Optimal VAT on Financial Services

Abstract

Recently, the European Commission is re-examining the VAT regime of financial services in Europe. This chapter deals with the important topic of the indirect taxation of financial services, studying firstly the consequences of an eventual shift from exemption of these services on VAT to taxing them based on previous literature and using an overlapping generations (OLG) model, and finally, analyzing the optimal way for taxing financial services under VAT. Theoretical results show a beneficial pass from exemption to taxation of this kind of services. 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. 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.