COVID-19 and Inequality: The Urgent Need for Tax Expenditure Reform
By: Council On Economic Policies
Tags: Tax Reform, Tax Expenditures, Inequality

By: Rita de la Feria and Agustin Redonda

This blog was originally published by Austaxpolicy (here).

The economic impact of COVID-19 is both unprecedented and far-reaching. There is now little doubt that the pandemic will disproportionally hit the worse-off, hence exacerbating inequality. It is also clear that the pandemic is particularly affecting groups and sectors that were already under significant stress before the start of the crisis, namely women, racial minorities, the young, and those working in the informal sector.

Against this background, it is more important than ever that we develop public policies to halt, and if possible help reverse, the widening of inequality in the aftermath of the crisis. Tax policy, as one of our main available tools to address inequality, should take centre stage in these discussions.

In our recent policy brief published by the Think 20 (T20) — the engagement group of think tanks and research institutions providing policy relevant recommendations to G20 leaders — we propose that tax expenditure reform should be one of the first, and critical steps, in that direction.

Tax expenditures — often opaque, regressive and ineffective

According to preliminary data by the Global Tax Expenditures Database (GTED), the revenue foregone through the implementation of tax expenditures can amount to as much as 7 per cent of GDP (for example, in Australia, Colombia and Senegal) and more than 30 per cent of total tax revenue (for example, in Ecuador, Mauritania and the United States).[1] Whilst these amounts are significant for rich countries, they are even more relevant for poorer economies, significantly undermining their domestic resources mobilization efforts. At the same time, the level of opacity in the tax expenditure field is striking, in particular when compared to higher levels of scrutiny imposed on direct spending.

In addition to their fiscal cost and lack of transparency, tax expenditures are often regressive and ineffective in supporting their stated objectives. For example, tax deductions in the personal income tax which are aimed at boosting homeownership and pension savings have been proven to particularly benefit higher-income households. Similarly, some tax credits, such as the United States tax credits for electric vehicles, pursue worthy goals like greening the economy, but are disproportionally captured by top earners.

In the Value Added Tax (VAT), common policies, such as exemptions and reduced VAT rates which are implemented with the aim of reducing inequality, are ineffective at best, and regressive at worst. These tax benefits are often not fully passed through to consumers, even when they are, they tend to benefit richer households who consume more, and they can trigger significant spillover effects, such as qualification problems, and avoidance and fraud opportunities.

Tackling inequality through tax expenditure reform

Given the above, and considering the growing revenue needs to deal with both the crisis and its aftermath, a global drive towards tax expenditure reform, both in advanced as well as emerging and developing economies, is vital. We propose the following three-steps:

1. Regularly estimating and reporting the fiscal cost of tax expenditures

Tax expenditure reporting is a first, and necessary (though not sufficient) condition to increase the effectiveness and fairness of tax systems. A comprehensive tax expenditure report, where detailed estimates on the revenue foregone through tax expenditure provisions are published, can be a resource and time-intensive exercise — particularly for countries that are at the early stages of tax expenditure reporting. Yet, in addition to increased transparency and accountability, improving tax expenditure reporting opens the door to better assess the impact of tax expenditure provisions, and hence to better design tax expenditure systems.

2. Assessing the effectiveness and distributive impact of tax expenditures

Once the data on the revenue foregone as a result of tax expenditures is available, step two is assessing the effectiveness and distributive impact of these provisions. Governments should not only analyse the effectiveness of tax expenditures that explicitly seek to yield distributional and social benefits, but go a step further by assessing whether their social benefits exceed the associated social costs. As mentioned above, some tax expenditure provisions may be implemented to reach worthy objectives, such as greening the economy, but may trigger significant negative impacts on income distribution.

3. Reforming tax expenditures

Finally, once the effectiveness and distributional assessment is available, tax expenditure reform should be designed accordingly. Tax expenditures that are shown to be effective and efficient should be safeguarded, whilst those that are not should be phased out. Of course, even when tax expenditure assessments are available, reform is far from straightforward, and often provisions that had been proven to be ineffective are kept in place.

Resistance to tax expenditure reform is common, and cannot be attributed to one single factor, but it is undoubtedly the case that political elements play a critical role. Understanding these political dynamics, and in particular the role of special interest groups and of cognitive biases, is fundamental to overcoming those resistances and implementing an effective tax expenditure reform.

COVID-19 and the momentum for tax expenditure reform

Tax expenditure reform is fundamental to mitigate inequality, whilst at the same time easing budget constraints. Although this is the case generally, the COVID-19 pandemic has given it a new urgency. Getting rid of ineffective tax expenditure provisions will increase tax revenues, and hence expand fiscal space, providing the much needed additional resources to fund social, educational, and health spending to reduce inequality. At the same time, reducing the inefficiencies and misallocation of capital created by many tax expenditures can also help promote economic development post-pandemic. Given the desperate need for resources, and the unprecedented challenges our societies are facing, keeping the status quo is not an option. We cannot continue to waste billions in measures that either fail to address inequality, or indeed contribute to its increase. The time for action is now.

[1] The GTED (to be launched in Q1 2021) is a joint effort led by the Council on Economic Policies (CEP) and the German Development Institute (DIE) to bring together national tax expenditure reports in one online database and thus to increase transparency, generate trustworthy information and expand research in the field of tax expenditures.