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Evaluation of Tax Expenditures Department of Finance Guidelines and Case Study Examples Presentation to TCD MSc in Economic Policy Studies, 11 December 2015 Brendan O’Connor, Economics Division, Department of Finance
1. What are Tax Expenditures?
Economic issues
2. Tax Expenditure Guidelines and approach
Ex ante Ex post Proportionate approach
3. Case Studies (and CBA concepts)
Outline of presentation
Term first coined by Stanley Surrey • Equivalent to direct expenditures, except that spending takes place through the tax system
(Pathways to Tax Reform, 1973)
Definition in Irish legislation draws on OECD definition • Transfer of public resources • Targeted at a narrow group or activity • Reduces tax obligations with respect to a benchmark tax
Impact on the exchequer Typically pro cyclical
Fiscal Illusion - Exclusion of tax expenditures from budget process, Leads to bigger, less
efficient government, and bigger deficits (NBER, 2011) Reducing tax expenditures also offers the possibility to raise net revenues while cutting
marginal tax rates and promoting economic growth - classic tax reform!!
What are tax expenditures?
See Burman and Pharp, NBER WP 17268 (2011)
What are tax expenditures – use two slides if necessary
Optimal taxation theory – principle of neutrality • Decisions (e.g. consumption, labour supply) should not be influenced by tax • By definition tax expenditures departs from neutrality • Very limited circumstances where optimal to depart from neutrality
– Internalise externality (R&D), incentivise labour supply (Mirrlees Review)
Market failure as motivation for tax expenditures • Imperfection in a market prevents achievement of economic efficiency • Situation where supply and demand do not balance at price that would apply in a
well functioning market • Positive or negative externalities, market power, information asymmetries, public
goods
Economic Issues
Guidelines - Background
“Though evaluation of tax expenditures may be difficult, a more serious problem may be the failure to try”. (OECD, 2010)
Background A tax-equivalent to the Public Spending Code
Builds on evaluations carried out by Department over recent years
E.g. property incentives (2011), Film (2012), R&D (2013)
Reports from Commissions on Taxation International practice in tax expenditure evaluation
Draws on the economic literature
Principles of neutrality Risk of tax capitalisation
Key Evaluation Questions
Ex Ante Evaluations Ex Post Evaluations
1. What objective does the tax expenditure aim to achieve?
1. Is the tax expenditure still relevant?
2. What market failure is being addressed?
2. How much did the tax expenditure cost?
3. Is a tax expenditure the best approach to address the market failure?
3. What was the impact of the tax expenditure?
4. What economic impact is the tax expenditure likely to have?
4. Was it efficient?
5. How much is it expected to cost?
Ex ante – 1. What’s the objective?
Essential for evaluation purposes to have clear statement of what
intervention is intended to achieve • Facilitates analysis of alternatives
Ex ante evaluation should interrogate this
• Clarity of objective • Consistency with Government policy • Does it lend itself to monitoring?
2. What’s the market failure?
Rationale for intervention via tax expenditure or other intervention hinges on existence of a market failure
Market failure: a situation where, for one reason or other, the market mechanism alone cannot achieve economic efficiency
Examples include • Externalities • Public goods • Imperfect information • Market power
Ex ante evaluation needs to identify the market failure
3. Is a tax expenditure the best approach?
Once the market failure is identified, the issue is one of identifying the most efficient intervention
Option analysis
Tax expenditure vs. direct subsidy vs. other intervention
Important to take account of existing instruments and how a new tax intervention would interact with these
Tax expenditures Direct subsidies
Cost control
Cost uncertain – depends on taxpayer participation (nature of market led intervention)
Cost capped by expenditure ceiling.
Accessibility for beneficiaries
Simple, due to their automatic (market-led) nature. Can facilitate a greater range of taxpayer choice
More complex, requiring selection/targeting
Effectiveness Make use of market knowledge. Additionality cannot be guaranteed – may finance activity that would have happened anyway
Risk of displacement of private sector.
See Villela, Lemgruber & Jorratt (2010)
Distinction between Tax Expenditures and Direct Expenditures
4. What economic impact will the tax expenditure have?
Even if we establish that a market failure exists and that a tax expenditure is a better option need to think about whether it will work
Is the design right? Incidence (who benefits?) A key issue in tax expenditure analysis
Need to think about how impact will be evaluated at ex post stage
and collection of data to facilitate this
5. How much will it cost?
Need to form some estimate of likely cost
Essential if a CBA is required
Most feasible approach likely to involve development of scenarios based on assumptions as to size of target population, take-up etc.
Important to put arrangements in place to collect cost data for later monitoring and evaluation purposes (lessons from R&D review)
Ex post – 1. Is it still relevant?
Is the objective still valid given changes since scheme inception?
Need to think about
• Developments in external environment, sectoral or market conditions • Policy changes, e.g., new programmes, regulations etc.
Analyse what these mean for the tax expenditure
2. How much did it cost?
Need to establish estimates of outturn costs
For CBA need estimate of “economic cost”
• Incorporate opportunity cost of public funds • Also need to account for legacy and other costs
3. What economic impact did it have?
Critical issue for ex post evaluation - what difference did the tax expenditure make?
• Did it change behaviour • Did it improve performance • Did it increase economic activity etc.
What is the counterfactual
• Surveys of beneficiaries • Econometric analysis • Randomised control trials
Focus on economic outcomes
Deadweight and displacement effects Shadow prices and opportunity costs
4. Was it efficient?
Efficiency = value for money
Scheme may be effective and have met its objectives but at what
cost?
Examine unit costs e.g., cost per job created and compare with other interventions including for public expenditure programmes
Leading to consideration of possible alternatives
For costly tax expenditures address through a CBA
Implementing the Guidelines- Proportionate Approach
Estimated Annual Cost
Level Ex Ante Ex Post Time Limit/ Review
Between €1m and €10m
Level 1 Ex ante assessment and identification of criteria for ex post evaluation
Application of ex post criteria
Five years to review
Between €10m and €50m
Level 2 Detailed assessment – scenario based analysis or similar and statement of proposed methods and data requirements for full ex post cost-benefit analysis (CBA)
Full ex post CBA Five years to trigger review
Interim review after three years if annual costs exceed €25m
Greater than €50m
Level 3 Full ex ante CBA and statement of methods and data requirements for full ex post CBA
Use of pilot scheme if possible
Full ex post CBA Interim review after three years
Case Study 1: R&D Tax Credit
Evaluation took place as part of a wider review of the R&D tax credit which was published with Budget 2014
This wider review involved • Public consultation • Survey • Analysis of Revenue data • International Comparison • Econometric evaluation
Econometric evaluation focused on whether the R&D tax credit was effective in stimulating R&D expenditure by firms
The R&D Tax Credit
BERD/GDP ratio converging on EU-27 • R&D tax credit introduced in 2004
• 25% credit on R&D over 2003 levels
• Payable credit if insufficient tax
liability
• Economic literature points to the role of R&D in driving economic growth and firm productivity
0.00
0.20
0.40
0.60
0.80
1.00
1.20
1.40
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
Ireland EU-27
0.00
0.50
1.00
1.50
2.00
2.50
3.00
Market Failures & Government interventions
Arrow (1962) describes two main market failures – Positive externalities (Spillover Benefits)
• Knowledge non-rival • Partially non-excludable (imperfect patents)
– Asymmetric Information leads to under-financing
Consequence is firms underinvest in R&D relative to the societal optimum level
Role for government in correcting this (Mirrlees, IFS, 2011) But possibility for Government failure
– Deadweight – Supply of researchers inelastic. See Goolsbee (1998)
Methodological Approach and Data
R&D demand equation – user cost of capital approach • Involves estimating the firms’ R&D expenditure over time in
response the R&D credit and changing costs of capital • In other words – did the credit lead to more R&D?
• Methodology used in UK (HMRC) and Australia
Assembled a dataset using Revenue administrative records (on a confidential basis) matched with company accounts filed with the companies registration office (CRO).
To make it into the dataset a firm had to be observed on all the
above variables over the period 2008-2011.
Limitations in estimation and data availability
Of the over 700 firms using the credit in 2008 only 400 were consistently claiming in the 4 years to 2011
Of these 400 firms only 53 had necessary data in all 4 years Time period in question (crisis period) impacted on results
0
200
400
600
800
1000
1200
1400
2007 2008 2009 2010 2011
Period of observation 2008-2011
Learnings
The nature of the R&D activity and the operation of the R&D credit make it very difficult to evaluate
The size of the enterprise base in Ireland makes generating an adequate sample size difficult where missing data exists
Evaluation of tax expenditures should be planned ex-ante to allow for necessary data to be collected
Methodological paper published as IGEES working paper
24
Section 481 How it operated In existence since 1987
Max of €50m per production
Income tax incentive (€50K per
investor @ marginal rate), Upfront benefit
TV, Film, Documentary, Animation
Reformed to tax credit to company (lower cost)
Case Study 2: The Film Relief 2011: €118m in expenditure, €55m cost
98 108 105
160
118
31 33 44
66
49
0
20
40
60
80
100
120
140
160
180
2007 2008 2009 2010 2011
Total Irish Expenditure
Tax Cost (€,m)
Case Study 2: Film Relief
Income tax relief at marginal rate High yield, low risk for investors Inefficient scheme – cost €41 per
€28 funding gap
€72
Content
€41 €100
€72
Commissioning
Body (Pay €72)
Production
Company
Investors (Pay
100)
Exchequer
(Tax loss of €41)
SPV
(pays
€72)
Main variables Data source Labour Expenditure Revenue Commissioners/Irish Film Board Materials and services expenditure Revenue Commissioners/Irish Film Board Multiplier CSO Tax Receipts (PAYE, USC, PRSI, VAT) Revenue Commissioners Tax Receipts (Schedule D) Dept. of Finance estimates using IBEC data
Social Welfare Savings Indecon (on behalf of IBEC)
Tax Costs Revenue Commissioners
• Assembling the dataset involved getting access to Revenue Commissioner administrative records on a confidential basis.
• Data also supplied by Irish Film Board.
• Some estimates made by Dept. Finance using own analysis and submissions received in consultation round
Data Sources
Public funds are financed through taxation Taxation imposes economic costs that must be recognised in CBA
Value usually greater than one, e.g. SCPF = 1 + α
Estimates for α range from 50%-100% (Honohon, 1996 and 1987), 30% (Forfas, 2003), 50% (DPER), 33% (European Commission, 2013)
Overall value depends on distribution of taxation across types of taxes
Concepts (1) – Shadow cost of public funds
Concept of opportunity cost Not all of wage/employment benefits are ‘additional’
Relationship between employment and unemployment not one for one
Opportunity cost - what would labour earn in absence of project?
Reduce wage benefits by the opportunity cost
Size of opportunity cost depends on occupation or economic sector
Close to 100% for high skilled workers
Generally not less than 80%
Concepts (2) – Shadow price of labour
Deadweight costs How much of scheme benefits would have occurred anyway
Use surveys/interviews, control/treatment groups, econometric analysis
Multiplier effects
Benefits can be increased to account for ‘indirect effects’
But not for ‘induced effects’
Sectoral output multipliers given in CSO supply and use and input-output tables (see Table 12)
Import multipliers available from same source (useful for ‘leakage’)
Concepts (3) – Deadweight and Multipliers
The Model (from Economic Impact Assessment of Film Relief)
SDW = Scheme deadweight
TDW = Tax deadweight (shadow price of public funds)
v = Shadow wage rate (shadow price of labour)
Benefits
B = [1 – SDW]*[(1 – v)*B1 + (1-v )*B2 + B3] B1 = Direct wage bill + Direct Irish profits (both inclusive of taxes)
B2 = Indirect wage bill + Indirect Irish profits (both inclusive of taxes)
B3 = Tax benefits (after shadow price)
Costs
C = (1 + TDW)*Scheme Cost Scheme cost includes tax foregone, administration costs and compliance costs
Finally, Sensitivity Tests
Shadow price of labour
100% 80% 60% 50% 40% 30% 20%
Deadweight
10% -€38.2m -€21.1m -€4.2m €4.1m €12.3m €20.5m €28.6m
20% -€41.8m -€26.5m -€11.6m -€4.2m €3.2m €10.4m €17.6m
35% -€47.1m -€34.7m -€22.5m -€16.5m -€10.6m -€4.7m €1.2m
40% -€48.9m -€37.4m -€26.2m -€20.7m -€15.2m -€9.7m -€4.3m
50% -€52.4m -€42.9m -€33.5m -€28.9m -€24.3m -€19.8m -€15.3m
60% -€56.0m -€48.4m -€40.9m -€37.2m -€33.5m -€29.9m -€26.3m
70% -€59.5m -€53.8m -€48.2m -€45.4m -€42.7m -€39.9m -€37.2m
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