VATon Financial services.pdf

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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 financial Services

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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

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