Tax reform is an ongoing process. The Irish republic’s tax system is like the proverbial curate’s egg – there are good bits and bad bits. I’m going to focus here on just one of the ‘bad bits’ but first let us consider the key objective of any tax system.
Key objectives
The key objectives of any tax system are to raise a meaningful amount of revenue for the exchequer while at the same time minimising administration and compliance costs, reducing inequality, minimising economic distortions, and changing behaviour. It is challenging to design a good taxation system that simultaneously adheres to the core principles of equity, efficiency and simplicity.
Tax expenditures
Tax expenditures are a type of public spending that benefits particular interest groups by treating certain activities or groups in a preferential way. The main distinction with public spending as commonly understood is that the preferential treatment for the recipient group comes in the form of reduced taxes instead of in the form of direct subsidies or other spending by a government department. Nevertheless, we should see the tax expenditure, or tax break, as analogous to a government-spending programme. Each tax break will have its own costs and benefits and these costs and benefits will not be uniform across the population.
Public spending in the form of tax expenditures tends to deliver larger benefits to higher income households. Many reliefs allow a tax deduction at the individual’s marginal rate of income tax. Such reliefs disproportionately benefit those with the highest incomes. Tax expenditures therefore tend to undermine the principle that individuals should pay tax in proportion to their ability to pay. The impact of these types of tax relief is to reduce the progressivity and equity of the tax system and to do so in a way that is less transparent than direct public spending. Certain tax reliefs may be equity improving but such examples are likely to be limited to reliefs on the consumption of necessities. According to James Poterba (2010):
“Tax expenditures are….effectively camouflaged expenditure programmes, and…their true effects are not obvious”.
In contrast, the benefits of public service provision such as health care and education have a more even distribution across the population and are more transparent. Poterba adds:
“Because tax expenditures narrow the tax base, it is necessary to set average tax rates higher than they would otherwise have to be. A key challenge for economists and other policy analysts is to review tax expenditures and to ask is there a justification for these exemptions and deductions”.
In general, a government that chooses a strategy of protecting or introducing tax breaks, while increasing other taxes and cutting other areas of public spending, is actively choosing to favour better off households at the expense of the rest of the population. The Combat Poverty Agency pointed out in 2005 that:
“...there is a double inequity associated with tax reliefs. On the one hand they reduce the tax base, thereby imposing higher tax burdens on average households not in a position to avail of many tax-relief schemes, and on the other hand they provide high earners with opportunities to avoid paying tax.”
Changing incentives
The standard rationale given for tax expenditures is to encourage a particular economic activity. However, there is often a deadweight loss associated with tax expenditures to the extent they subsidise economic activity that would have happened anyway in the absence of the tax break. Tax expenditures change the incentive structure for households and firms and therefore influence the behaviour of households and firms.
The behavioural changes induced can have positive and negative impacts on both short-run and long-run economic growth and also on overall societal wellbeing. The behavioural effects of tax expenditures can also have unintended consequences. For example, the variety of property related tax breaks in place in Ireland during the 2000s incentivised speculation in property at the expense of saving and at the expense of investment in productive assets. This was almost certainly a factor in the pre-2008 asset price boom. If this analysis is correct, the tax expenditures inadvertently contributed to the severe balance sheet recession that followed.
In general, tax breaks can negatively affect growth by distorting allocative efficiency, by creating inefficiencies in production and consumption, and by diverting economic activity toward rent-seeking behaviour. More positively, well targeted tax breaks can have beneficial impacts over the long-term to the extent they reduce negative externalities such as pollution, and also to the extent they encourage activities such as basic research that generate positive externalities.
Cost benefit analysis and sunset clauses
Even where there is a clear public policy case for supporting a particular group, or activity, through tax expenditure there still needs to be a rigorous social cost benefit analysis of the overall effect of the proposed tax expenditure. The results of this social cost benefit exercise should be transparent with the winners and losers clearly identified months in advance of the proposed tax break becoming law.
Policymakers should measure the social cost benefit ratio for the tax break against the cost benefit ratio for direct public subsidy of the group or activity. Tax breaks on capital stocks and stock-generated income are likely to be regressive given the unequal distribution of wealth. Tax breaks such as those related to Capital Acquisitions Tax or the exemption of the principal private residence from Capital Gains Tax are particularly difficult to justify from an equity perspective.
Finally, all tax breaks should have a built-in sunset clause of no longer than three years, which automatically triggers unless the Dáil actively renews the tax break. An updated and transparent cost benefit analysis should form part of the process of review in advance of the tax break’s expiration with continuation of the measure made contingent upon the results of the cost benefit analysis.