1 How to Deal with Tax expenditures: Policy Options Minimize the use of tax expenditures! Compared to more developed countries, countries that suffer from weaknesses in public finance management and in governance more broadly, experience greater negative effects of tax expenditures (including ineffectiveness, inefficiency, revenue loss, and murkiness). Hana

2 Tax expenditures may be harmful if not anchored in a good public finance management system Adequate institutional arrangements and capacity to expose tax expenditures to scrutiny of their n fit with policy objectives n potential macro impact (revenue loss) n distributional impact n relative efficiency are needed to reduce the likelihood that tax expenditures become an avenue for serving special interests A coherent tax system and capable tax administration are needed to prevent tax expenditures from further eroding tax compliance. Hana

3 Therefore, countries should keep the use of tax expenditures and other off-budget spending mechanisms, such as contingent liabilities, to the very minimum – by law – before they meet some benchmarks of institutional development. And, as part of public finance management reforms, institutions need to extend their coverage to cover tax expenditures (the same argument as has been followed for contingent liabilities in recent years). Hana

4 But tax expenditures are common in developing and emerging market economies Investment incentives in transition countries (2001) HungaryPolandCzech RSlovakiaLatviaLithuaniaBelarusUkraineSlovenia Tax holidays X XX XX Profit exemption X X X X Acceler. deprec. X Invest. allowance X X Tax credit X XX Customs exemption XXXXX VAT deferral X Special zones XXXnaXXXXX Source: OECD (2003): Tax Policy Assessment and Design in Support of Direct Investment Hana

5 … and experience has not been good Recent studies of current and past incentive use in transition countries show that:  most transition countries first launched an array of tax incentives to target foreign investors, later made adjustments toward national treatment (mainly out of concerns over negative consequences of denying incentive relief to domestic investors and out of recognition that in practice foreign investors are the main beneficiaries of direct tax incentives)  revenue loss has been of such a magnitude as to disrupt budget management and fiscal planning  tax incentives have largely been unsuccessful in encouraging new capital formation (confirmed by investor survey findings) Hana

6  it is unlikely that additional investor activity has been of the scale required to more than offset direct and indirect revenue losses to targeted and unintended recipients (this is based on general findings of the efficiency of tax incentives and of the difficulties in administering tax incentive programs in countries with weak tax administration systems)  investors place greater value on stable and predictable policy environment and transparent administrative practices, that is the basics of a good business climate, rather than tax incentives (confirmed by investor survey findings) Hana

7 What could be done? Reporting The IMF Fiscal Transparency Code sets an example. Currently, only very few countries other than a number of OECD countries report tax expenditures. A simple compilation could include information on each tax expenditure, its objective, nature and legal basis. Reporting should not be held hostage to complicated estimation methodologies. Although government’s view on the originally expected and actual effects, both in policy and fiscal terms, would be useful... … even a simple compilation would allow academics and the civil society, to develop their own assessment. This, in turn, would broaden public understanding of government fiscal performance. Hana

8 Scrutiny The existing and newly proposed tax expenditures need to be discussed as part of the budget process. Annually, the existing tax expenditures would be exposed to scrutiny in the context of the government’s overall fiscal policy analysis. For both the existing and new tax expenditures, scrutiny could be built around five questions:  What is the root problem that needs to be corrected?  To correct this problem (achieve the respective objective), how big a budgetary allocation would be justifiable?  What is the most efficient way to achieve the stated objective?  What are the likely fiscal and socioeconomic effects?  How should the program be designed to minimize possible negative effects? Hana

9 Integrating tax expenditures with the budget process and the medium term fiscal framework, however, is proving to be challenging, perhaps more challenging than it has been for contingent liabilities. Innovative approaches may need to be worked out to:  address the methodological and technical issues related to tax expenditure analysis  overcome the typical institutional obstacles, such as the division of revenue and spending responsibilities among a number of separate government agencies and legislative committees, and make fiscal policy decision-making more cohesive across the different activities of fiscal nature Hana