Financial Services: Issues and Options. R. Kavita Rao NIPFP

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1 Financial Services: Issues and Options R. Kavita Rao NIPFP

2 The Problem GST is proposed on the input tax credit principle. Every supplier is allowed to take credit for any input taxes that might have been paid, against taxes collected in supplies Value added is the difference between value of supplies and value of purchases In financial services, sometimes, the value added or the return for a service provided is embedded in a margin Bank s s income from financial intermediation is the interest margin between deposits and lending In this case, there are two issues that alter the basic VAT operation Since services are provided to both the buyer and the seller, deriving the income attributable to one or the other is not straight forward Since all components of a capital transaction are not completed in the same time period, there is a possibility of default in default the income of the bank is reduced

3 Difficulties with exemption Taxes paid on purchases by these institutions would become a part t of the cost of the service cascading would remain the system. In order to avoid this distortion, the service providers could opt o for self-supply supply or import of the inputs such that they would be free of taxes. Over-taxation of business entities and under-taxation of consumption demand. In order to avoid such tax liabilities, the business entities could attempt to source their financial services from outside the jurisdiction since most jurisdictions would zero-rate rate exports, they could get the services free of taxes. Under-taxation of consumption demand should introduce an incentive in favour of these services when compared to other goods and services that are subject to taxation. Further accentuated when the fee based services are subject to a tax while margin based services are exempt Change in form from fee based to margin based final consumer might prefer margin based services while for business entities, the fee based services provide a mechanism for tax credit and hence might be a preferable option.

4 Two Questions First, what is the extent of distortions if we continue to exempt financial services? If the distortions are not significant, incentive to change the system might not be large I-O O tables as well as CMIE Prowess database for 200 large firms suggest inputs are about 7.5 percent of net income from financial services If GST is 18%, embedded costs would be 1.36 percent of net income from financial services Lot of variation in the ratios for individual firms Do these costs distort average ratio for top 200 fund based service providers is 8.65 percent while that for the top 100 fee based firms is percent.

5 Two Questions Second, if we do attempt to tax these services, what is the extent of revenue additionality? Financial services to final consumers account for 18.8 percent of o total supplies of financial services(i-o). Supplies to government account for 3.4 percent. If all these are margin based services the value of taxable services would be 1.77 percent of total financial services With GST rate of 18 percent, the balance would imply additional tax of 3.68 percent The FISIM for different sectors suggest that margin based services in intermediate use would be 28 percent. Of this, taxable inputs would be 2.24 percent with related tax liability of 0.4 percent The revenue additionality would be 3.48 percent of value of financial services. Taking figures, the revenue additionality of Rs 7400 crore

6 Alternative models Zero-rating rating of business transactions Would correct the distortions from cascading taxes on intermediate use services Final consumers remain outside tax base distortion Addition and subtraction methods Can capture the value addition but cannot be incorporated into invoice based GST For non-financial firms, this treatment of financial services can be distorting A loan may not be backed by a deposit interest margin is also total interest income.

7 Alternative models Cash Flow Method All inflows of cash whether they be capital or otherwise would be treated as equivalent to sales and vice versa. A loan would be taxable in the hands of the receiver and a deposit in the hands of the bank this system has a lot of advantages it taxes final consumers and lets business entities claim full input i tax credit, it allocates all margin based fees between the users of these services, it provides information for every single transaction separately some distinct disadvantages both financial institutions as well as all other business entities es which have a few financial transactions have to account for these transactions and comply with the entire system. Further, every single transaction is treated separately and accounted for as such. Changing tax rates is difficult to manage

8 Alternative models Modified Cash Flow with TCA for each capital transaction, a Tax Calculation Account is to be maintained. Tax liabilities/refunds which are to be reversed subsequently are entered. When the transaction is terminated, the net tax is remitted Indexation is done using government bond rate Non-financial firms too have to maintain these TCAs Truncated Cash Flow with TCA Compliance requirements limited to financial firms Transaction wise accounting still has to be maintained

9 How to decide? One, is the focus on revenue generation or good VAT regime? Second, is the focus on design alone or should compliance issues too be taken into account? Tempting to suggest Truncated Cash Flow with TCA. Alternatively, zero-rating rating for businesses and average rate applied for final consumers