VAT and Financial Supplies: What should be taxed?

The service provided by financial institutions such as banks is described as an "intermediary service", linking depositors with money to lend and borrowers seeking loan funds. Banks collect a fee for these services through the spread on interest they pay to depositors and charge to borrowers. At present, the VAT system operates in a complex way to impose a tax on this service that is lower than the full tax imposed on other services. As the VAT is intended to be a tax on final consumers only, normally business customers are allowed to recover fully any tax they pay on acquisitions used in the business. However, they are not permitted to recover the VAT embedded in the price of financial intermediary supplies. Conventional analysis of VAT and financial intermediary services suggests the partial taxation system undertaxes final consumers and overtaxes business. In recent years some countries have moved to address these problems by relieving business from VAT on financial intermediary supplies and increasing it for final consumers. This article tests the assumption that current rules overtax business and undertax final consumers and reviews the alternative systems that have been proposed.