Avoiding the Pitfalls in Taxing Financial Intermediation

Enthusiasts for financial sector tax reform typically come either with some form of quot;flat taxquot; (including value added tax on financial services, zero taxation on capital income, or a universal transactions tax) or advocating corrective taxes designed to offset market failures or achieve other targeted objectives. As a result the tax systems in most countries often end up with a complex mixture. Honohan argues that practical policy for taxation of the financial sector needs to take into account two key features of the sector: Its capacity for arbitrage and its sensitivity to inflation and thus to nonindexed taxes. Where these aspects have been neglected, poorly constructed tax systems - whether the consequence of a drive for revenue or of misdirected sophistication - often have sizable unexpected side effects. A defensive stance making the minimization of such distortions as its cornerstone is the best policy.This paper - a product of Finance, Development Research Group - is part of a larger effort in the group to assess the role of taxation in financial sector development