Are The Tax Expenditures Worth The Benefits?

Zahid Hussain | 16 June 2021
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The National Board of Revenue (NBR), according to several media reports, has estimated that tax exemptions resulted in nearly 7.9% of GDP loss in tax revenues in FY20. In economic jargon, this is known as tax expenditures – public resource transfers achieved by reducing tax obligations. This exercise by the NBR can help explain why Bangladesh has found it challenging to turn economic growth into tax revenue growth.

Tax revenues constitute over 80% of all revenues and are well below expectations for Bangladesh's level of income per capita.

There are many exemptions in the tax policy which benefit specific industries, single companies, and sometimes are under nontransparent Statutory Regulatory Order labels. According to the World Bank's Public Expenditure Review Update in 2015, an analysis of customs transaction data at the tariff line level found the presence of exemptions in almost 30% of the total number of transactions and 44% of total trade value.

Even under the same 8-digit HS code categories, different imports were taxed differently which indicates a special treatment in the case of certain imports.

Overall, tax expenditures in Bangladesh appear to be extremely high. The last analysis undertaken by the Bangladesh Bank in 2008 estimated that tax expenditures were equivalent to around 2.5% of GDP.

According to the latest NBR estimates, the government provided tax exemptions of around Tk2.5 lakh crore in FY20. Of this, Tk46,755 crore was exempted for importing raw materials, capital machinery, and other goods while Tk1,51,738 crore was waived against bond facilities for export-oriented industries. VAT and income tax exemptions amounted to about Tk50,000 crore.

Conceptually tax expenditures are similar but not quite the same as budgetary spending. Both are policy instruments requiring a fiscal sacrifice to achieve a policy objective. These objectives are often clearer in the case of budgetary expenditures but are typically not as clear in case of tax expenditures.

In addition, tax expenditures are easier to approve and more difficult to eliminate than budgetary spending. Tax expenditures tend not to be subject to systematic evaluations that are often applied to equivalent expenditure programmes.

There are only a few countries, including the most developed, that perform these evaluations on a systematic basis. The focus is most often on measuring revenue forgone. Periodic evaluations can help ensure that policy objectives of specific tax expenditures remain relevant.

Ideally, every tax expenditure should respond to a well-defined and clearly articulated policy objective. This may not always be the case in practice. In some cases, certain tax expenditures benefit only its target group without benefitting society. In other cases, the objectives may have been relevant when the tax expenditure was introduced but over time the social return diminishes but the expenditure remains in effect.

Tax expenditures can be a good way to intervene under some circumstances. They should be compared with alternative policy instruments, such as budgetary expenditures or regulation, each of which also involves deficient processes for approval while introducing policy and economic distortions. Tax expenditures tend to function better when administrative costs and compliance costs are low; there is a low probability of fraud and abuse; and the use of a spending agency is not appropriate.

There are several counter arguments as well. Tax expenditures always lose revenue to the extent they are used opportunistically. These expenditures limit the tax rate reductions by eroding the tax base. Many tax expenditure schemes are a response to various interest groups rather than to actual needs, resulting in loss of efficiency by favouring some sectors and activities, but not others.

Tax expenditures usually provide advantages for income from capital rather than labour. The well-to-do also have more tax liability in the first instance, and so have more to gain from tax expenditures.

Last but not the least, tax expenditures can be complex, generating high compliance and administration costs. The resulting complexity of the whole can often exceed the sum of the complexity of the parts.

The regulations establishing preferential treatment for specific groups of taxpayers in certain economic sectors tend to grow either through direct or indirect demand. Specific benefits generate direct demand given that they have a significant impact on reducing the tax burden or produce an indirect demand from other groups or sectors, which clamour for access to the same advantages. The norms that regulate access to specific benefits are, in some cases, too lax and open the door to tax evasion and avoidance.

Should policy makers be concerned? The answer is affirmative given that the net benefit of a fiscal cost equivalent to 7.9% of GDP is unknown.

The taxpayers that benefit from the exemptions tend to put up significant resistance to any subsequent attempt at tax reform. The establishment of effective periods for these benefits is an important instrument in managing tax expenditures.

However, in Bangladesh, many tax expenditures have no time limits and the limits on those that have it, keep getting extended. Consequently, one option for managing the upward trend in tax expenditures is to explicitly repeal these measures through legal amendments. But this is a slow and difficult process.

Short-term administrative and legal measures often do not work. Making administrative controls tougher or delaying responses to requests are insufficient to put the brakes on growing demand for tax expenditures.

The current situation requires a structural response that goes beyond short-term patchwork. A structural response requires developing fiscal rules and technical measures to improve the tax design as well as improved systems of control and ex-post evaluation.

The approval process for tax expenditures should be subjected to the same steps as those used for direct expenditure programmes. All the new tax expenditure proposals must be accompanied by an evaluation of corresponding costs and benefits.

Similarly, moves to eliminate tax expenditures through legal venues should be based on an evaluation that justifies this decision. The decision to extend should be based on ex-post evaluation showing expenditure has effectively and efficiently fulfilled the objectives sought and has the potential to do more.

The search for tax revenues to offset expenditures must focus on heading off distortions that may arise from increasing the tax burden in specific sectors or groups of taxpayers due to the incentives or benefits that have been extended to other sectors or groups of the population. As such, tax equity must also be considered in the decision-making process.

The NBR ought to be commended for their effort in estimating the fiscal cost, but their job is only half done. The implicit assumption of the status quo is that the net benefit for society is positive for all tax expenditures. It is impractical to conduct a complete evaluation of all tax expenditures that currently exist.

The NBR could start by evaluating the tax expenditures that have a high fiscal cost in terms of revenue foregone. Subsequently, evaluations can be extended to tax expenditures with a lower impact on collections.

Increasing the transparency of the process to establish tax benefits and incentives is key to bringing about social acceptance of the tax system and faith in the credibility of tax policy. Tax expenditures should be subject to the same controls required of direct spending programmes to fully integrate these tax benefits or incentives in the general budgetary process.

The tax expenditure estimates are not an endorsement for raising taxes but an input into the policy process seeking to balance revenue raising measures, competitiveness, and tax justice.

Zahid Hussain, Economist.

This article was originally published on The Business Standard.  
Views in this article are author’s own and do not necessarily reflect CGS policy.