Swedish financial tax: how will it impact you?

Will the proposed financial tax lead to reduced headcount and salaries in the financial industry, or higher interest on mortgage loans?

Amid struggles to balance the budget following the refugee crisis, the Swedish Government is intending to impose a new financial tax from 2018. A tax of 15 % with salaries as tax base has been proposed. Interest deductions for subordinated debt may also be abolished, the government says. Norway is introducing a similar tax taking effect on January 1, 2017.

The Swedish banking industry has criticised the new tax, claiming 16 000 jobs will be lost or moved abroad. That would represent close to 20 % of all jobs in the industry. In that case, many employees have reason to worry.

The Government of Sweden argues that the VAT exemption the financial industry enjoys, leads to a distortion in terms of private overconsumption of financial products. With warnings about a housing bubble and historic household debt levels, imposing a new tax that could remediate the distortion of high private lending and at the same time balance the budget may seem reasonable at the surface. The problems are real and the issues valid, but is the solution prescribed a sign of populism or competence?

Distortions from VAT exemption

The VAT exemption creates a few noteworthy distortions in the economy.

1. Subsidy towards private consumption of financial products, due to lower prices for consumers because of no VAT

2. Distortion in international competition, due to hidden VAT

3. Distortion in domestic competition between industries, due to regulatory leakage / hidden VAT

4. Bias against outsourcing, due to hidden VAT

5. Higher costs for non-financial enterprises, firms invest less, due to hidden VAT

6. Compliance costs etc.

An important term to understand in order to follow the discussion around effects of VAT exemption, is hidden VAT. Companies exempt from VAT (such as banks) cannot deduct the VAT from services and products they buy from other companies. Hence, the higher price they pay due to VAT is passed on in the sense of a hidden VAT, which will increase the prices of end products. Conceptually, it's only the value added to the final product by the bank which has no VAT added to it. It's the lack of VAT on this component that leads to lower prices and a private overconsumption of financial products. In times of high profits, such as these, the VAT-free component is higher and hence the impact of VAT-exemption on private consumption greater. Similarly, companies that would otherwise be able to deduct the VAT component must pay for the hidden VAT component, which leads to an increased cost for non-financial enterprises and less investment. The same mechanism causes a bias against outsourcing.

The effects of a financial tax

The Government emphasises the first distortion and increased tax income as motivations for their proposed financial tax. For the tax to work as intended, i.e. to increase tax income and reduce the distortion 1, the increased cost of labour must lead to higher consumer prices to achieve the objective. The other outcome, which the industry is concerned about, is loss of jobs and competitiveness (and hence also the tax base). Let's consider these two extremes:

Scenario 1: the new tax leads to higher prices. This could be the case with limited international competition and limited possibility to move jobs. The outcome is the following:

· Subsidy towards private consumption (goes down)

· Distortion in international competition (goes up)

· Distortion in domestic competition between industries (goes up)

· Bias against outsourcing (reduced)

· Higher costs for non-financial enterprises, firms invest less (goes up)

Scenario 2: the new tax impacts wages or profits.

· Subsidy towards private consumption (unchanged)

· Distortion in international competition (goes up)

· Distortion in domestic competition between industries (goes up)

· Bias against outsourcing (reduced)

· Higher costs for non-financial enterprises, firms invest less (unchanged)

In reality, a mixture of these two scenarios will happen. It can be concluded with certainty that the competitiveness of Swedish financial industry will weaken and the bias against outsourcing will be reduced. Banks will be incentivised to automate jobs and move them abroad – both are likely possibilities. Private consumers may see increased prices for certain products and so do non-financial firms, although the magnitude depends on the above scenarios. In a time of automation and technological transformation, the banks are incentivised to hurry the process to reduce the headcount. The tax base chosen, salary, is continuously diminishing and possible to influence through relocation of operations. These are not very attractive characteristics of a tax base. To the extent that the intended scenario 1 plays out, politicians can impose a tax on private consumers hidden behind the veil of evil banks. Those supporting a higher taxation on banks may not realise they, the general public, are the ones who will be paying the bill in this best-case scenario. And in the other scenario, there are just no positive effects from the new tax - whatsoever.

There are other solutions that would be better for the Swedish society and business environment. Unfortunately, the current wind of populism renders those solutions unlikely. Read more in this follow-up article.

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