The World Bank J a n u a r y PREMnotes 2 0 0 3 n u m b e r 7 7 Economic Policy Why worry about tax expenditures? Developing and transition economies are increasingly using tax expenditures to pursue economic and social goals. But these instruments are often introduced without full understanding of their potential effects. What should be done? Tax expenditures are concessions that fall effects, tax expenditures should be treated outside tax norms or benchmarks. These similarly to direct government expendi- norms include accounting conventions, the tures--meaning they should be included in structure of tax rates, the deductibility of annual budget reviews and subjected to care- Tax expenditures compulsory payments, provisions to facili- ful fiscal analysis. tate tax administration, and norms related are deviations to international fiscal obligations. Tax Benefits and drawbacks expenditures are deviations from these The literature identifies several pros and from tax norms norms, implemented to encourage behav- cons of tax expenditure programs. Posi- ior deemed desirable by policymakers, and tive aspects include: can take a number of forms--including tax · Encouraging private sector participation exemptions, allowances, credits, deferrals, in social programs. and relief (see OECD 1996). The classic · Promoting private rather than govern- example is a tax deduction for charitable ment decisionmaking. contributions, where the reduction in tax · Requiring less government oversight of revenue is more than offset by the increase such spending. in support for charitable activities. Most of the drawbacks of tax expenditure Tax expenditures are not a free lunch, programs are related to their potential inef- however. They can lead to inefficiencies and ficiencies and inequities, including: inequities, stimulating no additional activ- · Paying beneficiaries to engage in activi- ity and making the tax regime more regres- ties they would engage in anyway, stim- sive. For instance, a tax concession granted ulating no additional activity. to employers who hire unskilled workers · Narrowing the tax base, limiting the might go to employers who would have scope for tax rate reductions. hired such workers anyway. Tax expendi- · Providing open-ended opportunities for tures also affect government budgets, government spending, making it more because they imply forgoing revenue that difficult to project tax revenues. could be used to fund direct government · Making tax laws more complex, increas- expenditures. ing the cost of enforcing them. But unlike direct expenditures, tax · Making government spending non- expenditures are fully funded before dis- transparent and free from budget cretionary programs and are open-ended scrutiny. entitlements. Once tax expenditures are · Making the tax system more regressive-- enacted, they usually come under little for example, by excluding nontaxpayers, scrutiny and are rarely repealed. This note who are among the poorest members of argues that, to minimize their downside any society. from the development economics vice presidency and pover ty reduction and economic management n e t w o r k Horizontal and vertical Managing tax expenditure inequalities programs Horizontal inequality between taxpayers As noted, tax expenditures affect govern- emerges when tax expenditures allow ment budgets because they are de facto sub- people with similar incomes and expenses stitutes for direct government expenditures. to pay different amounts of taxes depend- But unlike direct expenditures, tax expen- ing on whether they engage in tax-subsi- ditures are usually approved outside the dized activities--as, for example, with tax budget, not subject to annual budget credits for college tuition payments, which reviews, open-ended (without spending ceil- benefit only taxpayers who pay college ings), and not subject to sunset clauses. This tuitions. Different tax liabilities for similarly implies that tax expenditures are subjected situated taxpayers violate horizontal equity. to softer spending constraints than those Tax expenditures Similarly, vertical inequality emerges imposed on direct expenditures. when not all taxpayers qualify for tax reduc- Strengthening the administration of tax affect government tions that require minimum spending. expenditure programs is an important first Moreover, even if taxpayers with lower step toward ensuring their effectiveness, effi- budgets because expenditures still qualify, they obtain fewer ciency, and equity. For instance, over the tax benefits because the value of the bene- years OECD countries have increased their they substitute fits increase with the taxable income level. scrutiny of tax expenditures toward levels This setup implies that tax expenditures dis- normally applied to direct expenditures. for direct proportionately benefit higher-income One of the best practices comes from groups, making the tax system less pro- Canada, which integrates tax expenditures government gressive and violating vertical equity. into the budget review process by including The inequities of tax expenditure pro- them in the overall expenditure envelopes expenditures grams can be seen by examining the effec- for each government function (for example, tive tax rate, defined as the ratio of an the economic development envelope, the individual's actual tax payments to actual social development envelope, and so on). At income. Here actual income is essentially the planning stage, federal tax and direct the income figure used on tax returns expenditure programs are split into "enve- increased by income excluded from the lope" targets. The ministers responsible for income tax and by taxable income offset by the programs under these envelopes are also personal exemptions and deductions. In responsible for meeting these targets. If they Poland in 1997 higher-income taxpayers want to expand certain programs or pursue (income brackets 2 and 3) paid much lower new initiatives, they must cut back on other effective tax rates (relative to statutory rates) programs. This approach avoids the risk of than did low-income taxpayers (table 1). ministers escaping direct expenditure limits Table 1 Effective personal income tax rates in Poland, 1997 (thousands of zlotys except where otherwise indicated) Exemptions Deductions Effective Effective rate/ Income bracket, Taxable from from Actual Taxes tax rate statutory rate statutory rate income income tax income tax income paid (percent) (percent) 1, 20% 171,722,513 3,136,473 2,485,172 177,344,158 25,168,838 14 71 2, 33% 27,741,684 1,189,689 896,722 29,828,095 4,733,368 16 50 3, 44% 24,553,612 2,089,551 1,027,193 27,670,356 6,875,381 25 56 Note: Data are totals for each income bracket. Actual income is the sum of taxable income, exemptions, and deductions. Effective tax rate is calculated by dividing taxes paid by actual income Source: Poland Ministry of Finance 1998; World Bank staff estimates. PREMnote 77 Januar y 2003 by proposing new or expanded tax expen- on tax expenditures as part of the report diture programs. Although ministers can still appended to the finance bill presented propose new or expanded tax expenditure before Parliament. programs, the fiscal cost of these programs is Another reason for subjecting tax expen- debited against the overall envelope spend- diture programs to scrutiny and control is ing limit. This "envelope target" approach the effect they have on the tax system, provides a level playing field between direct because the number and size of these pro- and tax expenditure programs. grams affect the tax rates required to gen- Although scrutiny of tax expenditures in erate a desired net tax revenue. Tax other OECD countries has not reached the expenditure programs reduce the effective levels in Canada, there are still substantial tax schedule across income tax brackets, reporting requirements. The U.S. govern- reducing overall tax revenue (figure 1). ment, for example, produces an annual Only when tax expenditure programs com- Tax expenditures report on tax expenditures that is included pete on a level playing field with direct in the Congressional budget process. The expenditures can policymakers have a yard- should be U.S. Department of Energy reports on tax stick against which to measure the oppor- expenditures affecting the energy industry, tunity costs of these programs. subjected to the with information on the main beneficiaries (natural gas and ethanol producers) and Conclusion same scrutiny estimates of total costs. In addition, several Tax expenditures hold an attraction for pol- U.S. states--including California, Massa- icymakers as a way to stimulate markets and as direct chusetts, and New York--require that bud- encourage certain behavior among tax- get proposals include tax expenditures and payers. But 25 years of experience with tax expenditures estimates of their costs, listed according to expenditure programs in OECD countries the taxes to which they pertain. suggest that policymakers need to guard As part of budget estimates, Germany's against these programs' potential down- federal government submits a report on sides. To minimize their risks, tax expen- tax concessions to Parliament and the Fed- ditures should be subjected to the same eral Council every two years. And France's scrutiny as direct expenditures by being government publishes an annual report included in annual budget reviews. Figure 1 Statutory and effective personal income tax rates in Poland, 1997­98 Percent 50 40 30 20 10 0 Tax bracket 1 Tax bracket 2 Tax bracket 3 Statutory tax rate, 1997 Effective tax rate, 1997 Statutory tax rate, 1998 Effective tax rate, 1998 Source: Poland Ministry of Finance 1998. PREMnote 77 Januar y 2003 Further reading United States." Working paper. Organi- Atkinson, Paul, and Paul van den Noord. sation for Economic Co-operation and 2001. "Managing Public Expenditure: Development, Paris. Some Emerging Policy Issues and a IMF (International Monetary Fund). 2001. Framework For Analysis." Working paper. Fiscal Transparency Manual. Washington, Organisation for Economic Co-operation D.C. and Development, Paris. OECD (Organisation for Economic Co-oper- Bird, Richard, and Oliver Oldman. 1990. ation and Development). 1996. "Tax Taxation in Developing Countries. Baltimore, Expenditures: Recent Experiences." Paris. Md.: The Johns Hopkins University Press. ------. 2001. "OECD Best Practices for Bud- Burns, Andrew, and Kwang-Yeol Yoo. 2002. get Transparency." Paris. "Improving the Efficiency and Sustain- Poland Ministry of Finance. 1998. "Analy- ability of Public Expenditure in the Czech sis of Current Tax System, Proposals for Republic." Working paper. Organisation Changes." White Paper for Taxes. Warsaw. for Economic Co-operation and Devel- opment, Paris. This note was written by Zhicheng Li Swift Cavalcanti, Carlos, and Zhicheng Li. 2001. (Research Analyst, PREM Unit, Europe and Cen- "Reforming Tax Expenditure Programs tral Asia Region) and Carlos B. Cavalcanti in Poland." Policy Research Working (Senior Economist, PREM Unit, Latin Amer- Paper 2465. World Bank, Washington, ica and Caribbean Region). D.C. If you are interested in similar topics, consider Herd, Richard, and Chiara Bronchi. 2001. joining the Quality of Fiscal Adjustment Thematic "Increasing Efficiency and Reducing Group. Contact Thomas Blatt Laursen (x38350) Complexity in the Tax System in the or click on Thematic Groups on PREMnet. This note series is intended to summarize good practice and key policy find- ings on PREM-related topics. The views expressed in these notes are those of the authors and do not necessarily reflect the views of the World Bank. 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