VAT on Financial Services, Dualism in Economic Inclusion Policy

The government proposes that financial and insurance services be exempted from the list of services not subject to Value Added Tax (VAT) in the Bill of General Provisions and Taxation Procedures (KUP) Law. The consequence is that financing, savings, and investments in the financial sector—which have been tax-free so far—have the potential to be subject to VAT. 

This is one of the many efforts of the government to boost tax revenue, which, as we all know, is hardly ever optimal every year. 

In fact, the Directorate General of Taxes (DGT) openly admits that so far it has only been able to collect 65.38% of the total VAT that should have been collected. The C-efficiency ratio of VAT is low because there are too many exemptions for goods and services, namely the facilities of VAT exemption or not-collected, and the 10% VAT rate is considered too low. 

Financial services and insurance are then targeted to be taxed as they are included in the business sector which has an unequal contribution to the Gross Domestic Product (GDP) and domestic VAT. 

Actually, if the government's proposal is passed by the parliament, it will not necessarily resolve the state revenue crisis. It is not impossible that this policy will lead to more complex issues. ? 

Not That Simple 

Before dissecting potential new problems that may arise, let us look back at Indonesia's VAT policy and the reasons why financial services have been categorized as Non-Taxable Services. 

Since the beginning of the enactment of VAT in 1985 until now, Indonesia has adopted the European VAT system because of its relatively simple implementation. 

The method used is the indirect subtractive method or the invoice or credit method. Simply put, the VAT must be paid and calculated based on VAT out minus VAT in. ? 

Regarding financial or financing services, in general, the European Union excludes financial services from the object of VAT. The reason, as the Organisation for Economic Co-operation and Development (OECD) explained, is that it is quite difficult to tax financial or financing services transactions. 

Especially in identifying the value of intermediation services and other financial services with implicit rewards, such as public fund collection services, lending services (financing), factoring services, credit card services, and risk insurance services. 

David Williams (Thuronyi, 1996) describes the reasons for the European Union to exempt financial services from VAT: (1) avoiding administrative hassles;  (2) avoiding difficulties in identifying the added value of fund intermediation services or the added value of a transaction;  and (3) avoiding the difficulty of identifying financial service rewards from interest expenses as time value of money, businesses profits, and other costs. 

Based on these considerations, the European Union mandates its member countries to exempt VAT on various financial services such as loans;  bank account;  and transactions in money, stocks, and bonds (including insurance). Except for explicit fee-based services provided by financial institutions which are still subject to tax, such as financial advisory and safe deposit box rental services. 

Prof. Gunadi also explained the thoughts of Alan A. Tait (1988), which states that interest is a complicated type of transaction price, especially if it is combined with other elements, such as real cost of capital, inflation rates, and intermediation costs. Therefore, banking and insurance are not properly included as objects of VAT and must be excluded. 

If it is still enforced, the difficulties that arise in taxing financial/financing services can actually eliminate income, add economic distortion, and cause the loss of real justice or neutrality (Edwards & Mayer in Tait, 1988). 

In addition, the imposition of VAT on financial/financing services can lead to endless debate (Auerbach and Gordon 2002 in Pena, 2019), especially related to the treatment of transaction costs. 

Those complexities make European Union countries choose not to collect VAT on financial/financing services. The same goes for Indonesia when it used to follow the footsteps of Europe. 

Moreover, there is a discourse that the government will implement a multi-rate VAT scheme (0-15%). This scheme will further complicate the implementation of the VAT out-VAT in mechanism related to policies on financial, financing, or insurance services. 

Interest Rates and Premiums 

One more thing that concerns me is the impact of VAT on financial services on banking interest rates and insurance premiums. 

As we all know, in the last few decades the government along with Bank Indonesia and the Financial Services Authority (OJK) have been actively promoting inclusive financing. Especially in the context of developing Micro, Small, and Medium Enterprises (MSMEs). 

Starting from launching the People's Business Credit (KUR) with low-interest rates, until recently, BI issued the Macroprudential Inclusive Financing Ratio (RPIM) policy to encourage the banking intermediation function. 

This effort is becoming increasingly significant, especially in the midst of the Coronavirus Disease 2019 (Covid-19) pandemic which has worsened the performance of almost all business sectors, particularly MSMEs. 

To stimulate the economy, the Central Bank has also cut the BI 7-day reverse repo rate benchmark by 250 basis points for the period of June 2020-September 2021, from 6% to 3.5%. 

This low-interest rate regime can end if the VAT on financial services is approved by the House. This is because the imposition of VAT on interest will automatically increase loan interest rates. The impact is a high-cost economy that will further burden MSMEs and, in turn, drive up the price of consumer goods. 

The same applies to VAT on insurance, which is not merely an investment. This policy will certainly increase insurance premiums and potentially reduce public health insurance. 

The proposal for VAT policy clearly shows the government's inconsistency. On the one hand, it promotes economic inclusion, on the other hand, it impedes economic inclusion through taxes. Dualism. 

I understand that the country needs a sound and strong fiscal to maintain conducive economic and social stability amid pandemics and crises. The public's spotlight on the surge in debt and low tax revenues is surely a heavy burden for the government. 

However, be careful when deciding a policy. Do not let the economic sectors that are closely related to the people's livelihood become easy targets. 

There have been countless studies and inputs from various parties on how to improve fiscal performance—especially tax revenues—without creating a high-cost economy. 

Starting from improving the administrative system, strengthening supervision, to taxing the rich people of the country. 

**) A short version of the article was published in Harian Bisnis Indonesia on 28 September 2021 with the title "Issues on Financial Service VAT"

Harian Bisnis Indonesia, 28 September 2021

Disclaimer! This article is a personal opinion and does not reflect the policies of the institution where the author works.