VAT and Financial Services: Competing Perspectives on What Should Be Taxed

Abstract

To date, the focus of most literature on VAT and financial supplies has been on the appropriate treatment of the cost of financial intermediary services related to investments and business loans. This paper broadens the inquiry to a wide range of financial services including consumer loans, leasing, insurance, credit cards, and gambling. It suggests the correct policy choice can vary greatly for different types of services. It also suggests that the correct policy choice depends on which of two different views of the consumption tax is adopted. The first takes the usual economist’s view that a policy is efficient if no one can be made better off without making someone else including the government worse off. In this Hobbesian based view, the test of whether a financial service should be taxed depends on whether it yields an increase in output great enough to offset the resources used to provide the service. The other perspective is based on the traditional expenditure tax in which any expenditure by an individual that is not for investment is consumption that should be taxed. The two views therefore agree that investment services should not be taxed, but they differ in respect of intermediary services related to consumer loans and insurance. For example, in the case of insurance (and lotteries), the economist’s Pareto perspective indicates that only the cost of the service, i.e., the loading charge, should be taxed at the level of the insurer or lottery operator, with the net proceeds received by a policyholder or lottery winner subject to tax when spent on taxable consumption. But there may be a case under the expenditure tax view for the full premium (or lottery ticket) to be taxed because it is not investment. The paper also addresses the practical problems of taxing financial services provided to both consumers and businesses under a VAT. It reviews the various schemes that have been suggested and the different policies actually adopted by a range of governments.