Managing the Effects of Tax Expenditures on National Budgets
| Author | Zhicheng Li Swift |
| Pages | WPS3927 |
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Managing the Effects of Tax Expenditures on National Budgets 1
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"Even though spending programs show up in the federal budget and tax expenditures are not included as federal spending, taxpayers are paying for the program in either case. Both should be transparent and subject to periodic oversight concerning such factors as whether they meet the program's objectives or conflict with other government programs, grants, and regulations that have similar objectives."
"Understanding the Tax Reform Debate: Background, Criteria, & Questions" Government Accountability Office, The United States, September, 2005
Tax incentives are popular policy measures used in both high- and low- income countries, but there are differences in how high-income and low-income countries deal with them. The high-income countries (most of them Organization for Economic Cooperations and Development (OECD) member states) recognize that a tax incentive is a type of government spending in the form of a tax expenditure. A tax expenditure, a component of the tax system, functionally provides government financial assistance by not collecting tax revenue otherwise due. High-income countries have introduced tax expenditure accounting and subject tax expenditures to normal budgetary controls.
Many low-income countries, even those with high public debt and those in which the majority of the population is below the poverty line (less than US$1 a day), have embraced tax incentives. Their spending in tax expenditures has decreased their revenue received, reducing these countries' capacity to assist the needs of the poor. Ironically, the poor do not benefit from tax incentives because their income is usually below the tax thresholds. None of these countries, so far, use tax expenditure accounting or subject tax expenditures to normal budgetary control. Many other transition economies and developing nations also use tax incentives, but in most cases they have not taken sufficient steps to make tax incentives accountable.
Similar to the differences between high- and low- income countries on tax incentives, there are differences of opinion between tax policy advisers. One group of tax policy advisers recognizes the concept of tax expenditures and understands that tax incentives are tax expenditures. They analyze tax incentives as spending items, using spending terminology. Other tax policy advisers attempt to discuss tax incentives as normative tax provisions. Stanley Surrey's comment on this approach: "A tax expenditure is a spending program and must therefore be analyzed in spending terms. To attempt to discuss the program as if it were a normative tax provision is to disregard this fact." (Surrey and McDaniel, 1985).
This paper analyzes the concept/definition, the size and the effects of tax expenditures, as well as the fiscal accountability and transparency of tax expenditure spending, based on the literature developed by Stanley S. Surrey and Paul R. McDaniel, the experience and practice of the OECD countries (who have dealt with tax expenditures for about 30 years); the Campos/Pradhan fiscal accountability model and the IMF fiscal transparency code. This paper will focus primarily on those developing countries that are Page 2 keen to apply the concept of tax expenditures but lack knowledge and experience2, Section I presents the concept of tax expenditures. Section II discusses the size and the fiscal effects of tax expenditures. Section III discusses fiscal accountability and transparency in tax expenditures. Section IV set forth the building blocks for fiscal accountability and transparency in tax expenditures. Section V concludes.
A tax expenditure, in broad terms, is a tax provision that deviates from a normative or a benchmark tax system. Tax expenditures may take a number of forms: exclusions, exemptions, allowance, deductions, credits, preferential tax rates, or tax deferrals. Tax holidays and tax free zones are tax expenditures subject to specific time periods or geographical areas.
To identify tax expenditures, a normative or a benchmark tax structure must be established. The normative or benchmark tax structure does not contain any tax provisions used to implement government spending programs for favored activities and groups.
"The tax expenditures concept recognizes that a tax system contains two components which are conceptually and functionally distinct, though interwoven, in the tax law. One component contains those provisions necessary to implement the normative tax structure; the other contains those provisions -- the tax expenditure provisions -- whose function and effect are to implement government spending programs" (McDaniel and Surrey, 1985).
The concept of a normative, or benchmark, income tax structure was first introduced in the US in the 1960s. Its analysis is appropriate to any broad-based tax intended for general application, such as a consumption tax (for examples, a retail sales tax, or a VAT), a property tax, or a wealth transfer tax (Surrey and McDaniel, 1985)3.
In a normative income tax structure, the concept of "net income" is defined based on the Schanz-Haig-Simons (S-H-S) economic definition of income as an increase in net economic wealth between two points of time, plus consumption during that period. "Consumption" covers all consumption except that incurred as a cost in the earning or production of income. However, that income concept using the S-H-S approach covers a very wide range of income. In fact, some of the items within the definition of "net income" are not commonly regarded as income for tax purposes, though they fall within this economic definition of income. The S-H-S approach has to be moderated.
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Also, the S-H-S approach does not specify the accounting technique to be used. A practical, commonly-used accounting technique, such as business accounting, must be identified. There are also other elements of a tax structure, such as the taxable unit, rate schedule, accounting period, and the determination of whether the tax base will be inflation-adjusted. There are no normative concepts for these elements. They reflect the decisions that must be made in accordance with fiscal and other policies. Once these decisions are made, any special departures from those decisions constitute tax expenditures.
To summarize, the concept of a normative income tax structure has been established in the US by the application of the S-H-S income concept, business accounting techniques, and the generally-accepted rules on with some exclusions of income (for example, the exclusion of "income" from unrealized appreciation in asset values) (Surrey and McDaniel, 1985). Because many elements of tax structures are decided based on "the generally-accepted rules," the normative income tax structure is also called the benchmark income tax structure.
Countries' tax laws differ in various aspects; so do definitions of normative or benchmark tax structures. As a result, applications of the definitions of tax expenditures (departures from normative tax structures) also differ from country to country (Box 1).
For example, a country may consider child-care expenses a cost of earning income and therefore a part of the benchmark tax structure, while others would consider tax assistance for child-care expenses to be a tax expenditure.
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Box 1. Definitions of Tax Expenditures, Country Examples
Austria: "Government income forgone due to exceptions from the general tax norm to the advantage of other agents with a view to their private activities performed in the interest of the general public."
Canada, using a broad approach: "only the most fundamental structural elements of each tax system are considered part of the benchmark." So that the deviations from tax benchmarks are tax expenditures
France: "Any legislative or administrative measure may be called a tax expenditures if its application entails a loss of revenue from the State, and hence a lessening of taxpayers' burden in comparison to that which would have resulted under the "norm", that is the general principles of French tax law."
Germany: tax expenditures are those tax incentives that are special deviations from the central concept of a tax norm, which involve a...
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