Draft: 9-26-01 Taxation of Financial Services under a VAT

In simple economic models, it is relatively easy to describe how to impose a value-added tax at a uniform rate on all consumption goods, and to demonstrate that this tax is equivalent to a proportional labor income tax, plus a tax on existing assets. The equivalence involves little more than the national income identity relating the sources and uses of income. Once one attempts to incorporate the costs of financial intermediation, however, tax analysis becomes more complicated. In attempting to determine how a VAT should treat financial transactions, various authors have attempted to apply results from simpler models. Unfortunately, these results can lead to conflicting, ambiguous, and misleading prescriptions. In this paper, we argue that one needs to rely more on the fundamental objectives of a VAT to decide how it should treat financial transactions. Adopting this approach, we find that, in principle, the VAT should apply to resources devoted to financial transactions in the same manner that it does in other sectors. As discussed below, there are real problems, however, in implementing such a tax on the financial sector that we do not attempt to address in this paper. I. Equivalence of a Labor Income Tax and a VAT The approach we will take to judge the appropriate treatment of financial services under a VAT is to make full use of the theoretical equivalence between a labor income tax and a proportional value-added tax. We begin with an individual’s lifetime budget constraint under a constant labor income tax: