Australia's Future Tax System

Final Report: Detailed Analysis

Chapter D: Taxing consumption

D4. Taxing financial services

D4–3 Alternative ways to tax consumption of financial services

Alternative methods of calculating the value of consumption of goods include an addition method, a tax calculation account method, and a reverse charging method. These could be investigated further, in consultation with the financial sector, and the most suitable method considered by government for adoption.

The addition method

Under an addition method tax, the value added is defined as the sum of each business's factors of production and its economic rent. An example for a non-financial supply chain (see Chart D4–1) shows that this is theoretically equivalent to both the cash flow (see Chart D1–1) and invoice-credit method (see Chart D2–2) consumption taxes.

Chart D4–1: Addition method consumption tax

Tax liability = tax rate (factor payments + economic rent)

Tax liability = tax rate (factor payments + economic rent)

For technical reasons already discussed, the invoice-credit method GST cannot efficiently tax financial services. Similarly, a simple cash flow tax that excludes financial flows (see Section D1 A cash flow tax) would not tax domestic consumption of financial products. However, the addition method can tax factor payments and economic rent from both financial and non-financial goods or services. It could therefore be used as an equivalent method of calculating the consumption tax liability.

An addition method financial services tax (FST) could be calculated from the wages and economic rent of financial institutions that are attributable to supplies to domestic consumers. To the extent that the financial institution has also received exemption from tax on inputs (for example, an input tax credit under the GST, or a cash flow tax refund), the tax base for the FST would also include inputs to ensure that the whole supply chain remains taxed.

The economic rent component could be calculated by reference to existing income tax concepts, provided adjustments are made to ensure that the normal return to capital is not taxed. For example, economic rent may be calculated on the basis of adjusted income tax liability. Adjustment would be necessary to allow a standard rate of return on equity capital, possibly calculated using a long term bond rate, similar to proposed arrangements for resource rent taxation (see Section C1 Charging for non-renewable resources). Income tax deductions given for depreciation may require variations.

Wages could be determined using the amounts provided in PAYG summaries (including fringe benefit amounts). However, because this approach is significantly more complicated than a direct cash flow approach for real goods and services, this additive approach to taxing consumption would not extend to incidental supplies of financial services, unless their value is significant. A common definition of financial supplies would be needed to ensure that financial supplies are subject to one consumption tax, reflecting the principle that services paid for in an implicit margin should be taxed under a FST.

An FST would tax only domestic consumption

To ensure that the FST operates as a destination-based consumption tax, only the proportion of a service provider's business transacted with domestic consumers would be subject to the tax. A company that deals only with businesses or non-residents would pay no tax.

As this method operates on overall profits, wages and costs calculated annually, it avoids the problem of allocating value between the parties in specific transactions for whom the bank is acting as an intermediary. Instead, financial institutions need to determine the profits and costs of each area of activity and determine the proportion of untaxed (business and foreign) customers within this area.

To determine the proportion of economic rent, wages and inputs that should be subject to the tax, FST payers might be required to use a global method to apportion amounts between domestic consumption (which would be taxed), and other supplies to business and exports (which would not be taxed). This proportion could be calculated as total revenue less revenue from exports and business supplies (where the customer can be identified as a business), divided by total revenue.

This suggests that while apportionment may be complex, it is not insurmountable given that banks are already required to apportion their inputs (between taxable, input taxed and GST-free uses) as well as to treat export supplies differently from other supplies.3

Such an approach has not yet been adopted elsewhere. Israel applies an additive method, taxing the profits and wages of financial institutions at the same rate as its value added tax on general consumption, similar to the model proposed here. However, this is not equivalent to a consumption tax, as there is no mechanism to credit tax paid on business inputs.

In the absence of direct international experience with the tax suggested in this section, the FST would need to be designed and developed in close consultation with the financial services sector, to ensure that FST concepts and liabilities are aligned with natural business systems.

Coordination with a cash flow tax or GST

The FST provides a method of taxing one sector of the economy (the financial sector) that cannot be effectively subject to a 'real' or 'R' base cash flow tax (see Section D1 A cash flow tax). However, the proposed FST could be introduced alongside the existing GST, in order to replace current input taxation of financial services. Box D4–2 includes a worked example.

An FST would also complement a cash flow tax. Businesses acquiring financial services would not receive a deduction for their financial acquisitions under a cash flow tax, but they would pay a lower 'tax-free' price for their financial services.

Box D4–2: Comparing GST treatment to FST

XYZ provides financial services with a base value before tax of $100. In providing these services, XYZ makes acquisitions valued at $80, with the result that XYZ is adding value of $20. All of XYZ's inputs are subject to GST.

Table D4–3: Worked example

  No tax GST Financial services tax
  Tax treatment: Supplies to:
Taxable Input taxed Business Domestic consumers
Cost of inputs 80 80 80 80 80
plus GST on inputs 0 8 8 8 8
less input tax credit 0 8 0 8 8
Final cost 80 80 80 80 80
Firm value-added 20 20 20 20 20
Base value 100 100 108 100 100
GST/FST payable   10
(10% of base value)
0 0 10
(10% of value-added + inputs)
Cost for domestic consumer 100 110 108 n/a 110
Cost for business 100 100
(after input tax credit)
108
(no input tax credit)
100 n/a

Amounts in bold indicate those components to which tax is applied.

The first column is where no consumption tax applies. This provides a baseline from which to consider the changes that result from the application of tax.

The next column considers what would occur if GST could be applied to financial services. As can be seen, costs effectively remain constant due to the availability of credits. The only real change occurs at the end where additional tax is borne by the consumer at the 10 per cent rate. This is the ideal outcome in taxing the consumption of financial supplies, but cannot in practice be achieved under the GST.

The third column illustrates the current input taxed treatment. This deviates significantly from the no tax and full GST examples. Costs increase as a result of the embedded tax. This increased cost is passed on to business and exports as well as to consumers.

The final two columns illustrate the effect of the FST and show how it varies with the customer base. The first shows FST on supplies solely to business, the second on supplies solely to consumers. The outcomes from the FST are the same as full taxation under the GST (the second column), but they are reached in a different way. Rather than taxing all supplies and allowing business a credit, the FST leaves supplies to businesses untaxed. Likewise, the full value of supplies to consumers is taxed by including XYZ's value added.

Tax calculation account method

An alternative method of identifying and taxing the value added by financial services is a form of cash flow tax that includes financial flows (an R+F cash flow tax — 'real plus financial' — is described in Section D1 A cash flow tax). As R+F cash flow taxation applies to all inflows and outflows, it does not require the determination of the particular component of the flow that represents consumption.

However, this model has its own problems. It would impose significant compliance costs for non-financial businesses and consumers due to the extra requirements associated with levying tax and claiming credits on all finance-related cash flows. Further, there would be significant transitional difficulties in the treatment of current financial arrangements.

However, a method of cash flow taxation that addresses most of these concerns was developed for the European Union during its consideration of cash flow taxation in the 1990s. The tax calculation account system avoided the transitional and compliance cost issues by suspending the collection or refund of tax until the end of the transaction, and indexing the suspended amount by the pure rate of interest.

The EU undertook a pilot study of the tax calculation account system involving a number of financial institutions. The system was found to be viable, although there were some concerns about the information revealed by institutions on tax invoices and the compliance costs associated with the change.

Reverse charging method

A method of taxing financial services by employing a form of modified reverse charge has also been developed (see Zee 2006, p. 458 for a more comprehensive outline of this method). This method differs from an R+F cash flow taxation method as it would not involve taxing or crediting all cash flows. Instead, tax would only be imposed on interest and charges (excluding the principal). Similarly, credits would only be allowed for acquisitions and interest paid by the financial service provider. Under this method, the tax on the consumption of the intermediation service would not be automatically split, but instead would be allocated by banks between the interest charges to depositors and borrowers between whom the bank is acting as an intermediary.

Like the tax calculation account method of cash flow taxation, the modified reverse charging method makes the financial service provider responsible for addressing the tax and calculation issues. Also like the tax calculation account method, the modified reverse charge method suspends tax and credits for a period. Credits and tax are eventually netted off before being charged to the final consumer. This modification results in the recipients only paying tax on the value of the consumption involved rather than on the full value of the interest charge.

This method has been developed more recently than the tax calculation account method and has not been the subject of the same level of consideration by academics and policy-makers. However, in theory at least it is another valid method for appropriately taxing the consumption of financial services.

Finding

To remove the adverse efficiency costs of input taxation on business and exports, financial services could be removed from the GST (effectively, made GST-free). However, this would have a large revenue cost and inappropriately exempt private consumption of financial services. The Australian government, in consultation with the financial sector, could further develop an alternative method of taxing domestic consumption of financial services to replace input taxation under the GST, or to complement a cash flow tax, to ensure that consumption of financial services is treated equivalently to other forms of consumption.


3 Financial services are generally input taxed, except when provided to a non-resident for consumption outside Australia, in which case they are treated as GST-free.