OPTIONS IN TAX POLICY OPTIONS IN TAX POLICY AND ADMINISTRATION AND ADMINISTRATION FOR THE FINANCIAL FOR THE FINANCIAL SERVICES SECTORSERVICES SECTOR

Peter MullinsPeter MullinsFiscal Affairs DepartmentFiscal Affairs Department

International Monetary FundInternational Monetary Fund

Saint Lucia, July 2006Saint Lucia, July 2006

OverviewOverview

Background on the financial Background on the financial services sector and tax policy services sector and tax policy designdesign

Some topical issues:Some topical issues:– VAT and financial servicesVAT and financial services– Financial transaction taxesFinancial transaction taxes– Regional Tax Co-ordinationRegional Tax Co-ordination– Flat taxFlat tax

Size of the financial Size of the financial services sector in the services sector in the

CaribbeanCaribbean The sector is significant:The sector is significant:

– 1000 offshore banks, 1200 insurance 1000 offshore banks, 1200 insurance companies and 5000 mutual funds companies and 5000 mutual funds (2000/01)(2000/01)

– Annual fees from the sector raise Annual fees from the sector raise 3.4% of government revenue 3.4% of government revenue (average for ECCU countries)(average for ECCU countries)

– Significant source of corporate tax Significant source of corporate tax revenues – e.g., 40% in Barbados revenues – e.g., 40% in Barbados (2000)(2000)

Considerations in tax Considerations in tax policy design for the policy design for the

sectorsector Policies should satisfy tax principles of Policies should satisfy tax principles of

equity, simplicity and efficiencyequity, simplicity and efficiency... which means avoiding distortions ... which means avoiding distortions

both:both:– within the sector – between different within the sector – between different

institutions or financial products; andinstitutions or financial products; and– with other sectors – sector is prone to seek with other sectors – sector is prone to seek

and often get preferential treatment ... this and often get preferential treatment ... this can lead to:can lead to:

Inefficient allocation of resources to the Inefficient allocation of resources to the sector; andsector; and

Tax arbitrageTax arbitrage

VAT and Financial VAT and Financial ServicesServices

What is the problem?What is the problem?

Financial services are of many different Financial services are of many different kinds:kinds:– Fee-based, such as safe-keeping or ATM Fee-based, such as safe-keeping or ATM

transactionstransactions– Asset managementAsset management– Intermediation between borrower and Intermediation between borrower and

lenderlender– InsuranceInsurance

Fee based services can usually be Fee based services can usually be measuredmeasured

Problem is with intermediation services Problem is with intermediation services as ... price charged for these services as ... price charged for these services often implicit rather than explicitoften implicit rather than explicit

ExampleExample Bank borrows at 5%, lends at 15%Bank borrows at 5%, lends at 15% So value of services is given by the So value of services is given by the

margin (10%)margin (10%) But how much of this goes to borrower But how much of this goes to borrower

and how much to lender?and how much to lender? Difficult to apply standard invoice-Difficult to apply standard invoice-

credit methodcredit method

Options for VAT on Options for VAT on financial servicesfinancial services

1.1. Basic exemptionBasic exemption

2.2. Exemption with input creditsExemption with input credits

3.3. Zero-rating business to businessZero-rating business to business

4.4. Taxing gross interestTaxing gross interest

5.5. Addition methodAddition method

6.6. Cash-flow approachCash-flow approach

1. Basic Exemption1. Basic Exemption

Most common practice/advice – Most common practice/advice – used by EU:used by EU:– Fee-based services fully taxedFee-based services fully taxed– Other financial services exempt Other financial services exempt

(except when exported which are (except when exported which are zero-rated)zero-rated)

Taxes some financial services Taxes some financial services thereby increasing revenues and thereby increasing revenues and reducing cascadingreducing cascading

But exemption of financial services But exemption of financial services gives a range of problems:gives a range of problems:– Need to apportion inputs between Need to apportion inputs between

exempt and taxed (including zero-exempt and taxed (including zero-rated) outputs – leads to arguments rated) outputs – leads to arguments between taxpayers and authoritiesbetween taxpayers and authorities

– Incentive to self-supplyIncentive to self-supply– CascadingCascading

EU currently reviewing basic EU currently reviewing basic exemption approachexemption approach

Credit for tax on inputs used to Credit for tax on inputs used to provide services to registered provide services to registered taxpayers by using a fixed taxpayers by using a fixed percentagepercentage

Singapore – percentage based on Singapore – percentage based on industry and type of institutionindustry and type of institution

Australia – 75% of input taxAustralia – 75% of input tax Overcomes some cascadingOvercomes some cascading

2. Exemption with input 2. Exemption with input creditscredits

Credit for tax on inputs used to provide Credit for tax on inputs used to provide services to registered taxpayers by services to registered taxpayers by specifically identifying taxpayersspecifically identifying taxpayers

New Zealand uses this approach – New Zealand uses this approach – credit only if registered taxpayer credit only if registered taxpayer satisfies a taxable sales thresholdsatisfies a taxable sales threshold

Overcomes some cascading Overcomes some cascading ... but requires financial institution to ... but requires financial institution to

identify registered taxpayers and whether identify registered taxpayers and whether they satisfy the thresholdthey satisfy the threshold

3. Zero-rating business to 3. Zero-rating business to businessbusiness

Levy VAT on gross interest on Levy VAT on gross interest on loansloans

Business borrowers claim credits Business borrowers claim credits butbut financial institution cannot financial institution cannot

Problems:Problems:– CascadingCascading– Tax on both cash price and financingTax on both cash price and financing

Argentina uses this approach – Argentina uses this approach – taxes at half standard rate (10.5% taxes at half standard rate (10.5% rather than 21%) due to problemsrather than 21%) due to problems

4. Taxing gross interest4. Taxing gross interest

VAT levied on sum of wages and VAT levied on sum of wages and profits (as proxy for value add)profits (as proxy for value add)

Simple method used in IsraelSimple method used in Israel Problems:Problems:

– CascadingCascading– Does not fit well with invoice-credit Does not fit well with invoice-credit

method as not on a transaction by method as not on a transaction by transaction approachtransaction approach

5. Addition method5. Addition method

As yet untried method - Treat all As yet untried method - Treat all cash inflows as sales, hence cash inflows as sales, hence taxable; treat all outflows as taxable; treat all outflows as purchases, hence creditablepurchases, hence creditable

Taxes value added by financial Taxes value added by financial institution institution butbut::– likely to cause cash flow problems to likely to cause cash flow problems to

businesses (due to tax on loans which businesses (due to tax on loans which are not offset until repayment), andare not offset until repayment), and

– Difficult transitional issues with Difficult transitional issues with existing loansexisting loans

6. Cash flow approach6. Cash flow approach

ConclusionConclusion

No perfect solutionNo perfect solution But may be benefits for But may be benefits for

Caribbean countries in taxing the Caribbean countries in taxing the sector as it:sector as it:– Removes distortionsRemoves distortions– Raises much needed revenueRaises much needed revenue

Financial Financial Transaction TaxesTransaction Taxes

Types of FTTsTypes of FTTs

Stamp dutiesStamp duties Turnover taxesTurnover taxes Taxes on bank deposits and Taxes on bank deposits and

withdrawalswithdrawals Insurance premium taxesInsurance premium taxes Tobin taxes – i.e., taxes on foreign Tobin taxes – i.e., taxes on foreign

currencycurrency

Advantages & Advantages & Disadvantages of FTTsDisadvantages of FTTs

Advantages:Advantages:– Raise significant revenue in short termRaise significant revenue in short term

Disadvantages:Disadvantages:– FTTs are distortionaryFTTs are distortionary– Contribute to financial Contribute to financial

disintermediation – i.e., financial disintermediation – i.e., financial transactions by-pass the financial transactions by-pass the financial sector ... which leads to ...sector ... which leads to ...

– Loss of revenue in medium term – from Loss of revenue in medium term – from disintermediation and decrease in disintermediation and decrease in corporate profitscorporate profits

International Trend for International Trend for FTTsFTTs

Trend is to move away from FTTs Trend is to move away from FTTs and rely on less distortionary and rely on less distortionary taxes such as VATtaxes such as VAT

Conclusion is that FTTs useful in Conclusion is that FTTs useful in times of fiscal crisis as a simple times of fiscal crisis as a simple means to raise revenue but ... means to raise revenue but ... should only be introduced for a should only be introduced for a

short period to be replaced by short period to be replaced by less distortionary taxesless distortionary taxes

Regional Tax Regional Tax CoordinationCoordination

Why coordinate?Why coordinate?

Proposed move to a single financial Proposed move to a single financial space in the region by removing cross-space in the region by removing cross-border restrictions – tax coordination border restrictions – tax coordination supports such a movesupports such a move

Avoids arbitrary distortions between Avoids arbitrary distortions between countries due to different tax systems ... countries due to different tax systems ... especially for the financial services especially for the financial services sectorsector

Danger of ‘race to the bottom’ – cuts in Danger of ‘race to the bottom’ – cuts in rates or erosion of base (e.g., through rates or erosion of base (e.g., through incentives) leaves rates and bases too incentives) leaves rates and bases too low in the collective interest low in the collective interest

International practiceInternational practice

EU Code of Conduct – non-binding EU Code of Conduct – non-binding coordination where members coordination where members agree to rollback existing agree to rollback existing measures, and not introduce new measures, and not introduce new measures which affect location of measures which affect location of investmentinvestment

OECD Harmful Tax Practice ProjectOECD Harmful Tax Practice Project

Central America ProjectCentral America Project

Working group on tax coordination in Working group on tax coordination in Central America and Dominican Republic Central America and Dominican Republic (with support from IMF, IADB, World Bank)(with support from IMF, IADB, World Bank)

Principles:Principles:– Protect tax base and strengthen the tax Protect tax base and strengthen the tax

systemssystems– Maintain a friendly tax environment for Maintain a friendly tax environment for

investmentinvestment– Avoid tax discrimination and tax competitionAvoid tax discrimination and tax competition– Respect national sovereigntyRespect national sovereignty

Central America ProjectCentral America Project

Preparing:Preparing:– a code of conduct on tax incentives a code of conduct on tax incentives

for investment – includes criteria for for investment – includes criteria for tax incentivestax incentives

– Regional model double tax treatyRegional model double tax treaty Work still in progress but may Work still in progress but may

provide model for the Caribbeanprovide model for the Caribbean

Flat TaxFlat Tax

What is the flat tax?What is the flat tax?

Classic Hall-Rabushka flat tax is Classic Hall-Rabushka flat tax is single rate tax on wages and a single rate tax on wages and a cash-flow tax on business income cash-flow tax on business income all levied at the same rate – all levied at the same rate – effectively, a single rate effectively, a single rate consumption taxconsumption tax

Classic flat tax not adopted by Classic flat tax not adopted by any countryany country

So called ‘flat taxes’ used in various So called ‘flat taxes’ used in various countries – usually a single rate of countries – usually a single rate of tax on labor income ... in some tax on labor income ... in some cases corporate tax rate is the samecases corporate tax rate is the same

Mainly found in Eastern Europe, but Mainly found in Eastern Europe, but a few countries, such as Jamaica, a few countries, such as Jamaica, have had a flat personal tax for have had a flat personal tax for some timesome time

CountryCountry Year Year of of

ReforReformm

Rates at Reform Rates at Reform (now)(now)

Previous Previous Rates Rates

PIT / CITPIT / CITPITPIT CIT CIT

EstoniaEstonia 19941994 26 (22)26 (22) 26 (22)26 (22) 16 – 33 / 3516 – 33 / 35

LithuaniLithuaniaa

19941994 3333 29 (15)29 (15) 18 – 33 / 2918 – 33 / 29

LatviaLatvia 19971997 2525 25 (15)25 (15) 10 – 25 / 2510 – 25 / 25

RussiaRussia 20012001 1313 37 (24)37 (24) 12 – 30 / 3512 – 30 / 35

Ukraine Ukraine 20042004 1313 2525 10 – 40 / 3010 – 40 / 30

SlovakiaSlovakia 20042004 1919 1919 10 – 38 / 2510 – 38 / 25

GeorgiaGeorgia 20052005 1212 2020 12 – 20 / 2012 – 20 / 20

RomaniRomaniaa

20052005 1616 1616 18 – 40 / 2518 – 40 / 25

Arguments for/against the Arguments for/against the flat taxflat tax

Arguments for:Arguments for:– SimpleSimple– Encourages supply-side effects such as Encourages supply-side effects such as

improved compliance ... although more due improved compliance ... although more due to low level of rate rather than flatnessto low level of rate rather than flatness

Arguments against:Arguments against:– Equity concerns from loss of progressivityEquity concerns from loss of progressivity– No evidence of increase in revenue effectsNo evidence of increase in revenue effects– Still much complexity due to exemptions Still much complexity due to exemptions

and exceptionsand exceptions

Implications for financial Implications for financial services sectorservices sector

Little effect unless corporate tax Little effect unless corporate tax rate aligned with flat personal tax rate aligned with flat personal tax raterate– in which case financial services in which case financial services

sector affected like other corporate sector affected like other corporate taxpayers ... unless sector already taxpayers ... unless sector already taxed at a concessional ratetaxed at a concessional rate

Source of further tax Source of further tax policy informationpolicy information

International Tax Dialogue - a International Tax Dialogue - a collaborative arrangement involving collaborative arrangement involving the IDB, IMF, OECD, UN and World Bank the IDB, IMF, OECD, UN and World Bank to encourage and facilitate discussion to encourage and facilitate discussion of tax matters among national tax of tax matters among national tax officials, international organizations, officials, international organizations, and a range of other key stakeholders. and a range of other key stakeholders.

Website at www.itdweb.orgWebsite at www.itdweb.org