Tax expenditures can be defined as tax provisions that constitute a deviation from a benchmark tax system, resulting in reduced or postponed tax liabilities. They can take several forms, including tax exemptions, deductions, credits, and reduced rates, among others. These reductions effectively serve as a form of government spending by reducing government revenue. Between 1990 and 2020, revenue forgone from tax expenditure globally varied between 3.3% and 4.9% of GDP. As such, it is a material area for governmental budgets.
Tax expenditures are designed to achieve a wide range of policy objectives, including to encourage investment, promote social goals, and provide compensation. However, tax expenditures have low visibility in budget processes, they are difficult to quantify and forecast, and their effectiveness can be difficult to evaluate. These characteristics contribute to countries accumulating a large number of them over time, which can pose risks to the fiscal management and sustainability of public finances.
This paper builds on existing OECD analysis by considering the role of tax expenditure from budgeting and fiscal management perspectives. It adopts a case study approach by analysing four OECD Member countries: Canada, Ireland, the Netherlands and the United Kingdom. The analysis and insights from this paper also contribute to the OECD Restoring Public Finances initiative.
Tax expenditures are a challenging topic, particularly as the definition and measurement of tax expenditures, as well as definition of benchmark tax systems, varies from country to country. To better understand these challenges in relation to budgeting and fiscal management, this paper considers the treatment of tax expenditures in budgets, the spending limits that apply, and the way in which tax expenditures are reported, evaluated, and scrutinised.
Within budget processes, the treatment of tax expenditures and direct expenditures tend to differ. For instance, tax expenditures are included in revenue forecasts and direct expenditures are included in baseline estimates. Furthermore, they are generally not explicitly identified within these revenue forecasts as the forecasts are prepared net of tax expenditures.
The treatment of refundable tax credits deserves a special mention. These credits are a specific type of tax expenditure that provides a refund when a taxpayer owes no tax, or when the credit exceeds the amount of taxes owed. Most case study countries record refundable tax credits as expenditure. However, they are not always treated as direct expenditure in budget processes, as tax credits do not necessarily form part of the expenditure appropriations for a ministry and are instead held by the tax administration authority.
For spending limits, fiscal rules and objectives specifically for tax expenditures are rare. Despite this, several fiscal rules encompass tax expenditures alongside direct expenditures. These generally include deficit ceilings and budget balances, although the Netherlands is a notable exception amongst the case study countries in that it sets monetary limits for certain tax expenditures.
All four case study countries have dedicated reports on tax expenditure. These reports provide in-depth information relative to budget documentation, and generally include cost projections, a description of the policy objective, description of the tax expenditure’s history, the quantification of revenue foregone. In some cases, they also explain why the measure is not included in the benchmark, and whether it is subject to a sunset clause. The publication of tax expenditure reports varies and is not always co-ordinated with budget processes.
All four case study countries also have systems to evaluate tax expenditures. In line with general recommendations, these systems evaluate the purpose of the tax expenditures and contain findings on whether the tax expenditures are meeting their intended purposes, and whether they should be maintained, amended or removed. At the same time, the evaluation systems do not necessarily result in a systematic approach to evaluating all tax expenditures over time, which can limit the information available on the fiscal impact of tax expenditures.
Parliamentary committees and oversight organisations, specifically independent fiscal institutions and supreme audit institutions, have responsibilities for the scrutiny and oversight of tax expenditures. This can involve reviewing the costings on tax expenditure proposals, as well as including them in reviews of whether governments are complying with fiscal rules. Generally, the parliamentary committees responsible for financial oversight have responsibility for tax expenditures, although once enacted, tax expenditures are rarely subject to further scrutiny by parliaments, other than ad hoc reviews.
Based on the analysis of the case study countries, this paper identifies five areas that would contribute to strengthening the fiscal management and control of tax expenditures in budgeting.
Institutional responsibility: Where practical, institutional responsibilities for tax expenditure through the budget process should include the relevant line ministry in conjunction with the ministry of finance, and in particular for refundable tax credits. The involvement by line ministries may vary, and could include contributing to the design, cost estimation, monitoring or evaluation of tax expenditures. While the authority to review and comment on tax expenditures remains with ministries of finance, line ministries have policy responsibilities and their inclusion in the budget process supports a co-ordinated approach to policy development and implementation.
Aligning tax expenditures with the budget process: In cases where a tax expenditure is developed through the budget process, line ministries, in conjunction with tax administration authorities, should provide cost estimates for tax expenditures (new and existing) to support informed decision making on the likely fiscal impact of the budget. In addition, financial reporting on tax expenditures should align with reporting on the budget to provide decision makers with information on all forms of expenditure.
Tax expenditure relative to direct expenditure: When a line ministry proposes a new tax expenditure, that ministry should demonstrate why alternative measures, including direct expenditure measures, would not be more appropriate to achieve the same policy goals. This is particularly relevant in cases where a proposed tax expenditure is developed through the budget process, as the budget provides a vehicle for the direct expenditure alternative.
Limits on the use of tax expenditure: Sunset clauses – provisions within tax expenditure legislation which set an end date for them – should be implemented and observed as a default practice, as they require policymakers to re-evaluate whether a provision continues to warrant its fiscal cost. While sunset clauses are required in countries such as Ireland and the Netherlands, the effective and systematic implementation of the clauses can remain challenging.
Tax expenditure evaluation: Given the complexity of reporting on the fiscal impact of some tax expenditures on a systematic basis, evaluations provide an alternative means to take an in-depth assessment of a tax expenditure to understand whether policy objectives are being met and at what cost. Systematic evaluations can also help bolster the effectiveness of sunset clauses.
The analysis in this paper has highlighted potential areas for further work in relation to budgeting, including ongoing work on a consistent benchmark on a cross-country basis, the further development of evaluation frameworks to inform which tax expenditures are meeting their intended objectives, and the development of possible ceilings specific to tax expenditures to support fiscal control.