Tax Expenditures: Concept expenditure analysis by TRD. and - - PowerPoint PPT Presentation

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Tax Expenditures: Concept and Framework for Analysis

Thomas F. Pogue

Presented to New Mexico Tax Research Institute 6th Annual Tax Policy Conference April 30, 2009

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• This research is part of a multi-year, tax-

expenditure analysis by TRD.

• Goal: To provide in-depth analysis to the

Legislature and the Executive.

• Part of TRD's ongoing responsibility to analyze

New Mexico's tax structure to help inform tax policy decision making.

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Topics to be discussed:

– The tax expenditure concept – Estimating tax expenditures – Evaluating tax expenditures – Comparison with other policy instruments

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The Tax Expenditure Concept

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• Tax expenditures (TE) arise when

governments pursue objectives by altering tax codes rather than with other policy instruments such as direct spending, regulation, loans, and grants.

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• Tax expenditures
• are the result of tax preferences – lower

taxes – for taxpayers who meet specified criteria.

• These may be exclusions, exemptions, deductions,

credits or special rates

• essentially spend revenues that the tax

system would otherwise generate.

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• Tax expenditures fall into two categories:

– Incentives for businesses or individuals to engage in specified activities

• attending college, entering work force, saving for

retirement, purchasing health insurance, producing specified products, investing in specified technologies.

– funding for taxpayers with specified characteristics

• elderly, blind, military veterans, low-income

workers, owners of small or new businesses.

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• Examples of NM tax expenditures:

– Medical services deductions from GRT – Tax holiday sales deductible from GRT – Solar market development credit – Land conservation incentives credit – Rural jobs tax credit – Research and development small business tax credit – Affordable housing tax credit – Etc., etc., etc.

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• Tax expenditures are defined and

measured with reference to baseline taxes.

– Baseline taxes define the revenue raising (or purely tax) part of the tax code. – Tax expenditures are deviations from the baseline tax system

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• Baseline taxes should be consistent with

standard tax principles:

– Fair – Economically neutral – Transparent – Low costs of administration, compliance, and enforcement.

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• But application of these principles typically

does not yield a unique baseline for a tax.

• Tradeoffs are required because the

principles conflict with one another.

• E.g. Tax that minimizes compliance and

administration costs may not be fair

– Example: lump sum tax

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• Baseline definitions differ across taxes:

– Income tax: all real income from all sources

• Adjust for ability to pay, e.g. standard income tax

deductions

• Adjust for costs of administration, e.g. tax capital

gains on realized instead of accrual basis

• Integrate corporation and personal income taxes?

– Gross receipts or retail sales tax: final sales of all goods and services.

• Adjust for costs of administration, e.g. no

compensating tax on small dollar imports

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• Baseline definitions differ across taxes:

– Property tax: current market value of all real property, regardless of how used or where located. – Highway user tax: measures of or proxies for highway wear and damages, congestion, and environmental damages.

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• Exclusions from a baseline for

– ability to pay

• e.g. standard deductions

– high administrative compliance costs

• e.g. accrued but unrealized capital gains

are not tax expenditures, i.e. Do not reflect decisions to use the tax system to pursue specific objectives.

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Estimating Tax Expenditures

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• A tax expenditures budget (TEB) is a set of

estimates of tax expenditures.

• Why prepare/publish a TEB?

– TE support specific activities just as do direct expenditures – a TEB shows revenue allocated to support specified activities – a TEB aids decision making about taxes and spending

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• TE estimates cannot be aggregated because TE

depend on the existence and use of other preferences

• E.g. taxpayers itemize deductions only if the total
• f all itemized deductions exceeds their standard

deductions.

– Eliminating any deduction, e.g. state & local taxes, reduces the number of taxpayers who itemize. – With fewer taxpayers itemizing deductions, TE due to

• ther deductions, e.g. mortgage interest, shrink.

– And the revenue gain from eliminating deduction of state-local taxes will exceed the TE attributed to that deduction.

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Evaluating Tax Expenditures

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• To evaluate a TE, we must determine

– how it changes resource allocation and income distribution, and – whether the changes are an improvement

• Ideally, evaluation should determine whether the

TE has brought about the best possible

• utcomes.

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• Direct changes triggered by a TE take two

forms:

– changes made in response to a TE

• For example, health insurance purchased because
• f an income tax credit

– changes that necessarily follow from the revenue loss due to the TE:

• other tax revenues increase
• borrowing increases
• and spending decreases.

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• These direct changes generate further

indirect changes that

– affect economic choices other than those targeted by the TE – are especially difficult to trace and to take into account.

• As a practical matter, evaluations of TE tend to

focus on the direct changes they precipitate.

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• Evaluation criteria can be stated as two

questions:

– First, when a TE increases production of a commodity

• r service,

is the additional production more valuable than the private-sector and/or government production that is necessarily forgone?

– Second, when a TE changes the distribution of income,

is the change fair or otherwise appropriate?

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• The first condition requires that the TE increase

the total value of production

– Just increasing the level of some activity, e.g. solar energy production, is not sufficient. Example: if a tax credit for solar energy production is

• ffset by

– decreases in other government activities, does the value of any increase in solar energy production exceed the value of forgone government activities? – increases in other taxes, does the value of any increase in solar energy production exceed the value

• f private-sector production necessarily lost because
• f those tax increases?
• If neither condition is met, the credit reduces the

total value of production and makes the state worse off.

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• Evaluating TE requires difficult-to-obtain

and difficult to interpret data:

– The criteria for evaluating TE are at once simple in concept and difficult to apply.

• TE should also be compared to other

policy instruments to determine which is more effective in achieving objectives.

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Comparison with Other Policy Instruments

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Advantages of tax expenditures

• Tax systems can link government with

virtually all economic agents:

– TE utilize these built-in links – TE greatest comparative advantage is in implementing policies

• to transfer income to individuals and

businesses

• or to influence and subsidize their choices.

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Advantages of tax expenditures

• TE are better for changing private behavior
• TE respond more readily to changing activity

levels and economic conditions

• TE decentralize decision making

– Taxpayers decide whether and how much to respond to the preference. – This decentralization may provide managerial or informational advantages.

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Disadvantages of tax expenditures

• Unless a TE has an expiration date, it

continues indefinitely – until action is taken to repeal it.

• Tax expenditures do not receive the
• versight and fine tuning that direct

spending programs often receive.

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Disadvantages of tax expenditures

• Except for estimates of revenue loss, data

and reports on overall effects of TE are not routinely available.

• TE may not allow as much discretion and

flexibility as a spending program.

– Writing such detailed targeting into the tax code would greatly complicate it.

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Disadvantages of tax expenditures

• TE are not well suited to providing public

goods, such as such national defense and a judicial system, that cannot be produced by action of individuals and businesses.

• TE add to the complexity of the tax

system, raise admin. & compliance costs

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Conclusions

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• Tax expenditure budgets can be useful,

but preparing and using such reports requires understanding the TE concept.

• TE should be evaluated by the same

criteria as direct spending, do they

– lead to a more equitable distribution of income? – shift production from less valuable to more valuable products? – increase the real incomes of the state’s residents?

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• If not effective by these expenditure criteria, a

TE should be eliminated. – But not eliminated solely because it violates standard tax principles

• A tax expenditure budget (TEB) is not a guide to

tax reform – Nevertheless, a TEB is sometimes opposed

• n the grounds that TE will be seen as such –

as a listing of tax system shortcomings that need to be remedied.

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• Although some might argue that the tax system

should be used only to raise revenue, accepting that limitation forgoes use of a valuable policy instrument.

• At the same time, it should be recognized that

TE can be used inappropriately – when other instruments would serve better or no public purpose is served.

• Bottom line: A tax expenditure budget is

necessary for preventing such inappropriate use.

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