Effectiveness and Economic Impact of Tax Incentives in the SADC ...

ECONOMIC TOOLKIT 4-11
The most serious problem arises from the usual methodology, which takes the size of the tax
base as given. Yet tax breaks alter taxpayer behavior. (That is why they are adopted.) To see
the importance of this issue, suppose that the standard tax rate is 35 percent and company A
faces a preferential rate of 15 percent. If A’s reported income is 1000, then the tax expenditure
is 200 (= 350 payable at the standard tax rate less 150 actually due). This is an accurate
measure of the benefit enjoyed by A. But it may or may not be a good measure of the
“revenue foregone” by the Treasury. If the incentive is redundant—that is, if the tax
preference had no effect on A’s investment decisions—then the tax expenditure calculation is
fully accurate as a measure of the direct revenue cost. But what if A exists only because of the
tax break? Then the revenue loss is zero: there would be nothing to tax at the 35 percent rate.
For the intermediate case of partial redundancy, the revenue loss lies somewhere between 200
and zero. In general, tax expenditure analysis overstates the direct revenue loss because it
neglects changes in taxpayer behavior due to the tax differentials. At the same time, it may
understate the revenue loss by neglecting indirect effects. Exhibit 4-3 explains more fully the
difference between the tax expenditure, as normally calculated, and the overall revenue
impact of a tax incentive.
In light of these problems, 56 is tax expenditure analysis worth using? In countries with
adequate data systems, the answer is a qualified yes. The conceptual gray areas are not a
major problem because most tax incentives fall clearly into the category of tax expenditure.
Also, empirical evidence from many countries (see chapter 2) suggests that most investments
are not driven by tax incentives. Hence, the tax expenditure tabulation provides a useful
approximation of the direct fiscal cost of incentives. Most important, tax expenditure
budgeting subjects incentive programs to public scrutiny and facilitates monitoring of the
fiscal costs. 57 Far better to measure these costs imperfectly than not to measure them at all,
which would leave the programs wide open to misuse.
Some simpler techniques can also be used to monitor and control the fiscal cost of investment
tax incentives. One method that has been used in Malawi and Mozambique is to establish a
ceiling for the value of tax breaks that can be approved by the government each fiscal year. A
second method is for the government to issue vouchers that are redeemable in lieu of taxes
due, up to a ceiling for each fiscal year. Tanzania is testing this approach, with the intention of
generalizing the practice if it works well. 58
56 Another issue is the philosophical objection to the presumption that tax breaks are a use of public resources.
The argument is that income inherently belongs to the earner, not to the state.
57 The IMF Manual on Fiscal Transparency (2001, paragraph 69), puts it this way: “Although there can be
serious difficulties in cost estimation, reporting the approximate cost of tax expenditures and describing the
basis of the estimates can significantly enhance transparency.”
58 A similar method is to include the tax benefit in the budget accounts by booking the normal tax liability and
then covering it partially or fully as government expenditure on investment promotion.