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  6. Financial Transactions and the Value Added Tax System --Thoughts Concerning a Consumption Tax on Financial Services--

Financial Transactions and the Value Added Tax System
-Thoughts Concerning a Consumption Tax on Financial Services-

No.252
February 2006
Research Fellow Seiji Shindo
Senior Research Associate Michiko Yoshida
Research Advisor Mitsuru Iwamura


ABSTRACT

The essence of Japan's consumption tax consists of a value added tax with a credit method mechanism. The value added tax is an excellent tax system from the point of view of taxation on firm activities in that it is not influenced by firms' accounting procedures or choice of office locations. On the other hand, the system is also problematic in that deposits, loans, and other financial transactions are exempt. While the current system has become a favorable one for the financial industry, from the perspective of creating a balance between the financial industry and other industries, this system is also contributing to the deterioration of the financial industry's competitiveness due to the so-called "tax cascading" effect. With this issue as a point of departure, this report investigates the potential for clarifying the added value occurring within financial transactions, and proposes a mechanism for satisfying the conditions of a well-balanced tax system. The proposal includes the following three points:

  1. When considering methods of taxing financial services by either a value added tax or a consumption tax, the tax base should not be calculated from the amount of loans or payments on interest. Rather, the tax base should be the remainder of the amount of interest paid minus the value of risk transfer and the transaction's time value of money (i.e. the interest rate on risk-free assets).
  2. Strictly speaking, the time value of money should apply to the contract term of financial transactions. Despite this, even if the kind of overnight interest rate that is observed in money markets is applied across the board, there is no significant difference in the value of the tax base.
  3. Regarding the value of risk transfer in financial transactions, for loans the equivalent risk premium of the borrower is deducted from the tax base, whereas for borrowing the equivalent risk premium of the borrower is added to the tax base.

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