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(Image Courtesy: US GAO)

 

The over-reliance on tax incentives/tax expenditures as an instrument for guiding socio-economic development, coupled with their flawed implementation, has transformed it into a big mess across the world. 

 

The muddle is manifested by complex tax regulations, tax disputes including litigation at the national and global level, crony capitalism and uncertain business environment across the globe.  Instances of mess are aplenty as we will find later in this column.   

And the mess is becoming messier with policy-makers focusing more on curbing clever use of multiple tax incentives instead of reducing them to bare minimum and aligning statutory tax rates with the effective tax rates.

The OECD-spearheaded Base Erosion Profit Shifting (BESP) action plan, General Anti-Avoidance Rules (GAAR), transfer pricing rules, Minimum Alternate Tax (MAT) and retrospective amendment to regulations are nothing but reactions to astute usage of tax incentives by the companies. 

 There would have been no need for such negative strategies and the resulting complexities had the Governments kept tax structure simple and free from clutter of tax incentives that are subject to many conditions and interpretations. 

Ever since the concept of tax expenditures for accounting of diverse tax incentives originated in the US in 1967, several countries and multilateral organizations have created framework for monitoring effectiveness of incentives and in making them transparent. Many developed countries present annual tax expenditure reports. So do the States in the United States. 

Developing Countries, on other hand, have miles to go in catching up with the developed countries in identifying tax expenditures, quantifying them, assessing their impact and in creating requisite transparency about incentives regimes.

Take the case of India, which is world’s third largest economy on the basis of Purchasing Price Parity (PPP)-assessed gross domestic product (GDP). 

India’s Comptroller and Auditor General in its lates report on Direct Taxes released on 18th July 2014 points out that Department of Revenue (DOR) has no mechanism  to monitor the results of impact of such revenue forgone due to tax expenditures. 

DOR contends that the result of impact of such revenue forgone on a particular sector are to be monitored by the respective ministries and they are not giving regular feedback on achievements of objectives. CAG report has cited many cases of income tax officials endorsing wrong availment of incentives in income tax returns. 

This underscores the need for undertaking comprehensive expenditure reforms by all governments at the national and State levels. The reforms should cover both incentives under the direct and indirect taxes domain, though this column is focused only on direct tax incentives.

The countries should agree on certain global direct taxes benchmarks to minimize tax disputes. It would perhaps be better to have a global MAT on MNCs applicable in all situations and in all countries. 

A WTO-type global understanding on tax expenditures would also reduce the cost of both enforcement and compliance with tax laws. It would also minimize the scope of tax incentives-driven capital flows.  

Before discussing the way forward, take a look at the mess across the globe. The United States Government Accountability Office (GAO), for instance, has identifies instances in the federal tax code where the same or similar term is defined differently or when taxpayers are subject to different rules under various tax provisions, particularly those aimed at similar objectives.

In its report dated 18th July 2014 submitted the US Senate’s Committee on Finance, GAO says: definitions for the same or similar terms can differ across tax provisions and policy objectives. These terms include (1) income, (2) small business, and (3) disabled. At least a dozen different tax code sections modify adjusted gross income (AGI) as part of determining the tax consequences of a particular provision. Depending on the code section, modified adjusted gross income (MAGI) is determined by incorporating as few as one and as many as nine modifications. The definition of small business can differ based on number of employees, amount of gross receipts, and other characteristics. The definition of disabled also varies across the tax code. Rules and definitions for the same or similar terms can also vary among tax provisions with similar policy objectives, such as (1) child-related tax benefits, (2) education tax benefits, and (3) retirement savings benefits.

While pitching for simplification of tax rules, GAO observes: “tradeoffs exist between simplifying tax provisions and achieving other goals of tax policy.”

Unlike GAO’s cautious report, an independent report in the US has pleaded for policy interventions to put an end to zero tax or minimal taxes paid by Fortune 500 or other American multinationals.

The report captioned ‘The Sorry State of Corporate Taxes’ published in February 2014 says that 26 multinational corporations (MNCs) including Boeing, General Electric, priceline.com and Verizon, paid no federal income tax at all over the five-year period ending 2012. As many as 111 MNCs paid zero or less in federal income taxes in at least one year from 2008 to 2012.

Prepared jointly by Washington-based advocacy group Citizens for Tax Justice (CTJ) and Institute on Taxation and Economic Policy (ITEP), the Report observes that the tax breaks claimed by these companies are highly concentrated in the hands of a few very large corporations. 

It says: “Just 25 companies claimed $174 billion in tax breaks over the five years between 2008 and 2012. That’s almost half the $364 billion in tax subsidies claimed by all of the 288 companies in our sample.”

The report’s recommendations include: 1) Congress should repeal the rule allowing American multinational corporations to indefinitely “defer” their U.S. taxes on their offshore profits. This reform would effectively remove the tax incentive to shift profits and jobs overseas.  2) Limit the ability of tech and other companies to use executive stock options to reduce their taxes by generating phantom “costs” these companies never actually incur. 3) Reinstate a strong corporate Alternative Minimum Tax that really does the job it was originally designed to do.

This Report gets credence from a presentation captioned ‘Tax Incentives in a BEPS World’ made by Eric M. Zolt, UCLA School of Law. The Presentation dated 4th June 2014 prepared under the UN Project on Protecting the Tax Base of Developing Countries.

It points out that the US regulation to not tax active income of foreign subsidiaries of US MNCs until repatriated has resulted in $3 trillion in un-repatriated profits.

In a report on tax expenditures published in April 2013, GAO noted that tax expenditures resulted in an estimated $1 trillion of revenue forgone by the federal government in fiscal year 2011. It observed: “With so much spending going through the tax code in the form of tax expenditures, the need to determine whether this spending is achieving its purpose becomes more pressing.”

The Report identified gaps in the data required to evaluate tax expenditures but did not recommend ways to fill these gaps. 

Even studies undertaken by staff of International Monetary Fund (IMF) have flagged the issue of adverse effects of tax expenditures.

A case in point is the IMF’s working paper captioned Reforming Tax Expenditures in Italy: What, Why, and How? Issued in January 2014, the Paper notes “tax expenditures in Italy are clearly elevated. Although some forms of tax support may be justified, such as the universal income tax credit in Italy that substitutes a minimum threshold, tax expenditures are often a poor way of pursuing policy objectives, create distortions, and escape public scrutiny.”

 The Paper points out that tax expenditures can have major consequences for the fairness, complexity, efficiency, and effectiveness of not only the tax system itself but, since they often serve purposes that might be (or are also) pursued through public spending, of the wider fiscal system.

The progress in undertaking tax expenditure reforms is patchy and inadequate across the world especially in the developing countries. 

According to a BEPS update titled ‘Bringing the International Tax Rules into the 21st Century’ prepared for a meeting of the OECD Council at Ministerial Level organized in May 2014,  “A series of tax incentives reviews which commenced in 2013 have already helped 6 developing countries identify and quantify their tax expenditure, which enables more informed tax policy design. This programme is now growing to cover additional countries while also exploring ways to support regional tax expenditure review programmes.” 

It is here pertinent to turn to a paper titled ‘The use of tax expenditures in times of fiscal consolidation’ published by European Commission (EC) in July 2014. It incorporates the proceedings of the workshop organised by EC’s Directorate General for Economic and Financial Affairs October 2013.

At the workshop, Thiess Büttner, Chair of Public Finance at FAU Erlangen Nuremberg pointed out that Member States apply tax expenditures to influence location and investment choices of businesses. He showed how the expansion of multinational companies went hand in hand with increased use of R&D tax incentives. He reminded that tax incentives might be rational for the individual government to attract foreign investment, but not necessarily efficient from a general economic perspective. If business tax incentives are provided by a set of competing governments, the policies might be mutually self-defeating and ultimately result in large revenue losses. In contrast, a coordinated elimination of those incentives might be preferable.”

The United Nations should convene a global conference to consider this valuable suggestion. The conference should also consider shift from upfront tax incentives to provision of world-class infrastructure and hassle-free secure, stable environment in areas where industries would normally prefer to avoid. This, coupled with preferential treatment in domestic purchases by the Government, can serve as good substitute to tax expenditures. 

In fact, the access to domestic markets in populous countries such as China, India, Bangladesh, Brazil, Pakistan and Indonesia should in itself serve as incentive for foreign direct investment. 

The conference should also agree on a global MAT on income of multinationals wherever they are stashed. This would reduce the attractiveness of treaty shopping, transfer pricing and circuitous routing of profits across different countries. 

The conference should also prepare a model expenditure tax reporting format to standardize transparent reporting and comparison of incentives. 

As put by the World Bank’s Book on tax expenditures published in 2004, “There is no internationally consistent format for tax expenditure report.”

The book titled Tax Expenditures—Shedding Light on Government Spending through the Tax System Lessons from Developed and Transition Economies' says:

 “Tax expenditures are seldom exposed to extensive analysis and scrutiny. Their true fiscal cost is hidden as revenue forgone. Revenue forgone, even if analyzed, is sometimes difficult to estimate. Similarly, considerations of the allocative and operational efficiency of tax expenditures are rarely required in the decision-making process. Even if most developed countries have implemented tax expenditure reporting, the gap between the level of scrutiny and transparency of tax expenditures compared with direct spending remains wide. Unless, however, tax expenditures are exposed to adequate scrutiny, they may invite fiscal opportunism.”