Optimal VAT on Financial Services: A Theoretical Model of Financial VAT

Introduction

Currently, some countries apply alternatives to levying Value Added Tax (VAT) on financial services through taxing labor income of financial institutions with a higher tax rate than other sectors, but households remain under-taxed. This paper explores new ways of reducing their under-taxation by taxing capital income with a higher tax rate where financial entities are allowed to credit their input VAT. A new model of optimal VAT of financial services is proposed where this fact is illustrated. There is a tax reform proposal in two alternative and equivalent fashions. As the model shows, this reform would eliminate under-taxation of households and over-taxation of businesses. This would decrease the prices of non-financial goods and services and would reach an optimal policy design for the tax system. The two different ways are given. First, theoretical evidence is provided about the need of a financial VAT reform that taxes the full value added of financial services as the rest of goods and services. Second, a substitute with the same result would consist on taxing capital income by levying the pure interest following a concrete rule. Finally, an additional tax rule is provided to determine whether the proposed tax rate on pure interest should be higher or lower than a usual direct tax on income.

This chapter also studies the consequences on the economy of passing from an exemption of financial services under VAT to the taxation of financial VAT. The consequences in terms of trade openness, revenue, financial sector size, equity, public expenditure and fiscal illusion are analyzed. We develop an overlapping generation model of two periods in an open economy with competitive businesses and financial sector, and with consumers and public sector. The impact of financial VAT on the economy is obtained positive for trade openness, revenue and equity; negative for public expenditure and fiscal illusion; and neutral for the size of the financial sector.

Few papers have analyzed the consequences of implementing a financial VAT on economy. Buettner and Erbe (2014a,b) analyze this topic from a theoretical and quantitative perspective, but only for revenue and welfare effects. By the same way, Aigner and Bierbrauer (2015) have also contributed with the theoretical analysis of the impact of financial VAT on economy, but studying mainly the impact of the tax on the size of the financial sector. Nonetheless, this paper aims to study in the same model the effects of financial VAT on revenue, trade openness, financial sector size, fiscal illusion and redistribution. For doing so, the author uses an overlapping generations (OLG) model of two periods of general equilibrium with external sector, firms, households in which financial sector and public sector are added. The equilibrium, the golden rule in consumption and the steady state are analyzed.

Some countries have recently applied alternatives to directly applying a VAT on financial services, countries such as Denmark or Norway, where financial entities are levied with, for instance, a higher tax rate on labor income. In spite of that, there is no attempt to levy financial value added by rising the tax rate of capital income higher in order to avoid the well-known under-taxation of households when they consume financial services as a final product. This paper deals with this topic by applying a simple model of optimal VAT on financial services and its equivalent in capital income. A raise on the tax collection of capital income is proposed as alternative to applying the current complex methods of taxing financial services on VAT. This is the first paper in applying the efficient treatment of banking services given by Peña (2019) to the wider-focused model of Auerbach and Gordon (2002).