A New Approach to Taxing Financial Intermediation Services Under a Value-Added Tax (European Union‪)‬

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.