Rationalising Tax Expenditures – a Core Element of Financing for Development

The Fourth International Conference on Financing for Development (FfD4) needs to address the issue of tax expenditures. These preferential tax treatments cause huge immediate public revenue losses while their effectiveness is often in doubt.

Governments worldwide use preferential tax treatments – called tax expenditures – to pursue different policy objectives, such as attracting investments, promoting employment, fighting poverty or curbing greenhouse gas emissions. According to the most recent data from the Global Tax Expenditures Database (GTED), revenue forgone from such preferential tax treatments amounted to 4 percent of GDP and 23.8 percent of tax revenue in 2021. It is very likely that the real numbers are significantly higher, as non- and underreporting is widespread.

Evidence generated by reports, evaluations and academic research reveals that tax expenditures are often ineffective in achieving their stated goals. In fact, they can even be counterproductive or harmful, for instance by creating negative externalities with regard to other policy objectives and third countries. At a moment when governments worldwide are desperately looking for funds to finance policies that help them meet the Sustainable Development Goals (SDGs) and the commitments made under the Paris Agreement, reforming or dismantling ill-designed tax expenditures should become a priority worldwide.

All too often, however, ineffective or harmful tax expenditures are maintained. Lack of reliable information about the fiscal impact of tax expenditures and their effects, but also about the tax expenditure regimes of other countries, is one of the factors that play a critical role in this regard. Consequently, more transparency on the use of tax expenditures, and more consistency in categorising and evaluating them are cornerstones of any national and international effort to address this key dimension of taxation and development financing, which has been widely neglected so far. The Zero Draft of the FfD4 Outcome Document acknowledges this by stating: “We also commit to increase transparency and improve oversight and management of tax expenditures, and to implement minimum standards for tax expenditure reporting”.

Transparency in tax expenditure use serves several purposes.

1. Given their significant impact on public coffers, estimating and reporting on tax expenditures is necessary for governments to gain a complete picture of public finances and to increase the reliability of their revenue forecasts.
2. Governments that publish reports on tax expenditures dedicate major efforts to the collection of data and information that might otherwise remain dispersed across a large number of governmental bodies. Thus, governments themselves, and policy-makers in particular, are the first to benefit from transparency as these data are key to evidence-based policy making.
3. Since tax expenditures are so widely used across the whole tax system, any public debate on taxation gains from access to such information. In this context, transparency may also contribute to preventing state capture and strengthening the governance of tax policy-making.
4. Transparency is also relevant with regard to international tax competition. While governments usually find it easy to get access to information on tax regimes of other countries, this is significantly more challenging with regard to tax expenditures. As so-called “harmful tax competition” relies to a large degree on the use of tax expenditures that erode other countries’ tax bases, access to information on this aspect is key to sustain talks on the rationalisation of tax expenditures on an international scale.

Governments should publish regular reports covering all the tax expenditures they use. They should provide information on the legal basis of the measures, their objectives and intended target groups, as well as the revenue forgone those measures generate. This information should be made available to the parliament at the moment of annual or semi-annual budget debates and linked to the government’s budget proposal. The Global Tax Expenditures Transparency Index (GTETI), launched in 2023, is based on a set of five dimensions and 25 indicators that together establish an ambitious, yet manageable framework for good tax expenditure reporting. The average overall GTETI score based on 105 assessed countries stands at 47.5 out of 100, which illustrates the need to improve the quality of tax expenditure reporting worldwide.

Transparency is a necessary condition for the rationalisation of tax expenditures, but it is certainly not a sufficient one. Consistency is a second dimension that governments need to take into account. It refers to the application of shared standards and regulations that govern the definition of tax expenditures, their evaluation and the estimation of revenue forgone – both domestically and internationally.

One important factor to take into account in this regard is the fact that tax expenditures are always granted upon a national benchmark system. The way how benchmarks are being defined and tax expenditures categorised differs widely across countries, but also across time within many countries. Lack of consistency in the identification of tax expenditures leads to uncertainty, adds to the complexity of tax systems and may undermine evidence-based fiscal policy. An international glossary and check list could assist governments to properly identify the tax expenditures they use and document major changes over time. In addition, governments should seek consistency in how they estimate revenue forgone. In recent years, several international organisations have set up toolkits or manuals that provide guidance in this regard. Not least, if the competencies of setting up and operating tax expenditures are spread across a large number of governmental bodies, policy consistency might be difficult to achieve.

To sum up, the Fourth International Conference on Financing for Development (FfD4) needs to note, and take action upon, two basic facts:

1. Tax expenditures are a hugely relevant, and so far widely neglected, element of public finance. Any efforts to make public revenue and expenditure systems fit for purpose for the challenges of the next decades must take tax expenditures into account. The international community should agree on minimum standards of public tax expenditure reporting, such as those laid out by the GTETI. In addition, governments should commit to regular and comprehensive evaluations of the tax expenditures they use, making sure that the results of such evaluations are published and fed into the policy making process.
2. While tax expenditures are typically set up and operated by national (and, in some cases, subnational) governments, they often impact on third countries. Hence, it is vital to consider them an object of international policy requiring proactive and concrete actions to enhance coordination similar to other elements of national tax policies. Public disclosure of tax expenditures, including estimates of revenue forgone, can help protect countries from harmful tax competition through base erosion and profit shifting.

 

This blog post is part of a series on the 4th FfD conference by the German Institute of Development and Sustainability (IDOS). Please also read the previous contributions to this series:

• Forging Consensus: Navigating Trade Controversies in the FfD4 Zero Draft, by Clara Brandi
• Cumbersome but Essential – The United Nations Financing for Development Process Ahead of its 4th Conference, by Kathrin Berensmann, Clara Brandi, Sören Hilbrich, and Yabibal Walle