Does VAT exemption give EU banks a tax advantage?

A new research by Professor Ben Lockwood of the University of Warwick undertaken with PwC has revealed that the VAT exemption which applies to European banks does not lead to a tax advantage for the banking sector. The report concludes that if bank services were subject to VAT (in place of the current exemption system) this would not lead to any significant increase in EU VAT revenues.

The report, “How the VAT exemptions impact the banking sector”, sets out in detail why the VAT exemption applying to banks does not lead to a tax advantage for banks. Under the current VAT exemption system, banks do not charge their customers VAT, but in return they cannot recover VAT on costs they incur. In the report, this irrecoverable VAT is estimated to amount to up to €33bn per annum.

VAT is meant to be a tax on final consumers and the VAT exemption for banks moves away from this principle by imposing the irrecoverable VAT on the banks themselves. One reason for this is the difficulty of imposing VAT on the value added by banks and charging customers. If EU banking services were to become subject to VAT, banks would be able to fully recover the VAT on their costs and EU government revenues from this source would decrease. While banks’ customers would be charged VAT, business customers would recover this so that government VAT revenues would only increase by the amount of VAT on non-business (or non-VAT registered) services to customers of banks.

The report finds it unlikely that the VAT raised from consumers would be significantly higher than the tax governments would lose because banks would recover VAT on their costs. Indeed, on some analysis, overall EU VAT tax revenues could even decrease as a result of imposing VAT on banking services. For this reason, the report concludes that the VAT exemption cannot be considered as giving rise to a tax advantage for the EU banking sector.

The economic analysis behind this report builds on, and significantly develops and refines an earlier study undertaken by Harry Huizinga in 2002. The conclusions are based on national income data from 26 (out of 27) EU member states and, while the study makes a number of assumptions, it does not support a view that imposing VAT on banking services would significantly increase VAT revenues. In fact, it could even decrease them.

There has been lots of debate about whether the VAT exemption for banks leads to the sector being undertaxed. The research shows that the VAT exemption does not give the banks a tax advantage and some calculations in the report suggest that its removal could actually lead to a decrease in tax revenue for the EU of up to €7bn.

In addition, the current tax regime places a significant administrative burden on the banking sector which should not be overlooked.

This report is the most sophisticated analysis of the impact of the VAT exemption on the banking system that has been undertaken. Given the importance of the issue it is long overdue and it contradicts the widely held view that the VAT exemption system leads to less tax being raised than would be the case if banks services were fully subject to VAT.