OPTIONS IN TAX POLICY
AND ADMINISTRATION FOR
THE FINANCIAL SERVICES
SECTOR
Peter Mullins
Fiscal Affairs Department
International Monetary Fund
Saint Lucia, July 2006
Overview


Background on the financial services
sector and tax policy design
Some topical issues:
– VAT and financial services
– Financial transaction taxes
– Regional Tax Co-ordination
– Flat tax
Size of the financial services
sector in the Caribbean

The sector is significant:
– 1000 offshore banks, 1200 insurance
companies and 5000 mutual funds
(2000/01)
– Annual fees from the sector raise 3.4% of
government revenue (average for ECCU
countries)
– Significant source of corporate tax
revenues – e.g., 40% in Barbados (2000)
Considerations in tax policy
design for the sector
Policies should satisfy tax principles of
equity, simplicity and efficiency
... which means avoiding distortions both:

– within the sector – between different institutions
or financial products; and
– with other sectors – sector is prone to seek and
often get preferential treatment ... this can lead
to:
 Inefficient allocation of resources to the
sector; and
 Tax arbitrage
VAT and Financial
Services
What is the problem?

Financial services are of many different
kinds:
– Fee-based, such as safe-keeping or ATM
transactions
– Asset management
– Intermediation between borrower and lender
– Insurance

Fee based services can usually be measured
Problem is with intermediation services as
... price charged for these services often
implicit rather than explicit
Example
 Bank borrows at 5%, lends at 15%
 So value of services is given by the margin
(10%)
 But how much of this goes to borrower and
how much to lender?
 Difficult to apply standard invoice-credit
method

Options for VAT on financial
services
1.
2.
3.
4.
5.
6.
Basic exemption
Exemption with input credits
Zero-rating business to business
Taxing gross interest
Addition method
Cash-flow approach
1. Basic Exemption

Most common practice/advice – used
by EU:
– Fee-based services fully taxed
– Other financial services exempt (except
when exported which are zero-rated)

Taxes some financial services thereby
increasing revenues and reducing
cascading

But exemption of financial services
gives a range of problems:
– Need to apportion inputs between
exempt and taxed (including zero-rated)
outputs – leads to arguments between
taxpayers and authorities
– Incentive to self-supply
– Cascading

EU currently reviewing basic
exemption approach
2. Exemption with input
credits




Credit for tax on inputs used to
provide services to registered
taxpayers by using a fixed percentage
Singapore – percentage based on
industry and type of institution
Australia – 75% of input tax
Overcomes some cascading
3. Zero-rating business to
business



Credit for tax on inputs used to provide
services to registered taxpayers by
specifically identifying taxpayers
New Zealand uses this approach – credit
only if registered taxpayer satisfies a taxable
sales threshold
Overcomes some cascading
... but requires financial institution to identify
registered taxpayers and whether they satisfy
the threshold
4. Taxing gross interest



Levy VAT on gross interest on loans
Business borrowers claim credits but
financial institution cannot
Problems:
– Cascading
– Tax on both cash price and financing

Argentina uses this approach – taxes
at half standard rate (10.5% rather
than 21%) due to problems
5. Addition method



VAT levied on sum of wages and
profits (as proxy for value add)
Simple method used in Israel
Problems:
– Cascading
– Does not fit well with invoice-credit
method as not on a transaction by
transaction approach
6. Cash flow approach


As yet untried method - Treat all cash
inflows as sales, hence taxable; treat
all outflows as purchases, hence
creditable
Taxes value added by financial
institution but:
– likely to cause cash flow problems to
businesses (due to tax on loans which are
not offset until repayment), and
– Difficult transitional issues with existing
loans
Conclusion


No perfect solution
But may be benefits for Caribbean
countries in taxing the sector as it:
– Removes distortions
– Raises much needed revenue
Financial Transaction
Taxes
Types of FTTs





Stamp duties
Turnover taxes
Taxes on bank deposits and
withdrawals
Insurance premium taxes
Tobin taxes – i.e., taxes on foreign
currency
Advantages & Disadvantages
of FTTs

Advantages:
– Raise significant revenue in short term

Disadvantages:
– FTTs are distortionary
– Contribute to financial disintermediation –
i.e., financial transactions by-pass the
financial sector ... which leads to ...
– Loss of revenue in medium term – from
disintermediation and decrease in
corporate profits
International Trend for FTTs


Trend is to move away from FTTs and
rely on less distortionary taxes such as
VAT
Conclusion is that FTTs useful in times
of fiscal crisis as a simple means to
raise revenue but ...
should only be introduced for a short
period to be replaced by less
distortionary taxes
Regional Tax
Coordination
Why coordinate?



Proposed move to a single financial space in
the region by removing cross-border
restrictions – tax coordination supports such
a move
Avoids arbitrary distortions between
countries due to different tax systems ...
especially for the financial services sector
Danger of ‘race to the bottom’ – cuts in
rates or erosion of base (e.g., through
incentives) leaves rates and bases too low in
the collective interest
International practice


EU Code of Conduct – non-binding
coordination where members agree to
rollback existing measures, and not
introduce new measures which affect
location of investment
OECD Harmful Tax Practice Project
Central America Project


Working group on tax coordination in
Central America and Dominican Republic
(with support from IMF, IADB, World Bank)
Principles:
– Protect tax base and strengthen the tax systems
– Maintain a friendly tax environment for
investment
– Avoid tax discrimination and tax competition
– Respect national sovereignty
Central America Project

Preparing:
– a code of conduct on tax incentives for
investment – includes criteria for tax
incentives
– Regional model double tax treaty

Work still in progress but may provide
model for the Caribbean
Flat Tax
What is the flat tax?


Classic Hall-Rabushka flat tax is single
rate tax on wages and a cash-flow tax
on business income all levied at the
same rate – effectively, a single rate
consumption tax
Classic flat tax not adopted by any
country


So called ‘flat taxes’ used in various
countries – usually a single rate of tax
on labor income ... in some cases
corporate tax rate is the same
Mainly found in Eastern Europe, but a
few countries, such as Jamaica, have
had a flat personal tax for some time
Country
Year of
Reform
Estonia
Lithuania
Latvia
Russia
Ukraine
Slovakia
Georgia
Romania
1994
1994
1997
2001
2004
2004
2005
2005
Rates at Reform
(now)
PIT
CIT
26 (22) 26 (22)
33
29 (15)
25
25 (15)
13
37 (24)
13
25
19
19
12
20
16
16
Previous
Rates
PIT / CIT
16
18
10
12
10
10
12
18
–
–
–
–
–
–
–
–
33
33
25
30
40
38
20
40
/
/
/
/
/
/
/
/
35
29
25
35
30
25
20
25
Arguments for/against the
flat tax

Arguments for:
– Simple
– Encourages supply-side effects such as improved
compliance ... although more due to low level of
rate rather than flatness

Arguments against:
– Equity concerns from loss of progressivity
– No evidence of increase in revenue effects
– Still much complexity due to exemptions and
exceptions
Implications for financial
services sector

Little effect unless corporate tax rate
aligned with flat personal tax rate
– in which case financial services sector
affected like other corporate taxpayers ...
unless sector already taxed at a
concessional rate
Source of further tax policy
information


International Tax Dialogue - a collaborative
arrangement involving the IDB, IMF, OECD,
UN and World Bank to encourage and
facilitate discussion of tax matters among
national tax officials, international
organizations, and a range of other key
stakeholders.
Website at www.itdweb.org