A new approach to taxing financial intermediation services under a value-added tax.

Integrating the financial sector into the invoice-credit mechanism of a value-added tax (VAT) is the remaining major outstanding issue in VAT design. The crux of the problem is that many financial services are rendered for implicit fees (interest margins), while it is widely believed that the proper operation of the invoice-credit mechanism requires taxable goods and services to be supplied with explicit charges. As a result, most countries that have a VAT have elected to exempt the financial sector from the tax to varying degrees. However, the exemption approach can entail significant economic distortions (overtaxation of business users of financial services due to cascading, and undertaxation of final consumers of such services) and give rise to administrative complications (separating input taxes of financial institutions between creditable and noncreditable portions). To alleviate these undesirable consequences, a number of countries have resorted to ad hoc measures, but none proves fully satisfactory in rectifying the fundamental problem.

This paper contains a proposal (referred to as the "modified reverse charging" approach) to tax financial services rendered for implicit fees under a VAT. At the heart of the proposal is the application of a reverse charge that shifts the collection of the VAT on deposit interest from depositors to banks, in conjunction with the establishment of a franking mechanism managed by banks that effectively transfers the VAT so collected to borrowers as credits against the VAT on their loan interest on a transaction by-transaction basis. The proposal is fully compatible with the invoice-credit mechanism of the VAT and is capable of delivering the correct theoretical result at minimal administrative costs.

INTRODUCTION

An overwhelming majority of the more than 120 countries with a value-added tax (VAT) today exempt the financial sector from the VAT to varying degrees. Generally, the scope of this exemption is narrower in developed than in developing countries: the former tend to apply the VAT to at least some financial services that are rendered for explicit fees, while the latter tend to exclude the entire financial sector. Even if all financial services with explicit fees are taxed, however, a significant share of the value-added of the financial sector--most notably the banking industry whose value-added is largely comprised of intermediation services represented by interest margins between lending and deposit-taking activities--would still be exempt. As pointed out by Zee (2004), since on average about a quarter of the GDP in developed countries originates from the financial sector (Table 1), exempting this sector from the VAT can give rise to significant economic distortions. (1) It is precisely concerns about these distortions that have motivated a number of countries in recent years to deviate from the exemption approach. Even the European Union (EU), which led the way with the exemption approach, has for some time been seriously exploring alternative VAT treatments of the financial sector. (2)

This paper contains a proposal for a new approach (henceforth referred to as "modified reverse-charging") for taxing financial intermediation services under a VAT that is both conceptually compelling in design and administratively simple to implement. At the heart of this approach is the application of a reverse charge that shifts the collection of the VAT on deposit interest from depositors to banks, (3) in conjunction with the establishment of a franking mechanism managed by banks that effectively transfers the VAT so collected to borrowers as credits against the VAT on their loan interest on a transaction-by-transaction basis. The outcome ensures that the net VAT revenue to be remitted to the government by a bank is equal to the VAT rate on the bank's provision of intermediation services, while, at the same time, the VAT burden on such services is borne by final consumers either directly as bank borrowers or indirectly when they consume goods and services in which the intermediation services have been embedded. Moreover, this modified reverse-charging approach is fully compatible with an invoice-credit VAT. Before delving further into the details of the new approach, the nature of the problem of taxing financial intermediation services under a VAT, as well as measures adopted by different countries to address it, are first briefly described and assessed in the next section. The third section then explains in detail the mechanics of the modified reverse-charging approach and compares it with other approaches. Some concluding remarks are given in the fourth section.

NATURE OF THE PROBLEM AND ALLEVIATING MEASURES IN PRACTICE (4)

The VAT is almost universally implemented on the basis of the invoice-credit method, by which the tax is imposed on the taxed goods or services (the output tax) supplied by VAT-registered businesses and a credit is given for the tax paid on the inputs (the input tax) used to produced the taxed output. (5) Both the output tax and the input tax are paid by the buyer and collected by the seller, which forms a credit chain tying one VAT-registered business to the next. Hence, for each such business, the net VAT to be remitted to the government would be its output tax (collected from its customers) less its input tax (paid to its suppliers). It is this crediting mechanism that allows the business to bear no VAT burden and merely serve as a VAT collection agent along the credit chain. Situated at the end of the chain is the final consumer, who has to pay the VAT on the taxed goods and services but, by definition, has no claimable credits to offset the tax liability. Hence, it is the final consumer that bears the entire VAT burden, although the actual collection of the VAT revenue is undertaken by all VAT-registered businesses along the many stages of the production and distribution process--each collecting a share of the revenue in proportion to its own value-added.

The above invoice-credit method works well for all goods and services (including financial services) that are supplied with explicit prices on which a VAT can be imposed. However, as noted earlier, a significant portion of the services provided by the financial sector is in fact of an intermediation nature for which the prices charged are typically implicit--in the form of interest margins or margins of a similar kind. Under such circumstances, the invoice-credit method is widely recognized to be inapplicable. It is worth pointing out that the perceived difficulty is related not to measuring the value-added of financial services rendered with implicit prices per se--such value-added can be measured easily enough by either the appropriate margins associated with the relevant transactions (the so-called "subtraction method" of determining value-added) or summing the wages and profits connected with the same transactions (the so-called "addition method") (6)--but rather to measuring their value-added on a transaction-by-transaction basis upon which the invoice-credit method relies. Furthermore, since a key input into the provision of financial intermediation services are deposits from final consumers who are necessarily not registered as VAT payers, they would not be able to collect the input tax paid by the bank on deposits even if a price for supplying the input (the deposit interest) could be identified for VAT purposes. Hence, it is widely believed that the only way to tax financial intermediation services under a VAT would be to apply the tax on the basis of the subtraction or addition method, (7) but this would in effect turn the VAT into an accounts-based tax as it relates to the financial sector, which is inconsistent with the transaction-based VAT applied using the invoice-credit method to other (nonfinancial) sectors. (8)

Faced with the above difficulty, the EU decided to simply VAT exempt the financial sector. (9) This decision has proved fateful, as most other countries emulated the EU model when introducing their own VATs. However, given that the VAT is supposed to be a broad-based tax and taxing financial services usually raises few equity concerns, exempting such a large sector of an economy for practical reasons seems decidedly uncompelling as a policy choice and unsatisfactory as an administrative solution. From a policy standpoint, the exemption approach has resulted in cascading--stemming from its breaking of the VAT credit chain--and, thus, in overtaxation of financial intermediation services when they are purchased by VAT registered businesses as inputs, but in undertaxation of such services when they are consumed by final consumers. (10) From an administrative standpoint, the exemption approach has not absolved financial institutions of all compliance costs: to the extent that some of their fee-based services are taxed, they would still need to identify the creditable portion of their input tax. (11) Moreover, as financial intermediation services have become increasingly mobile globally in recent years, many countries have felt an urgent need to enhance the international competitiveness of their financial sectors. Under such circumstances, it is not surprising that the limitations of the exemption approach have come into sharp focus--with increasing attention now being paid to searching for alternative, better approaches. In this context, a number of countries have adopted measures that--though they vary in details--share the common objective of rectifying the problem of overtaxation of financial intermediation services consumed as a business input, rather than the undertaxation of such services consumed by final consumers. (12)