCA (or even a
better system), are alternatives that might be even
less attractive:
Putting hope over experience and believe insubstantial near term progress in dealing with the
two closely linked dossiers: distortions betweenexempt and non-exempt providers and compliance
issues resulting from unclear rules. Among member
states, this would also include smoothing the
uneven taxation of financial services harming the
single market.
Use second best measures such as imposing a taxon:
a) value added in financial institutions (i.e. thesimple Financial Activity Tax solution as
reviewed in the EU Commissions proposal
that ended up endorsing the Financial
Transaction Tax)
b) the employment cost bill as done inter alia inFrance and Denmark.
Both model a) and b) increase the business costs
of financial institutions. Thus, it might reduce one
distortion, namely, the too low cost of providing
services to private consumes. This is, however,
clearly at the cost of raising other distortions.
Both models add a further cost component for
already over-taxed business customers (domestic
or foreign) while they do nothing about the
issues related to compliance costs.
What effects on revenues and welfare?
Discussions of a VAT reform should also include a
discussion about the implications for revenues and
welfare. Indeed, the revenue effects are linked to
welfare effects on the macro level: Two examples:
High rates of non-reclaimable VAT for businesscustomers linked to bankspurchases of goods
and services, suggest:
a) a high level of distortions linked to biastowards insourcing as well too high costs of
buying financial services for VAT registered
firms
b) solving the problem in a) leads to highrevenue losses
A high macro level of consumer purchases offinancial service products suggest:
a) a high level of distortions associated withtoo low costs of buying such products
b) potential large revenue gains from imposingVAT
Presently, empirical estimates of the effects are both
scarce and pointing in many directions. At the EU
level, the EU Commission has estimated a revenue
gain of 18 billion while a private study from E&Y
suggest essentially no revenue gains at all. A recent
overview study commissioned by DG TAX
underlined the uncertainties associated with current
estimates while claiming that additional UK revenues
could equal 11 billion. A recent German study
suggested that German revenue gains could be as low
as 1,6billion while a Danish official study suggest
that the tax exemption in Denmark amounts to
approximately 1billion (static gains). Estimates of
welfare gains are presented in both the EU
Commission study and the German study.
Table 1 VAT on financial services:
revenues and welfare gains
Revenues,
EUR Bn.
Welfare,
EUR Bn.
Revenues'
GDP share,
per cent
EU:
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EU-C(2012) 18 0.14E&Y (2009) +/- 0 0
Germany:
Buettner/Erbe(2012) 1.5 1 0.06UK
Mirrles(2011) 11 0.58DK
CE based on theDanish Tax Ministry
(2011)and other
inputs
1.3 0.55
Source: Referred to sources, GDP from Eurostat
A first quick glance across effects for both revenues
and welfare suggest that either we have a very
diverse structure of financial services or otherwise
availability of data/use of methodology lacks in
comparability between countries. In particular, it isdifficult to understand why the UK revenue should be
7 times higher than German2and why the absolute
revenue gains in Germany and Denmark should be of
about equal size.
As researchers say, this merits further study.
References
Buettner & Erbe (2012): Revenue and Welfare Effects
of Financial Sector VAT Exemption, TaxFACTs
Schriftenreihe.
Ernst & Young (2009): Design and Impact of the
Option to Tax System for Application of VAT to
Financial Services.
European Commission (2008): Harmonisation of
turnover taxes, Directorate General Taxation and
Customs Union.
European Commission (2012): Impact assessment
accompanying the proposal for Council Directive on
a common system of financial transaction tax andamending Directive 2008/7/EC. Com-mission Staff
Working Paper, vol. 1, 6, and 12.
2It should be kept in mind that the absolute size ofthe UK financial sector is about the same as theGerman while the larger relative importance of thefinancial sector in UK very much relates to export offinancial services.
de laFeria & Lockwood (2010): Opting for Opting In?
An Evaluation of the European Commissions
Proposals for Reforming VAT on Financial Services,
Warwick Economic Research papers, the University
of Warwick.
Grubert & Krever (2012): VAT and Financial Services:
Competing Perspectives on What Should Be Taxed,
New York University Tax Law Review.
Kaiser (2012): Taxes on Balance Sheets, European
Banking Federation, Bruegel-IMF workshop on
financial sector tax, Brussels.
Kerrigan (2010): The elusiveness of neutralitywhy
is it so difficult to apply VAT to financial services?
European Commission, Taxation and Customs Union
Directorate General.
Mirrlees et al. (2011): Tax by Design: the Mirrlees
Review, Oxford University Press.
PricewaterhouseCoopers (2011): How the EU VAT
exemptions impact the Banking Sector.
Skatteministeriet (2008): Supplerende grundnotat
vedr. forslag til Rdets direktiv om ndring af direktiv
2006/112/EF om det flles mervrdiafgiftssystem
med hensyn til behandling af forsikringstjenester og
finansielle tjenester, KOM (2008) 0147 samt forslag tilRdets forordning om gennemfrselsbestemmelser
med hensyn til behandling af forsikringstjenester og
finansielle tjenester, KOM (2007) 0746.
Skatteministeriet (2011): Answer on the effect of
changing the wage sum tax, Skatteministeriet J.nr.
2009-211-0011