The banking crisis of 2008-2009 was very costly to national public finances – in some countries, it was ruinous. As governments try to regain their fiscal footing, the spotlight naturally turns to the fiscal contribution made by the financial sector. There are several reasons to believe that banks are currently under-taxed. Their crises have large negative effects on the overall economy, they benefit from underpriced bail-out guarantees, they receive cheap central-bank funding, and, not least, in the EU they enjoy low value-added taxation (VAT) in the form of the VAT exemption.1

Last year, the G20 asked the IMF to assess the options available to policymakers to ensure that the financial sector makes a fair and substantial contribution to government revenue. The IMF (2010) came out in favour of a new tax dubbed the Financial Activities Tax. This tax would apply to the combined profits and wage bill of financial institutions. Thus, the Financial Activities Tax is a broad tax on income generated in the financial sector, which has the advantages that it does not discriminate among various financial-sector activities and is able to generate considerable revenue at low tax rates. The base of the Financial Activities Tax amounts to the financial sector's value added so that this tax corrects for the current under-taxation of the financial sector through the VAT. The European Commission (2010) has announced that it is now conducting an impact assessment study of the Financial Activities Tax, among other financial taxes. Next, the European Commission may publish a proposal for a directive to coordinate financial-sector taxation such as a Financial Activities Tax.

A meaningful impact assessment of the Financial Activities Tax requires insight into how this tax is likely to affect the pricing and volume of financial-sector activities. Direct evidence on this is impossible to obtain, given that this tax has not yet been tried. Indirectly, however, we can learn about the likely impact of a Financial Activities Tax by considering how banks currently respond to the international taxation of corporate income. The corporate income tax, like the proposed Financial Activities Tax, is a tax on income generated in the financial sector, even if the corporate income tax has a narrower base. Corporate income taxation in an international context provides for considerable variation in applicable tax rates, as is potentially the case with a future Financial Activities Tax.

In a new paper (Huizinga et al. 2011), we investigate how the international taxation of banking income affects banking-sector pricing and volumes. Foreign-owned banks often face additional taxes on their profits. These additional taxes, imposed by foreign and home countries alike, tend to vary considerably. The international double taxation of banking income depends on the ownership of a bank, providing an ideal opportunity to measure the impact of income taxation on the banking sector. Our study covers multinational banks in a sample of 38 countries over the 1998-2008 period.

The international double tax rate on foreign-source income is 3.5% on average. This additional taxation of international banking is considerable, compared to an average domestic corporate income tax rate of 36.1%. We find that the burden of international double taxation is almost fully passed on to a bank’s lending and depositor customers in the form of a higher bank interest margin. An estimated 86.2% of the additional international tax is reflected in higher bank interest margins abroad, while only 13.8% of this tax appears to be borne by bank shareholders.

Multinational banks – subject to high double taxation – are able to achieve higher interest margin by restricting their supply of financial services abroad, apparently exploiting some market power. We estimate that an increase in the international double tax rate by 1 percentage point causes multinational banks to reduce their banking assets abroad by 7.1%. Multinational banks similarly operate fewer foreign subsidiaries in highly-taxed foreign environments. A higher international double tax by one percentage point reduces the number of foreign banking subsidiaries by 3.2%.

Large pricing and volume responses to international double taxation in the banking sector mean that such taxation is highly distortive, as taxation evidently is a major factor in determining local financial-sector activity.

Our investigation of international corporate income taxation has two main implications for a future Financial Activities Tax.

First, banks are likely to pass on the burden of this tax almost completely to their customers through higher bank interest margins and bank fees. This makes the Financial Activities Tax a tax on bank customers rather than on bank shareholders. This notwithstanding, the Financial Activities Tax is an appropriate instrument to reduce or eliminate the current under-taxation of banks.

Second, a Financial Activities Tax potentially leads to a large dislocation of financial activity, especially if it is levied with widely varying tax rates. The Financial Activities Tax rate is likely to be determined at the national level, with the potential of substantial variation in tax rates across countries. Furthermore, applicable tax rates could in practice vary across financial institutions in the same country, which would be even worse. (Within-country tax rate variation arises if a Financial Activities Tax fails to cover all bank-like financial institutions.) Also, tax rates can differ within the same country, if the Financial Activities Tax is levied based on the international ownership of the bank – as is currently the case with the corporate income tax.

A Financial Activities Tax should be designed so as to minimise the scope for financial-activity dislocation stemming from tax rate differentials. To this aim, a well-designed Financial Activities Tax should:

  1. be levied at comparable rates internationally,
  2. cover all bank-like financial institutions in a country, and
  3. apply only to financial-sector income generated domestically, thus exempting foreign-source, financial-sector income from domestic taxation.

De la Feria, Rita and Ben Lockwood (2010), “Opting for opting-in? An evaluation of the European Commission’s proposals for reforming the VAT on financial services”, Fiscal Studies, 31:171-202.

European Commission (2010), “Communication on the taxation of the financial sector”, Brussels.

International Monetary Fund (2010), “A fair and substantial contribution by the financial sector”, Final report for the G20.

Huizinga, Harry, Johannes Voget, and Wolf Wagner (2011), “International taxation and cross-border banking”, CEPR Working Paper 7047.


1 See De la Feria and Lockwood (2010) for a discussion of the VAT treatment of banks in the EU.


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