Federal tax expenditure review: The Process
The federal government is in the midst of reviewing tax expenditures, assessing them against their fairness, efficiency and cost. It is a daunting task: The federal government identifies about 250 measures as tax expenditures, expected to cost about $140 billion in 2017. The task can be greatly simplified, however, by putting tax expenditures into three buckets.
The first bucket would contain measures addressing the fairness and efficiency of the tax system. It would include initiatives implemented to ensure taxpayers in similar circumstances pay similar amounts of tax, such as the disability tax credit, to recognize costs of earning income, to avoid double taxation and to keep administration and compliance costs at reasonable levels.
The second bucket would contain measures related to the design of the tax system. A key design issue is how to tax income from capital, including initiatives related to tax-assisted savings plans, tax-free savings accounts, partial taxation of capital gains and dividend tax credits.
The third bucket would contain measures that are perfect or reasonably close substitutes for program spending. Refundable tax credits, such as the small firm SR&ED tax credit, are perfect substitutes for program spending. Its non-refundable counterpart, while not a perfect substitute, fulfills the same function as program spending.
Measures in the first two buckets should be assessed in a revenue-neutral tax reform exercise. But it is important to keep them separate: Changes to measures in the first bucket raise mostly narrowly-defined technical issues while changes to measures in the second raise fairness-efficiency trade-offs as well as complex technical issues.
Measures in the third bucket should be reviewed at the same time as program spending, with an eye to eliminating the least effective programs overall as a contribution to deficit reduction. Reviewing tax-based and program spending at the same time has three advantages.
- The burden of controlling expenditures can be spread more fairly.
- It focusses attention on the overall level of support in a given program area.
- It encourages an assessment of the most efficient and effective way to deliver support.
The review of tax-based and direct spending programs should be undertaken before tax reform, which should be tackled after a deficit-reduction plan has been set out. Adopting this approach will give both review processes a better shot at success. Tax reform and deficit reduction will both generate significant opposition, but fiscal consolidation does not create any direct winners while implementing tax reform without the pressure to raise revenues will result in both winners and losers, which should make it easier to implement.
What criteria should the government use to assess tax-based spending? As part of a fiscal consolidation exercise, eliminating a targeted tax measure avoids either a cut in program spending or a general tax increase. Considering the revenue side of the ledger, the government should compare the benefits of each targeted tax reduction with the cost of raising other taxes to finance it.
This benefit-cost approach is straight-forward to apply to programs promoting economic development. The economic benefit of a targeted incentive is usually easy to determine as is the cost of the general tax increase required to finance it. But it is important to keep in mind that these two changes are revenue-neutral, so the net impact on economic activity will be close to zero: The distribution of activity will change, but not its overall level. The two changes will only improve economic performance if markets failing to do a good job allocating capital and labour to their best uses. About a third of federal tax-based spending is intended to correct a market failure.
The benefit-cost approach is harder to apply to measures with a social objective, which usually involve a trade-off between fairness and efficiency. The classic case is income support measures, which change the distribution of income but usually harm economic performance by affecting incentives to work, save or invest. But the trade-off is not always between a more equal distribution of income and lower efficiency. For example, the favourable tax treatment of employer contributions to private health and dental insurance plans promotes efficiency in health care spending, but makes the distribution of income less equal. In both cases, the economic cost or benefit of achieving the objective is useful input to an assessment of the measure.
Since they usually involve fairness issues, benefit-cost analysis is just one of several factors to consider when assessing measures with a social goal. In contrast, economic development programs are intended to improve economic performance, so failing a benefit-cost test is sufficient reason to modify or eliminate them.
I will explain in my next blog entry how tax expenditure review could make a substantial contribution to deficit reduction.