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Taxation of Financial Intermediation: Summary of Project Findings

The project provides a framework for assessing the many proposals for tax policy reform affecting the financial sector. Such proposals typically come from one or other of two powerful perspectives. Either the reformer is an enthusiast for a big simplification, usually some form of “flat tax” (including VAT on financial services, a universal transactions tax, or zero taxation on capital income) or she is the advocate of subtle corrective taxation designed to offset some of the many market failures to which the financial sector is prone or to achieve other targeted objectives. In practice these two perspectives can conflict rather severely. As a result, the tax systems in most countries often end up as a complex mixture defying any straightforward rationalization. The big flat-tax ideas are diluted and modified, the corrective taxes may misfire by conflicting with others introduced for different reasons.

We conclude that neither of these reform approaches should be taken to an extreme.

However, while none of the three big “flat tax” reform ideas provides a complete and practical solution, each has lessons for a good system.

  • Even if practicalities impede its introduction as such, the notion of a VAT on financial services represents a useful benchmark against which existing and proposed indirect taxes can be compared for their burden and impact.
  • Significant financial transactions taxes are hard to justify on theoretical grounds and should be resorted to only as a transitory device when fiscal revenue is under particular pressure.
  • Heavy emphasis on the taxation of income from capital should be avoided.

Attempts at corrective taxation should be undertaken with extreme caution as history suggests that unintended side-effects or deadweight losses may dominate the results. This implies that special tax-based schemes to encourage stock exchange listing, household saving and the like, should be viewed with caution, bearing in mind the substantial opportunity cost in terms of lost revenue and the questionable gains.

Instead, policy advisors should focus on avoiding two distinctive traps, often neglected, and into which financial sector taxation can fall, namely (a) the sector’s unique capacity for arbitrage and (b) its sensitivity to inflation and thus to non-indexed taxes. All financial sector taxes need to be designed to be as arbitrage-proof, and as inflation-proof as possible.

Researcher

  • Patrick Honohan

 




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