Copenhagen Economics Discussion note

VAT on financial Services

Why, how and what revenues?
Helge Sigurd Nss-Schmidt Workshop Copenhagen Economics 9/25/2013

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 not convinced policy-makers. A possible factor might be that existing studies still show a wide range of effects from such reforms, including on net revenue effects, suggesting that a renewed review of pros and benefits is warranted.

 VAT on financial Services

VAT on financial Services

Why, 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 more academic papers have also contributed to this debate. This discussion note focuses on the practical merits of introducing a VAT on financial services, focusing on three issues: The Why: Recapping the basic distortions arising from the VAT exemption in the EU VAT system. The How: If a VAT on Financial services were to be implemented, how should it be constructed in practice? What effects on revenues and welfare: what do really know from existing studies?

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 is imposed 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-financial enterprises : VAT registered buyers of financial services derive no benefits from the VATexemption on the value added within financial firms. The input deduction mechanism in the VAT 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 VAT exemption 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 defines which financial services that are VAT except and which are not. As many financial institutions provide both service types, they constantly face two 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?

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.

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 VAT on financial Services

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 exempt and 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 to provide 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.

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 allows two 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 on a portfolio basis allows two things: 1) It reduces

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 lead an 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 on paper1. 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
1

The description of the models is mostly based on Ernst & Young(2009) but evaluations of pros and cons are similar in some of the other background studies in the reference lists. Page 2

 VAT on financial Services

complexity while 2) it also removes the distortion of not taxing households consumption 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 in substantial near term progress in dealing with the two closely linked dossiers: distortions between exempt 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 tax on: a) value added in financial institutions (i.e. the simple 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 in France 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.

welfare. Indeed, the revenue effects are linked to welfare effects on the macro level: Two examples: High rates of non-reclaimable VAT for business customers linked to banks purchases of goods and services, suggest: a) a high level of distortions linked to bias towards insourcing as well too high costs of buying financial services for VAT registered firms b) solving the problem in a) leads to high revenue losses A high macro level of consumer purchases of financial service products suggest: a) a high level of distortions associated with too low costs of buying such products b) potential large revenue gains from imposing VAT

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 1,6 billion 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: What effects on revenues and welfare? Discussions of a VAT reform should also include a discussion about the implications for revenues and revenues and welfare gains
Revenues, EUR Bn. EU: Welfare, EUR Bn. Revenues' GDP share, per cent

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 VAT on financial Services

EU-C(2012) E&Y (2009) Germany: Buettner/Erbe(2012) UK Mirrles(2011) DK CE based on the Danish Tax Ministry (2011)and other inputs Source:

18 +/- 0

0.14 0

1.5

0.06

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 neutrality why 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 til Rdets 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

11

0.58

1.3

0.55

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 is difficult to understand why the UK revenue should be 7 times higher than German2 and 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 and amending Directive 2008/7/EC. Com-mission Staff Working Paper, vol. 1, 6, and 12.
2

It should be kept in mind that the absolute size of the UK financial sector is about the same as the German while the larger relative importance of the financial sector in UK very much relates to export of financial services. Page 4