Tax Expenditures Drain Revenues Needed for Development

Reducing tax incentives can lead to better revenue management and contribute to domestic resource mobilization. Photo credit: ADB.

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Published: 30 September 2022

Data analysis and tax transparency can guide governments in rationalizing their tax expenditure policies while still creating a level playing field for businesses.

Introduction

Tax expenditures, in particular investment tax incentives, are widely used in Asia and the Pacific. These tax concessions are often introduced with the policy objective of attracting domestic and foreign investments, creating new jobs, and promoting sustainable economic growth. In practice, they represent a significant revenue loss for governments without providing visible value for money in most cases.

For many Asian Development Bank (ADB) member countries, the economic impact and net benefits of tax expenditures are poorly understood. In ADB’s workshops and surveys, senior tax experts from developing member countries identified rationalizing tax expenditures as a priority policy reform for raising tax revenues for the following reasons:

  • Tax expenditures are ineffective in achieving a country’s policy objective, distort the level playing field between businesses, create opportunities for tax abuse, and come with high compliance and administrative costs for tax administrations.
  • Tax expenditures often lack transparency and accountability. In many countries, these are granted by a variety of government agencies operating outside the Finance Ministry. This makes tax incentives susceptible to corruption and rent-seeking behavior, especially when they are discretionary and granted without institutional oversight or review.
  • Data on tax expenditures are not published on a regular basis. There is a lack of a framework for measuring the costs and benefits of tax expenditures, as well as their impact on economic behavior.
Rationalizing Tax Policies

The coronavirus disease (COVID-19) pandemic pushed 80 million people in Asia and the Pacific into extreme poverty, rolled back decades of progress on sustainable development, and forced developing Asian countries to spend trillions on protecting their economies. Governments continue to require sufficient financial resources to contain the spread of COVID-19, procure safe and effective vaccines, and get their economies back to on track. 

ADB President Masa has proposed tax measures to help developing countries get back on track, including minimizing tax expenditure (foregone taxes), increasing green and health taxes, improving value-added tax (VAT) collection, especially from the expanding digital economy, and strengthening personal income and property taxes.

ADB has assisted member countries in reforming their tax reform policies. These include Armenia, Azerbaijan, and the Philippines.

Armenia

The government of Armenia faces significant fiscal challenges, which increase the need to strengthen domestic resource mobilization. The COVID-19 pandemic and the recent conflict have severely impacted the economy.

The government’s tax reform strategy includes a commitment to develop deeper analysis of the impact and interaction of existing tax incentives through cost–benefit analyses to assure their purposeful and targeted application. This will help the government to make informed policy decisions on reducing the scope of tax expenditures while creating a more level playing field for all types of businesses.

ADB has conducted a policy review and economic analysis on VAT-related expenditures and on the presumptive tax regime for small- and medium-sized enterprises. It developed a Tax Expenditure Impact Analysis Model, which provides an analytical framework to assess the fiscal and social economic impact of VAT exemptions and zero-rating compared to a counterfactual of fully taxing such items. It provides a methodology for measuring the impact on consumption and household income, although the accuracy of results will depend upon the accuracy and availability of user inputted data. The model can demonstrate the impact of VAT expenditures for each income percentile, taking into account how consumption is distributed across income percentiles and certain other assumptions.

The analysis shows that VAT exemptions are an ineffective instrument for income redistribution. Exemptions that are designed to make certain goods and services more accessible and affordable for low-income households, such as healthcare and education, come with a significant price-tag for governments and the reduction may not be passed on to the consumer. Even in the event of full pass-through, tax expenditures often disproportionally benefit higher-income households.

Azerbaijan

The Azerbaijan government, with ADB technical assistance support, has developed economic tools for rationalizing tax expenditures, which quantify the revenue at stake and analyze their economic impact. There are 219 tax expenditures in the tax code in the form of exemptions, deductions and reduced tax rates, and special economic zones. 

The analytical tools include micro-simulation models to estimate the revenue forgone from concessions on major taxes (corporate income tax, personal income tax, and value-added tax) using taxpayer data or survey data collected by the statistics agencies. A marginal cost of public funds methodology was developed to estimate the economic benefits (welfare gain) of tax expenditures under all major taxes.

Staff were trained on the definitions of tax expenditure, preparation of tax expenditure reports, and estimation of the revenue impact of tax expenditures. A register was also established to record all the corporate beneficiaries of tax expenditures, including data on the operations of the businesses.

Philippines

Following years of diligent work, the Philippines enacted the reform of its tax incentives in April 2021. The law terminates existing incentives but with quite generous “sunset” provisions. Future incentives will be reviewed by a Financial Incentive Review Board chaired by the Secretary of Finance. 

There is hope that the appetite for tax incentives has been reduced and that transparency of tax expenditure reports will ensure better management of tax revenues and contribute to domestic resource mobilization.

Prior to the new law, the system in place was complex, opaque, very generous, poorly targeted, and resistant to political and legislative change. With 342 investment and non-investment laws that provided incentives outside the tax code, and 13 investment promotion agencies that had the authority to grant exemptions without disclosing the names of firms and the amount of incentives given, the Philippines’ tax incentive system lacked transparency and accountability.

The revenue foregone had been increasing year on year—and despite tax incentives being generous and open-ended, the benefits were absent.

  • In 2017, over 441 billion Philippine pesos (2.8% of GDP) was granted to only 3,150 firms.
  • An estimated PHP63 billion (0.4% of GDP) was lost due to possible abuse of transfer pricing and misallocation of profits and costs. 
  • Export competitiveness was in decline, and foreign direct investment was lower than neighboring countries. 
  • Counterfactual analysis showed no significant difference in performance between firms receiving incentives and those that did not. 
Promoting Evidence-Based Policy Making

ADB has been working closely with developing member countries and the Organisation for Economic Cooperation and Development (OECD) to promote evidence-based policy making, including assessing the effectiveness of tax expenditures. 

Data availability has been recognized by developing countries in Asia and the Pacific as critical for tax reform. For many, a key step has been publishing their national tax statistics. ADB has partnered with OECD in building the Tax Statistics for Asia and the Pacific database. 

Publication of data on tax expenditures is essential for tax transparency. The work by the Philippines shows that it has the key analysis skills in place—informed by studying international best practices, and it has generously shared its experience in ADB’s regional forum. ADB’s work in Central and Western Asia also brings together economists and tax policy experts to work with and transfer skills and tools to the fiscal policy units.

ADB will build on its work in developing member countries to develop knowledge products and support peer-to-peer learning to provide wider support. This initiative is being echoed by other development organizations. A recent innovation is the Global Tax Expenditures Database, which will provide a welcome benchmarking tool.

The COVID-19 pandemic offers an impetus for countries to rationalize tax incentives, as does the recent international agreement endorsed by the G20 on a common minimum effective corporate tax rate under the Pillar Two solution. 

As the lockdowns recede, there is a growing momentum to develop fiscal strategies for reform, including managing the transition to a carbon-free economy. While tax incentives may have a role here, these need to be based on good practice—bearing in mind that direct expenditure may be better than foregoing revenue. While sustainable reforms will be challenged by the addiction to tax incentives that persists in many countries, the primary treatment for that is transparency.

This article is based on a presentation by Y. Miyaki on “Tax Expenditure Reform, Perspectives from ADB Technical Support” at the DIE-ATI-CEP 9th International DRM Workshop on Tax Expenditures and Domestic Revenue Mobilisation.

Yuji Miyaki
Public Management Specialist (Taxation), Central and West Asia Department, Asian Development Bank

Yuji Miyaki works in the areas of development and implementation of policies on public finance and capacity development in the Central and West Asia. Prior to joining ADB, he was with the Ministry of Finance and the National Tax Agency in Japan. His international tax policy work includes negotiating tax treaties, designing international taxation through tax law and regulation revision, and participating in international tax policy discussions. He also worked as an administrator at the OECD Centre for Tax Policy and Administration.

Sissie Fung
International Tax Policy Specialist (Consultant), Asian Development Bank

Sissie Fung provides technical assistance on tax policy and administrative reform to enhance domestic resource mobilization. She has conducted benchmarking and diagnostic studies, designed capacity building workshops, tax expenditure review and analysis, and environmentally-related taxes and strategies for effective tax reform for countries in Asia and the Pacific. She holds a master’s degree in Private and Notary Law and Tax Law from the University of Groningen.

Brian McAuley
International Tax Administration Specialist (Consultant), Asian Development Bank

Brian McAuley is an independent tax administration adviser working with ADB since 2014. He also works with other international organizations. His work focuses on domestic resource mobilization through reforms on tax policy and administration.

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The Asian Development Bank is committed to achieving a prosperous, inclusive, resilient, and sustainable Asia and the Pacific, while sustaining its efforts to eradicate extreme poverty. Established in 1966, it is owned by 68 members—49 from the region. Its main instruments for helping its developing member countries are policy dialogue, loans, equity investments, guarantees, grants, and technical assistance.

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