Tax policies are critical to the sound development of most segments of finance, yet taxation is a highly complex and country-specific matter within which the issues relating to
the financial sector cannot ever be fully isolated. A full analysis of taxation issues will normally be outside the scope of financial sector assessments, but each sectoral review should be alert to particularly important tax aspects and should take a cross-cutting overall view of how urgent or important it is to correct the most prominent distortions (Honohan 2003).
Taxation policies should aim at broad neutrality between similar financial products and services, especially between identical products provided through different institutional forms. The tax burden on financial intermediation should be commensurate with that on other sectors. Tax design should avoid sensitivity to the inflation rate. Financial transaction taxes have been used in several countries with weak fiscal systems as a means of tapping revenue quickly. Though they can be effective in the short run, they should be scrutinized for the degree to which they are being arbitraged away (eventually resulting in transactions costs rather than tax revenue), with the remaining revenue having an unintended and perhaps regressive incidence. Although the application of a value added tax (VAT) to financial services raises administrative complications that are unlikely to be overcome in low – or low-middle-income countries, a theoretical VAT does represent a useful benchmark against which to measure and compare the actual financial tax burden on intermediation and other financial services. This comparison can be especially useful in checking how inflation-proof the financial tax system is.
In some respects, especially through quasi-taxes that masquerade as regulations (such as unremunerated reserve requirements), finance has been overtaxed in many countries. But it is the removal of such special impositions that will be beneficial, not the creation of special privileges. Special pleading by financial sector participants must be treated with a degree of skepticism in this regard: Neutrality, rather than tax-based incentivizing of particular markets or institutions, is preferred. Instead of attempting to use financial sector taxes as “corrective instruments” in this way, the authorities would be well advised to concentrate on making the financial tax system as arbitrage-proof and as inflation-proof as is practicable.
Subsidy of finance creates damaging distortions and can have a chilling effect on the development of more-effective and less-corruptible commercial substitutes for the product or market being subsidized. Such distortions are especially relevant in the context of government-sponsored providers of financial service, providers whose activities may undercut private provision without delivering adequate quality. Detailed examination of credit programs from government agencies will typically be beyond the scope of financial sector assessments, but a general awareness of these and similar subsidies needs to inform analysis of the missing market issue and of the performance of the nearbanks in particular.