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This paper provides a legal and economic analysis of the European Commission's recent proposals for reforming the application of VAT to financial services, with particular focus on their 'third pillar', under which firms would be allowed to opt in to taxation on exempt insurance and financial services. From a legal perspective, we show that the proposals''first and second pillars' would give rise to considerable interpretative and qualification problems, resulting in as much complexity and legal uncertainty as the current regime. Equally, an option to tax could potentially follow significantly different legal designs, which would give rise to discrepancies in the application of the option amongst Member States of the European Union (EU). On the economic side, we show that quite generally, when firms cannot coordinate their behaviour, they have an individual incentive to opt in on business-to-business (B2B) transactions, but not on business-to-consumer (B2C) transactions. We also show that opting-in eliminates the cost disadvantage that EU financial services firms face in competing with foreign firms for B2B sales. But these results do not hold if firms can coordinate their behaviour. An estimate of the upper bound on the amount of tax revenue that might be lost from allowing opting-in is provided for a number of EU countries.

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