Occasional Papers 207 December 2014 [609919]
EUROPEAN
ECONOMY
Occasional Papers 207 | December 2014
Tax expenditures in direct taxation
in EU Member States
Economic and
Financial AffairsISSN 1725-3209 (online)
ISSN 1725-3195 (print)
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Tax expenditures in direct taxation
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EUROPEAN ECONOMY Occasional Papers 207
ACKNOWLEDGEMENTS
2 This paper was coordinated by Athena Kalyva under th e supervision of Gilles Mourre (Head of Unit) and
under the direction of Lucio Pench (Director).
The authors are Caterina Astarita, Lovise Bauger, Serena Fatica, Athena Kalyva, Gilles Mourre, and
Florian Wöhlbier. The views expressed in this paper are those of the authors and do not necessarily represent the views of the Eur opean Commission or DG ECFIN.
The authors are grateful for valuable contributions and comments received by Servaas Deroose, Asa
Johannesson-Linden, George Isbasoiu, Anne van Bruggen and Eugeniu Colesnic. Support on layout was provided by Maria Stampouli.
Country specific comments by Patrick D’Souza, Janis Malzubris, Mart Maivali and other colleagues in
DG ECFIN are gratefully acknowledged. Comments and suggestions by members of the Economic Policy Committee are gratefully acknowledged. The authors thank in particular Paula Banescu, Susan Battles, Birgitte Bjørnbak, Samuel Borralho, Matthieu Combaud, Paula Costa, Ana Claudia Gouveia, Toep van Dijk, Agata Ludwiniak, Beatriz Perez Raposo, and Mari nela Petrova, for their comments received at the
Economic Policy Committee and through written consultation. The paper also benefited from comments and suggestions by colleagues in the Directorate General for Taxation and Customs Union (DG TAXUD), in particular Agnieszka Skonieczna, on an earlier version of the document.
Contact information: [anonimizat]
EXECUTIVE SUMMARY
3 Tax expenditures are reductions in government revenue through preferential tax treatment of specific
groups of tax payers or specific activities. EU Member States make ample use of tax expenditures with a
wide variety of aims including employment creation, innovation, education, entrepreneurship, home
ownership and income redistribution. While tax expenditures may be motivated by relevant economic or social goals, they are not necessarily the most cost-efficient instrument and may, in some cases, lead to
severe economic distortions. Such preferential treatment could alternatively be provided through government spending or granted through direct regulation.
In a context of constrained public finances, it is important to better understand the budgetary and
economic impact of tax expenditures. Tax expenditures allow certain groups of taxpayers to reduce their tax burden and, therefore, could be regarded as revenue losses attributable to derogatory tax provisions. This paper provides an overview of major categories of tax expenditures, highlighting possible risks and challenges that Member States face and that are impor tant to bear in mind when assessing or considering
policies in this area.
Regular reporting on tax expenditures is a key issue with a view to increasing the transparency of tax
systems and some progress has recently been made in this area. By mid-2013 around 2/3 of Member
States were carrying out such reporting. However, diverse reporting practices render a meaningful
interpretation of revenue cost estimates across coun tries problematic and hinder reliable cross-country
comparison. The information provided is often fragmen ted and not fully transparent. In addition, while
the central government level is in general fairly well covered, the local dimension tends to be captured to a lesser extent (partly due to the heterogeneity of ta xes applied). As of 2014, the Budgetary Frameworks
Directive requires Member States to publish information on the impact of tax expenditures on revenues for all sub-sectors of general government.
Member States apply numerous tax expenditures in pe rsonal and corporate income taxation as well as in
VAT. Cross-country comparisons are di fficult in practice due to different definitional, classification and
benchmark approaches. Moreover, there are limited data available or reliable which would allow for
comparing the use of tax expenditures in EU Member St ates. Nevertheless, available data indicate that the
budgetary cost of tax expenditures amounts to a non-negligible percentage of GDP in many Member States, with tax expenditures in personal income taxation generally representing the lion’s share. This is not surprising given that tax expenditures are extensively used by governments as instruments for income redistribution as well as to encourage investment, employment and growth. In terms of development, tax expenditures appear to have somewhat increased durin g the last decade, while pressure has emerged more
recently to moderate their growing use.
The economic relevance of tax expenditures can be a ssessed against a small number of criteria. A first
group of criteria covers various facets of microeconomic efficiency (internalising externalities,
minimising distortions generated by taxation and remaining compatible with a sound functioning of the single market). The second group of criteria reflects th e capacity to meet social or strategic objectives
defined by the government with the best available instruments, which are not necessarily tax expenditures. The last group of criteria relates to the efficient functioning of fiscal policy, which would usually include keeping the tax system simple and stable and ensuring transparency and accountability. A thorough assessment of tax expenditures includes an evaluation of their impact on these three dimensions.
Considering the first criterion, tax expenditures might cause severe microeconomic distortions and
encourage rent seeking behaviours, as other types of preferential treatment. The required increase in
statutory tax rates to counter the narrowing of tax bases contributes to welfare loses, by inducing sub-optimal behaviours. An evaluation of the efficiency of tax expenditure s requires a case by case analysis
for different policy areas of how tax expenditures could – or could not – help meet given economic objectives in these areas.
4 As regards the second group, a thorough assessment of tax expenditures also includes an evaluation of
their impact on social equity. This involves discu ssing their potential benefits and limitations in
comparison with the alternative available tool s, not necessarily related to tax policy.
Concerning the third group of criteria, tax expenditures might also impact the fiscal framework. Caution is required when deciding on whether to apply tax expenditures, as they could increase the complexity and instability of the tax system, may risk overburdening tax administrations and might lead to welfare losses. Simultaneously, they are often subject to less control and scrutiny by national parliament, although recent progress has been made in many Member Stat es regarding transparency. They are more vulnerable
to influential lobbies as well, compared to direct spending.
A number of specific tax expenditures in personal income taxation deserve particularly close scrutiny in
terms of their costs and benefits.
• Making Work Pay policies – aimed at addressing inactivity traps and supporting those who face
poverty or social exclusion – deserve careful scrutiny as there is mixed evidence on their efficiency.
• Self-employment is another area to be closely looked at, given the increasing importance in the EU
and its often specific treatment in the tax system. Closing unnecessary loopholes in this area or
establishing stringent conditionality is crucial to avoid abuse of the tax system, such as ‘fake’ self-employed.
• Tax incentives to induce higher rates of private pension savings or more favourable tax treatment of
private pension schemes to compensate the income loss after retirement are widely used in the EU. These incentives are granted in th e context of ageing population and also with a view to encouraging
long-term saving in the economy. They may have a considerable impact on the budget and on
income redistribution, now and even more in the future.
• Tax expenditures promoting home ownership also deserve close scrutiny. While they are justified by
the assumption that they generates positive externalities for society, the paper highlights that such
policies is generally costly and risk being regressive and detrimental to social equity. They could also encourage the misallocation of resources, contribute to higher house prices, thereby favouring debt accumulation. These concerns are especially re levant as around half of the Member States
subsidise housing investment, through a low taxation compared with other investment items, and could encourage household indebtedness, via more or less generous mortgage interest reliefs.
As regards tax expenditures in corporate taxation, the discussed items include special corporate income tax regimes, reduced rates for SMEs and tax incentives for R&D. These items find their economic rationale in market failures but tax expenditures do not seem to be the first-best policy instruments in many cases. Furthermore, special tax rules (e.g. for SMEs) may conflict with each other. R&D tax
incentives aim at increasing innovative activities by lowering the marginal cost of investment and indeed there is a general consensus in the economic literature that tax incentives for R&D have the potential to positively impact business expenditure in innovative act ivities. However, there are also associated risks
and unintended consequences that increase their social cost (e.g. possible impact on tax competition including business location, in case of ‘Patent box regimes’ among others).
All in all, there is strong need for stringent monitoring, effective evaluations and transparent
communication on the application of tax expenditures by the Member States. While well-designed expenditures can be justified and enhance positive spill overs and welfare, it is im portant to ensure that
they do not cause economic distortions and that they are the most cost-efficient means of achieving
economic and social policy goals. That is why the potential impact of these instruments – positive and negative – deserves more attention. This paper intend s to serve as a roadmap to identify possible risks and
challenges that Member States face when maximisi ng the economic efficiency of tax expenditures and
that are important to bear in mind when assessing policies applied or considered in Member States.
CONTENTS
5 1. Introduction 7
2. Trends in tax expenditures – Some orders of magnitude 9
3. General issues with tax expenditures evaluation 11
3.1. The problems of identification 11
3.2. Guiding principles: increasing policy efficiency 12
3.3. Political economy dynamics: risk of misuse of tax expenditures and persistence 16
4. Tax expenditures reporting in member states 19
5. Economic and distributive aspects of se lected tax expenditures in personal
income taxation 23
5.1. Making Work Pay tax expenditures 23
5.2. Tax expenditures for self-employed 25
5.3. Pension related tax expenditures 27
5.4. Tax expenditures for education 31
5.5. Housing related tax expenditures 34
6. Economic aspects of selected tax expenditures in corporate income taxation:
the national and the international dimension 37
6.1. Special corporate income tax regimes 37
6.2. Reduced rates for SMEs and companies operating in specail regions or sectors 39
6.3. Tax incentives for R&D 41
7. Concluding remarks 45
Annex 47
References 49
LIST OF TABLES
3.1. Standard typology of government policy instruments 15
4.1. National reporting of tax expenditures 19
4.2. Elements of regular reporting practices 20
5.1. Private pension payments and tax breaks in selected countries, 2009 30
5.2. Tax incentives for education in personal income taxation 32
6 5.3. Tax incentives for education in corporate income taxation 33
6.1. Types of Corporate Income Tax regimes, with international dimension in EU Member States 38
6.2. Reduced corporate income tax rates for small businesses, 2013 40
6.3. Reduced corporate income tax rates and special tax regimes for specific regions and
sectors 41
7.1. Evaluation of tax expenditures in some major areas 46
A.1. Top statutory tax rates in personal and corporate income taxation, in % 47
A.2. References to national publications on tax expenditures 48
LIST OF GRAPHS
2.1. Tax expenditures in selected EU MS and the US as % of GDP (left) and as % of total tax revenues (right) 9
2.2. Change in top personal income tax rate a nd adjusted top corporate income tax rate
(1995-2013) 10
5.1. Private pension expenditure in 2010 and 2060 in selected Member States (as % of GDP) 27
LIST OF BOXES
5.1. The tax treatment of pension savings and the benchmark for tax expenditures 28
1. INTRODUCTION
7 Tax expenditures are widely used to promote public policies . Governments use favourable
special/derogatory regimes (tax expendi tures) to influence the allocation of resources in some direction or
to achieve specific social aims, such as the fight against poverty or the reduction in income inequality.
While formally generally defined as a reduction in tax revenue in the National Account, they are often economically equivalent to a public expenditure. They could be considered functionally as ‘hidden subsidies’, since they are designed to affect specific tax payers who are benefiting from a reduced tax liability. Recently, trends toward greater transparency in fiscal policy a nd the growing use of cost-benefits
analysis of tax expenditures led to an increased interest in tax expenditures throughout the world. Relevant work by the IMF(
1), the OECD(2) and other international bodies emphasizes the need for
various countries to review the tax expenditures when designing their budget.
Tax expenditures can be budgetary costly and may, in many cases, turn out inefficient. Tax
expenditures reduce the tax burden for certain groups of taxpayers, resulting in revenue losses. They may
achieve the assigned objective, but at large costs. For instance, they may be insufficiently targeted by
benefitting only those who actually have a positive tax liability, thereby excluding many low-income households or companies with actually no taxable income. Alternative targeted measures on the
expenditure side of the budget may often be more eco nomically efficient. Using such measures may help
mitigate social resistance to and political cost from tax expenditures removal. A removal of distortive tax
expenditures can also create fiscal space allowing for stronger consolidation or a revenue neutral
reduction in statutory tax rates, supporting growth. It may also imply a growth-friendly tax shift as is the
case for VAT when abolishing current exemptions at unchanged statutory rates allowing for reduction of labour taxes.
However, in specific cases, tax expenditures may be an efficient policy instrument or – as a second
best solution – the most efficient one available. This may be the case of targeted cuts in labour taxation
(including social security contributions) to stimulate the labour force participation of disadvantaged
groups (with highly reactive labour supply) and increase their employability by firms. Other examples could be investment and R&D-friendly tax cuts to reduce the cost of capital and stimulate innovation in periods of strong recession and special allowances to address the debt bias in corporate taxation (ACE).
This justifies a cautious and case-by-case approa ch, considering the economic goal sought by the
government and possible alternative instruments.
Focusing on direct t axation, this paper traces key developments and outlines main issues related to
tax expenditures. It looks at tax expenditures at large but also examines particular groups of tax
expenditures associated with speci fic economic issues. The paper is organised as follows. Section 2
provides some orders of magnitude and presents the recent trends in different tax expenditures. Section 3
investigates general issues related to tax expenditures, mainly the difficulty to measure and the risk to use tax expenditures in an inefficient way. Section 4 consid ers efforts made at Member States level to report
tax expenditures systematically in order to raise transp arency and avoid practices and to weaken the fiscal
framework. Section 5 and 6 cover the specific economic and distributive aspects of selected types of tax
expenditures in the personal income tax (PIT) and co rporate income tax (CIT) area respectively. The final
section briefly summarizes findings and offers some concluding remarks.
(1) See Fiscal Monitor (IMF, 2011)
(2) See Tax expenditures in OE CD Countries (OECD, 2010a)
2. TRENDS IN TAX EXPENDITURES – SOME ORDERS OF
MAGNITUDE
9 Reported tax expenditures add up to a non-neglig ible share of GDP in many EU Member States.
Graph 2.1 shows the total size of reported tax expenditures as a percentage of GDP and total tax revenues
in selected EU Member States plus the US. Italy, the UK and Spain are Member States with the highest
share of reported tax expenditures in GDP (8.1%, 5.9% and 5.5% respectively). Such figures give some indication of the order of magnitude, but cannot be interpreted directly as budgetary costs. International comparisons however can be misleading given the pr oblem of measurability and comparability, which are
highlighted in the next section.
Graph 2.1: Tax expenditures in selected EU MS and the US as % of GDP (left) and as % of total tax revenues (right)
00,511,522,533,544,55
AT BE DK FR DE EL IT NL PL PT ES UK USPIT
CIT
VAT
024681012141618
AT BE DK FR DE EL IT NL PL PT ES UK USPIT
CIT
VAT
Note: Reporting years vary from 2005 (Belgium) to 2012 (Poland). Fo r Austria there is no data on VAT tax expenditures and the
US does not apply VAT. All sample countries estimate the va lue of tax expenditures in terms of revenue foregone. Worth
noting that existing data do not capture all recent trends (e.g. the decreasing trend for Spain since 2010 in PIT and since 200 9
for CIT etc.). In the case of Italy, measures linked to the pr ogressive structure of the tax, e.g. the basic threshold of the f amily
component allowances, is considered as tax expenditure and cont ributes to the high ratio for tax expenditures in PIT.
Source: OECD (2010).
The size of reported tax expenditures in PIT generally exceeds that in CIT. The exceptions in our
sample based on OCED data are Denmark and the Netherlands. The size of total tax expenditure is
captured by the sum of all tax expenditures as a percentage of GDP. It could amount to 2%-4% of GDP in some countries, but in half of those covered here it stands below 1% of GDP. Of course, one should not
lose sight of the limits of such a measure and the limited sample of countries shown in Graph 2.1.
As an element of comparison, the size of reported tax expenditures in direct taxation is generally
higher than that of tax expenditures in VAT. The total size of VAT tax expenditures is influenced by
the level and the frequency of reduced rates and exemptions as well as by the broadness of the benchmark
definition. While the reported VAT tax expenditures could be relatively high in some countries (2% or 3% of GDP), they generally generate a lower revenue loss than the reported tax expenditures in PIT. Denmark, for instance, has a high VAT rate that is used as benchmark and both lower rates and
exemptions, even those that follow the VAT directive, are considered tax expenditures (Gebauer et al.,
2010).
Tax expenditures in PIT have increased over the la st decade, while those in CIT have remained
broadly stable or slightly on the rise.(
3) The following factors might plau sibly explain this trend. The
rise in PIT rates in many countries has mechanically increased the monetary amounts of deductions and
exemptions and encouraged new exemptions as a co mpensation scheme for specific groups, including the
most vulnerable. This expansion of tax expenditures is accompanied by a decrease in top rates (see Graph 2.2). At the same time, sharp reductions in statutory CIT rates in many Member States have been financed
(3) OECD (2010b) observed an incr easing trend of tax expenditures in PIT in many OECD Countries in recent decades (e.g.
Belgium, France, Spain, Portugal, Greece, Australia, US). At th e same time most countries reported a stable or increasing trend
in tax expenditures in CIT.
European Commission
TAX EXPENDITURES IN DIRECT TAXATION IN EU MEMBER STATES
10 by a broadening of the tax base and the abolition of tax expenditure items. In addition, the strong
reduction of CIT statutory rates over the last d ecade reduces mechanically the monetary amounts of
deductions and exemptions. Moreover, during the 2000s and until the crisis, some governments created new PIT tax expenditures in order to circumvent more stringent spending controls in place in the
respective countries.
More recently, there is a tendency of offsetting p ressures on tax expenditures in direct taxation in
EU Member States.(
4) On one hand, constrained public finances push towards the reduction in tax
expenditures. Moreover, some countrie s have enacted or are considering fiscal rules that may increase the
transparency and the budgetary control of tax expenditures (OECD, 2010a and 2010b). On the other hand,
governments want to encourage investment, employment and growth, which has resulted in a trend to a wider application of specific tax expenditure items in PIT and CIT, such as tax incentives to boost investment and R&D.
Graph 2.2: Change in top personal income tax rate and adjusted top corporate income tax rate (1995-2013)
Note: 2010-2013 change for Croatia.
Source: Commission Services.
(4) See European Commission (2013a)
3. GENERAL ISSUES WITH TAX EXPENDITURES EVALUATION
11 3.1. THE PROBLEMS OF IDENTIFICATION
Unclear definitions: the thorny issue of the benchmark
The analysis of tax expenditures faces fundamental definitional obstacles, related to the
determination of the relevant benchmark. More precisely, the difficulties arise from the concept of
benchmark tax system, which varies across countrie s and academic studies. Since tax expenditures are a
deviation from a benchmark tax system, they are genera lly rather difficult to identify in a straightforward
and unequivocal way. For example, the same tax relie f could be classified as tax expenditure in one
country, while being considered as a part of the benchmark tax system in another.
Usually three general approaches are distinguished that countries use to define the benchmark tax
system and to identify tax expenditures. According to Craig and Allan (2001) these are: i) the
conceptual approach; ii) the legal approach and iii) the analogous subsidy approach. The conceptual
approach links the benchmark tax to a normative tax structure, the legal approach takes the current tax
legislation as a basis for defining the benchmark tax and, thereby, for identifying tax expenditures, and
the analogous subsidy approach identifies as tax expenditures only those tax provisions that are clearly
analogous to a direct subsidy. The conceptual approa ch constitutes in practice the widest definition of the
three approaches, resulting in a more extensive lis t of tax expenditures with greater total cost.
The choice between a consumption tax and a comprehensive income tax benchmark exemplifies the
different conceptual approaches that can be taken for the area of income taxation. Under a
(comprehensive) income tax benchmark, any provision that reduces or postpones revenue from the
taxation of income derived from capital is tax expenditure. Whereas under a consumption tax benchmark, any taxation of income from capital is a negative tax expenditure or a tax sanction.
Tax expenditures in individual income taxa tion can take many different forms. These include
deductions, exclusions, non-refundable tax credits, refundable tax credits or reduced rates for specific
activities. With non-refundable credits taxpayers may only reduce or eliminate the tax liability, while with refundable credits the taxpayer receives the excess or ‘negative tax liability’ as a payment in case the
credit exceeds pre-credit tax liability.
Favourable tax treatment in corp orate income taxation is also very diverse and often concerns a
specific sector or activity. This is particularly the case of acceler ated depreciation fo r specific types of
investment, and special tax regimes. Other examples of tax expenditure in corporate taxation are deferral
allowances, special exclusions, exemptions or deductions from gross income. This implies that the legal
approach is often used in corporate taxation to define the benchmark tax system.
Countries use different classifi cations of tax expenditures. Many countries classify according to the
tax base (PIT, CIT, VAT, etc.) and by types of provisions (reduced rates, exemptions, deductions, deferrals, reliefs, and credits). Some countries also use a classification by beneficiary, in order to show the sector or type of taxpayer th at receives the tax advantage, or by the purpose or function of the tax
expenditure (housing, low income earners, environmental, etc.). To allow for comparison with spending programmes, countries sometimes also closely relate the items to a spending category in the budget. A
detailed review on the different classifications applied in EU Member States can be found in Table 4.2 in Chapter 4.
Different methods to measure the revenue costs of tax expenditures
The calculation of revenue cost is a cruc ial component of a tax expenditure report. A precise
quantification of the costs or value of tax expenditures is, however, not straightforward. Such
European Commission
TAX EXPENDITURES IN DIRECT TAXATION IN EU MEMBER STATES
12 quantification ideally needs to consider behavioural re sponses, interactions with other tax bases and other
methodological issues. OECD Member States mainly apply three methods to es timate the costs or value
of tax expenditures, i.e. (i) the revenue forgone met hod, (ii) the revenue gain method and (iii) the outlay
equivalence method (OECD, 2010a).
Member States most often use the revenue fo rgone method in their regular tax expenditure
reporting.(5) The revenue forgone method is the easiest estimation method. Behavioural responses or the
interaction with other tax bases is disregarded. The tax expenditure is typically the product of the tax
provision (e.g. rate reduction) and the volume it applies to (e.g. income). This method has, therefore, important drawbacks for estimating the budgetary costs and can only give a very first illustration of the possible revenue effects of a tax provision. The revenue gain method takes account of behavioural
responses and tax interaction and, therefore, gives a more precise cost estimate. It considers the increase in revenue that could be expected if a particular provision was to be repealed. Behavioural reactions can have substantial effects on budgetary outcomes. The latte r is, e.g., exemplified by the results of Barrios et
al. (2014) which suggest that behavi oural effects reduce the revenue cost of work-related tax expenditures
by around 1/3 in selected Member States. The reve nue forgone estimate has, however, the advantage of
giving a rather determinate estimate compared to a more subjective revenue gain estimate. The outlay
equivalence approach (also called ‘resource cost measure’) es timates what direct spending would be
required to achieve the same goals and benefits. It calculates the outlay that would have resulted in a similar gain for the taxpayer as the considered tax expe nditure. In other words, it considers the situation in
which tax expenditures were replaced by a direct expenditure, delivered outside the tax system , in the
budget function.
The measurement of tax expenditures faces a wide range of met hodological issues. It can, for
example involve the choice of a calculation method for tax expenditures which allows estimating
postponed or forgone tax revenues (e.g. the case of depreciation rules or taxation of pension savings). Here a standard ‘present value’ approach can be used or a micro-simulation model. The choice of micro simulation models depends on available tax data, and other technical issues (e.g. algorithms used), since these models are usually used if full data for estimati ng the cost of tax expenditures are not available, and
for projections over several years. Another choice is whether revenue estimates should be based on an accrual or cash basis etc.
3.2. GUIDING PRINCIPLES: INCREASING POLICY EFFICIENCY
The economic relevance of tax expenditures could be assessed through a small number of criteria. This
section first identifies three groups of guiding principles and then analyses how tax expenditures could affect the performance of public policy according to each of these criteria.
Identifying guiding principles
The first group of criteria covers various facets of the microeconomic efficiency , which corresponds
to the use of resources maximizing the production of goods and services and are referred to by Musgrave (1939) as the ‘resource allocation’ function of taxation:
• Internalising externalities , so as to provide the socially-optimal level of good and services. This could
refer to positive externalities, like for instance th ose generated by R&D and innovation, or negative
externalities, created by pollution and greenhouse gas emission. In the latter case, tax expenditures
may actually reduce economic distortions.
(5) See European Commission, 2013.
3. General issues with tax expenditures evaluation
13 • Minimising distortions generated by taxation . Taxation is considered to distort the production and
allocation of good and services, compared with the unrealistic absence of taxation. However, given a
certain level of tax burden (to finance a number of public good and services), the introduction or
removal of tax expenditures may impact the level of economic distortion. For instance, the cost generated by a particular tax expenditure should be financed by a low distortive form of taxation and not by growth-harmful form of taxation, such as tax on labour. Beyond static inefficiency, tax expenditures may durably affect inefficient behaviour such as rent seeking activity instead of efficient
investment in the long run (dynamic inefficiency). In some case, however, tax expenditures can reduce the distortions generated by taxation: e.g while classic corporate income tax systems favour debt as a source of financing compared to equity, a tax expenditure in the form of the Allowance for Corporate Equity (ACE) reduces that distortion.
• Remaining compatible with a sound functioning of the single market. The existence of tax
expenditures, especially in the area of corporate taxes, may in crease mismatches and double non-
taxation in the EU. This may affect profit shifting and base erosions.
The second group of criteria covers the capacity to meet efficiently social or strategic objectives
defined by the government. The issue is therefore not about the relevance of the governmental
objectives, but, rather, about the choice of the best instruments to meet the objectives assigned. Tax
expenditures may be one of the possible instruments, but, it should be checked if other instruments could reach the same target at a lower cost.
• Improving social equity. This corresponds to the redistributive function of taxation, identified by
Musgrave. Tax expenditures could be used as a means to reduce income inequality and combat
poverty. In some cases, for instance favourable tax treatment (e.g. on energy consumption to support low-income outcome) may conflict with economic objectives (e.g. reduce carbon emission or use energy resource efficiently).
• Reaching strategic goals . The paper does not cover this dimension because of its strong political
economy character. These objectives may be manifold but generally related to industrial policy and the promotion of national champions or flagship sectors. This should be done in the respect of the Single Market.
The last group of criteria relates to the efficient functioning of fiscal policy. This may corresponds to
the ‘stabilisation’ function of fiscal policy and macroeconomic stability as defined by Musgrave.
• Simplicity and stability of the tax system. Reducing its complexity will positively affect the
compliance costs for firms and citizens and the coll ection costs for public administration. In some
cases, tax expenditures are in fact designed to reduce compliance and collection costs (e.g. fringe
benefits such as employee provided, health insura nce, education allowances, childcare and assistance
allowance).
• Keeping transparency and accountability of fiscal policy. Tax expenditures – as an allegedly less
transparent and less accountable form of public expe nditure – should be used in a fashion compatible
with a sound functioning of national fiscal framework.
Microeconomic efficiency
Tax expenditures could be used to internalise externalities, but this faces an identification problem.
This requires identif ying the (negative or positive) externality precisely and calibrating the amount of tax
reduction accurately to ‘price in’ th e externality. In practice, this is a delicate exercise, requiring a large
amount of evidence.
European Commission
TAX EXPENDITURES IN DIRECT TAXATION IN EU MEMBER STATES
14 The introduction of tax expendi tures narrow tax bases, which often leads to higher tax rates.
General textbook analysis stresses the virtue of a large tax base and low tax rates. The economic
distortions are more than proportional to the tax rate. Indeed, a higher marginal tax rate is more likely to affect behaviour, especially if th e economic agents are highly reactive to changes in relative income.
Tax expenditures affect the behaviour of economi c agents and can distort the allocation of
resources. Some tax expenditures can lead to welfare losses by distorting investment and consumption
choices. Introducing tax expenditures to support a gi ven sector will divert resources and activity from
other sectors of the economy. A key question is then to know if the reallocation of resource is efficient, as
is the case with direct spending. A general response to this question is impossible and any assessment should be made on a case by case basis, addressing the specific economic issues at hand.
Tax expenditures, like other government policies, including direct spending may lead to rent
seeking behaviour by tax payers. This results in a sub-optimal allo cation of resources, which is often
accompanied by allegations of undue influence by sp ecial interest groups. Rent seeking can be quite
costly for economic growth through hurting innovatio n and creating inequalities. Substantial resources are
dedicated to tax optimisation at the expense of more productive activities. In the assessment of tax expenditures, possible undesi rable interactions with other tax bases should
be taken into account. While a given tax expenditure can be immediately related to the reduction in the
beneficiary’s tax liability for the corresponding base, the overall impact on revenues depends crucially
upon the interaction with other relevant taxes. A typical example is the introduction of tax relief on mortgages, which could indirectly reduce or increase tax revenue from dividend and interest income once households have readjusted their portfolios to accommodate the lower cost of mortgages (OECD, 2010a) (Capozza et al., 1996). This difficulty arises indepe ndently of the method applied for the measurement of
tax expenditures.
Tax expenditures may complicate the fu nctioning of the single market. The existence of mismatches
and loopholes across tax systems, particularly in th e area of corporate taxes, may encourage firms to
engage in tax planning, with a view to minimise tax liabilities. This may reduce the capacity of collecting
tax revenue in the EU as a whole, because of the induced base erosion and the presence of double non-taxation. This may encourage profit shifting and base erosions, which could push some Member States to further tax less mobile tax base like labour, leading to a harmful impact on growth for some countries and a sub-optimal allocation of resource at the EU level.
Clear cost and benefit analysis can show that – in some cases – tax expenditures are well justified.
There are valid reasons for govern ment involvement. Such involv ement can, for instance, aim at
stimulating the consumption of merit goods, to promote innovation etc. Some objectives can be achieved
at lower administrative cost via the use of tax expenditure (due to the use of existing tax information) compared to spending programmes. Tax expenditures could be justified in the case of market imperfections e.g. linked with the access to financial market.
Achieving social goals with more efficient means?
Tax expenditures are not necessarily the most efficient policy inst rument to reach a desired goal.
Various instruments are available in the hands of governments and can be classified as follows i) financial instruments (subsidies, general tax/revenue policy and tax expenditures), ii) legal or regulatory instruments and iii) communication and information policy (see Graph 3.1). Before introducing any new tax expenditure, one should determine whether this instrument is more efficient than a legal or
information instrument and to estimate whether it is better when compared to other available financial instruments – and vice versa.
3. General issues with tax expenditures evaluation
15
Table 3.1: Standard typology of government policy instruments
Source: Classification of Financial Policy instruments. Polackova, B., et al World Bank (2004)
Tax expenditures can be regressive and may no t be targeted enough, generating windfall. Some tax
expenditures provide the largest benefit to high-incom e taxpayers and little or no benefit to low income
households, which is not least problematic from a social equity viewpoint. Indeed, tax expenditures tend
to favour those who can actually reduce their tax liability by a large amount, that is, the high income tax-payers. This in particular applies to tax deductions as compared to tax credits. In the first case the
reduction in the tax due depends on the marginal tax rate, whereas in the second case the reduction is the same for all tax payers with a positive tax due. The poorest taxpayers, who are likely to pay a relatively modest amount of taxes, have less or no opportunity to reduce further their tax liabilities. The exception are refundable tax credits, which give rise to a ‘nega tive tax’ in the form of a benefit, classified as
subsidy(
6), if the tax credit exceeds total tax liabilities. Therefore, all taxpayers benefit the same way.
The distributional effects of tax expenditures are difficult to measure and to control, unlike in the
case of targeted subsidies or benefits. More affluent tax payers often have a better knowledge of the tax
system and can afford the advice of tax counsellors, with a view to using tax expenditures as a tool of tax optimisation. Many tax expenditures are, however, not means-tested and benefit all income levels.
Depending on the purpose of the tax expenditure, this could generate large dead-weight costs, which could be avoided by using targeted benefits to support the most vulnerable households. Means-testing or targeting would result in other well-known difficulties, such as increased marginal effective tax rates in the area of the threshold. The distributional effects of targeted spending programs are often easier to
control but in some cases it may require more administration.
Distorting effects on fiscal framework and fiscal policy
Tax expenditures increase the complexity of the tax system and risk to overburden tax
administration resulting in additional revenue losses. Tax expenditures may: i) generate higher
compliance and administrative costs by rendering the tax system more complex, ii) weaken the fiscal
framework and iii) possibly generate a misallocation of public funds. The complexity of the tax system increases the compliance costs for households, entreprene urs and SMEs. It is also raises the cost of tax
collection.
(6) The move from ESA 95 to ESA 2010 is expected to change th e classification of some tax expenditures. ESA 2010 introduces
among others explicit new rules for recording tax credits in na tional accounts. This treatment represents a clear difference as
compared to the previous recording under the ESA 95. Tax cred its that constitute non-contingent liability of government are
now treated as expenditure instead of reduction of tax revenue and recorded at the moment when government recognises the
obligation to pay. The new recording on gross (rather than net) basis results in an increase in total revenue and total expendi ture
indicators, compared to the previous practice.
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TAX EXPENDITURES IN DIRECT TAXATION IN EU MEMBER STATES
16 Tax expenditures are less transparent than direct sp ending and do not have to be approved in all
Member States regularly by the relevant legislat ive body, reducing the political accountability. The
use of tax expenditures does not provide the same assurance of transparency as the use of direct subsidies
and benefits. Even in the most developed countries with a well-functioning tax expenditure reporting, the gap between the level of scrutiny and transparency of tax expenditures compared with direct spending remains an issue. Tax expenditures can have a consider able lower cost in the year of introduction than
over time. The development in revenue cost of tax expe nditures is much less tran sparent than in the case
of spending on the expenditure side of the budget. The opacity generated by the existence of numerous and large tax expenditures can complicate revenue management.
In terms of fiscal governance, tax expenditures reduce the certainty of the budgetary process
because of their uncapped funding. While spending programmes tend to be routinely reviewed when
drafting the annual budget and are subject to budgetary ceilings, tax expenditures in some countries do
not face similar scrutiny, and thei r budgetary effect ultimately de pends upon behaviour (i.e. upon the
take-up ratio). The open ended character of tax expenditures results in a lack of control over the entire budget, which jeopardizes fiscal balance and fiscal sustainability. This issue is particularly relevant in times of fiscal consolidation, when resorting to ta x expenditure can in practice be used to circumvent
existing expenditure rules and limits on direct spending programmes if such limits do not take (changes in) tax expenditures into account. However, many countries have increased the governance of tax
expenditures in recent years. The amounts of tax e xpenditures are more often presented in spending
programmes and tax expenditures are included in spending reviews more frequently.
Since tax expenditures are usually easier to intro duce than direct expenditure , they may be given a
higher budget priority, regardless of their effectiveness and efficiency. This may distort the
prioritization of fiscal items and affect the fiscal allocations. Moreover, tax expenditures might not be co-
ordinated with regular spending or other tax expenditures, undermining further the efficiency in allocating public resources.
3.3. POLITICAL ECONOMY DYNAMICS: RISK OF MISUSE OF TAX EXPENDITURES AND PERSISTENCE
Tax expenditures are particularly vulnerable to their capture by lobbies. A lack of co-ordination and
control of tax expenditures may increase the risk of abuse and possibilities for introducing provisions in favour of interest groups (e.g. tax holidays). In a ddition, governments may prefer tax expenditures,
because they reduce measures of the overall tax pr essure and do not increase the measure of spending.
Thus, they may give the appearance of reducing the government’s size. For this reason, tax expenditures
have strong political appeal in some countries. In fact, however, tax expenditures can actually expand
government’s interference in the economy, partly becau se they induce changes in taxpayers’ behaviour.
The economic rents captured by some actors combined with the lack of transparency render tax
expenditures quite persistent, even when their raison d ’être has disappeared. Like direct spending,
tax expenditures must also be paid for through higher taxes or reduced spending elsewhere. This appeal
for tax expenditures also echoes the ‘deficit bias’ eff ect, generated amongst others by i) electoral motives
such as high spending in elec tion years (Drazen, 2000), ii) ‘fiscal illusions’ on inter-temporal budget
constraints, affecting voters (Buchanan and Wagner, 1977), and iii) the wish to constrain successor
government with different spending preferences (T abellini and Alesina, 1990). Hence, rent seeking
activity is promoted taking into account the fact that a focussed advantage benefitting a small target population is more visible than cost broadly spread over the general taxpaying population. On the other hand, and unlike a direct spending programme, tax expenditure does not give rise to bureaucracy with a vested interest in maintaining it.
The discussion above highlights general issues that are important in the evaluation of tax
expenditures . These general issues are related mainly to economic efficiency of tax expenditures, their
3. General issues with tax expenditures evaluation
17 impact on social-equity, the need to address market imperfections, to foster entrepreneurship and growth
and to complement non-tax policy solutions. An evaluation of the efficiency of tax expenditures requires
identifying different policy areas and an assessment of how tax expenditures could – or not – help meet given economic objectives in these areas. A case-by-case analysis with the focus on specific groups or
categories of tax expenditures associated wi th specific economic issues is needed ( bottom up or thematic
approach ) in order to identify policy options. The main challenge is through an analysis of costs and
benefits to help limit the use of tax expenditures to cases where, based on the above general guiding principles, considerable market failures exist and where obvious administrative advantages over
comparable spending programs can be identified.
4. TAX EXPENDITURES REPORT ING IN MEMBER STATES
19 Tax expenditures reports play an important role in increasing transparency of the tax regime. The
estimates of revenue cost need to be interpreted caref ully but can provide a useful starting point for policy
and decision makers, considering the pros and cons in reforming tax systems. Table 4.1 gives an overview
of existing tax expenditure reporting in Member States. It shows that 18 Member States regularly report
on tax expenditures and Bulgaria already decided to do so as of 2014. The reporting practices are
however very diverse across countries and vary a lot in presentation, deepness and coverage. For some countries, one-off tax expenditure reviews or inventories have been produced recently (see the third column). These reports are generally more extensive, produced in some cases by independent experts (e.g. in Denmark, Ireland and Finland) and could include reviews or judgments on specific tax expenditure measures. The contents, do, however, vary from report to report. References to national publications connected with regular reporting and the specific reports can be found in Table A.2 in the Annex.
Table 4.1: National reporting of tax expenditures
Country regular (annual* ) non-regular (latest)
BE X
DE X 2009
EE X
IE 2009
EL X
ES X
FR X 2011
IT X 2010/2011
CY
LU
MT
NL X
AT X
PT X
SI
SK X
FI X 2010
BG (X) 2011
CZ
DK (X)
HRLV X
LTHU X
PL X
ROSE X
UK X
Note: Regular reporting is biannual in Germany. In Denmark, no t all tax expenditures are updated annually. In Bulgaria, the
new Law on Public Finances adopted at the end of January 2013 and entering into force at the beginning of 2014 provides
for annual publication of tax expenditure information. Latvia published a report on reliefs in PIT in 2011.
Source: Commission services
Some general common features of regular reporting practices can be identified. Reporting (mostly
annual) is typically conducted by the Ministry of Finance, Economics or Taxation or by services reporting
to these Ministries. Some Member States, following a legal approach, publish tax expenditure figures
together with other budget documents, while others publish them as individual reports. The countries in general use the revenue forgone method for calculating tax expenditures, but there are important
differences in methodology, for instance whether re venues are estimated on a cash or accrual basis.
European Commission
TAX EXPENDITURES IN DIRECT TAXATION IN EU MEMBER STATES
20
Table 4.2: Elements of regular reporting practices
Central
governmentState
governmentLocal
governmentSocial security
funds
BE X X t-5, t-4, t-3, t-2, t-1 tax base, purpose
DE X X X X t-2, t-1, t, t+1 tax base, type of tax measure, purpose, secto r
EE X n.a. t, t+1 tax base, purpose
EL X X n.a. n.a t-2 tax base, purpose, secto r
ES X X X t+1 tax base, type of tax measure, expenditure categor y
FR X X n.a. X t-1, t, t+1 tax base, expenditure categor y
IT X X n.a. t, t+1, t+2 type of tax measure, purpose, sector
NL X X n.a. t-2, t-1, t, t+1, t+2, t+3, t+4 tax base, sector, law, policy are a
AT X X X t-3, t-2, t-1 tax base, sector
PT X X n.a. t-2, t-1, t, t+1 tax base, purpose
SK X X n.a. X X t-2, t-1, t, t+1, t+2, t+3 tax base
FI X n.a. X t-1, t, t+1 tax base, purpose
DK X n.a. X various years tax base
LV X n.a. t-2, t-1 tax base
HU X X n.a. t+1 tax base
PL X n.a. X t-1 tax base, purpose
SE X X n.a. X X t-1, t+1, t+2tax base, type of tax measure, purpose/sector (expenditure
category or technical tax ex penditure )
UK X n.a. X t-1, t tax base CountryLegal
requirementLevels of government covered
Time coverage Categorization
Note: In the column for time coverage ‘t’ refers to the year of publication. ‘n.a. ’ stands for ‘not applicable’. State
government refers to the Länder in Austria and Germany, th e gewesten en gemeenschappen / régions et communautés in
Belgium and the comunidades autonomas in Spain. In Belgiu m, the reporting covers taxe s collected by the federal
government. In Spain, the autonomous communities publish diffe rent tax expenditure reports. In Bulgaria, the new Law on
Public Finance provides for annual publication of tax expenditure information as of 2014. Detailed information on reporting is
not available yet. In France the reporting of tax expenditure in social security funds refers to the Projet de loi de financeme nt
d e l a S é c u r i t é s o c i a l e – A n n e x e 5 : P r é s entation des mesures d’exonérations de co tisations et contributions et de leurs
compensations. In Finland, time coverage refers to numbers pu blished for individual tax expenditure items by the Ministry of
Finance in the budget proposal. The VAT report identifies all tax expenditure for t-2, t-1, t and t+1. In Netherlands Ministrie s
also have to report tax expenditures that fall within the policy area individually in their budget reports
Source: Commission services based on national sources
In 2013, there was a national le gal requirement to report on tax expenditures in 10 of the 18
Member States that report regularly today. In addition to whether national law requires reporting on
tax expenditures, Table 4.2 provides information on coverage in terms of level of government and time
and the categorisation of tax expenditures used. The levels of government covered vary between countries. While central government is always covered, tax expenditures related to local taxes and social security funds seem to be less well captured. In the cas e of local and state government, this is partly due
to the heterogeneity of the taxes applied.
There is great variance in the number of years covered and whether reporting is backward or
forward looking. In Austria and Belgium, the reporting is clearly backward looking covering the last
three or even five years, whereas in Sweden tax expenditures are report ed for last year, current year and
two years forward. The Netherlands ha s the longest reporting period and the reporting is both forward as
backward looking. The most frequent years reported on are the past year, the cu rrent year and the coming
year (see Table 4.2 for detailed information). Tax expenditures are identified in reference to their tax base, but combinations with other
categorizations are common as well. Tax expenditure is generally cate gorised according to the tax base
(e.g. VAT, PIT, or CIT) and often grouped according to type of tax measure (e.g. allowances, rate relief,
and exemptions), purpose (low income earners, housing, etc.) or sector (households, businesses, or
agriculture). Some countries also link tax expenditure to the expenditure side of the budget (e.g. Spain, France and Sweden). Overall, those countries that do not report so far on tax expenditure regularly find it difficult to provide such information. Based on available information by June 2013, these countries are: Ireland, Cyprus, Luxembourg, Malta, Slovenia, the Czech Republic, Croatia, Lithuania and Romania.(
7)
Overall, information on tax expe nditures in force or planned in M ember States is often fragmented
and not fully transparent. This makes it more difficult to identify possible improvements in fiscal and
(7) In accordance with EU directive on requirements for budgetary frameworks, Romania has introduced in the legislation the
obligation to report data on the impact of tax expenditure. The data will be available starting with the 2015 budget law.
4. Tax expenditures reporting in member states
21 tax arrangements and can make fiscal policy-making less effective and efficient. Th is in turn affects the
strength of the domestic budgetary framework because — more or less hidden — revenue losses may
weaken the impact of enhanced transparency on the expenditure side. The changes recently introduced with ESA 2010 in the recording of some tax credits in national accounts, may have an impact on tax expenditures classification(
8) and are expected to en hance budgetary transparen cy and impact budgetary
discipline .
In the absence of a commonly agreed definition of tax expenditures, the case for transparent
reporting is even stronger and now mandated by EU legislation. Within the context of the
transposition of the Directive on requirements for budgetary frameworks (2011/85/EU), Member States
are required (since 1 January, 2014) to provide information on the tax expenditures and their impact on
revenues. Article 14(2) of the Directive states that: ‘Member States shall publish detailed information on
the impact of tax expenditures on revenues’. While it is not the intention of the provision to establish or
enforce a standardised procedure for the Member States to evaluate tax expenditures in this context, the
Commission has issued broad guidelines to assist Member States in complying with this obligation to publish, which are summed up below. As a subsequent step the Commission may have to assess the degree to which various Member States comply with the core requirements of the above Directive. This
will allow the Commission to gain a better understanding of the present (new or improved) reporting practices of the Member States and possibly to suggest further reporting improvements to be discussed in the future.
To raise awareness of tax expenditures in the budget process and among the public, it is advisable
to include information an d data on tax expenditures in the budget documents. A transparent
presentation should be attempted and an explanation of the main approaches including benchmark,
revenue estimate and coverage should be given. The reporting should include cost estimates and a broad coverage of all areas of taxation incl. social secu rity contributions and local taxes. A more detailed
explanation of methodology could be needed. Such information could also be provided in a separate reference. A listing of tax expenditures in the budget documents that would allow for easy comparison with spending programs in the same field would help visualize the relative magnitude of such concessions and give a more comprehensive picture of public s upport in a specific policy ar ea. Such a grouped listing
(in connection to, or close to spending lines) could be an addition to a separate section or report on tax expenditures.
Beyond having tax expenditures reported in the budge t, the next step should be to perform regular
formal evaluations. Such reviews should judge the tax expend itures in terms of efficiency and cost
effectiveness and could be more extensive and repeated on a less than annual frequency. Government
bodies might not be always best placed to perform an objective review of tax expenditures. Independent
bodies or commissions could be better suited for this task. Such reviews should be publicly available.
(8) See footnote 6 in Section 3 for mo re information on recent changes.
5. ECONOMIC AND DISTRIBUTIVE ASPECTS OF SELECTED
TAX EXPENDITURES IN PERSONAL INCOME TAXATION
23 This section discusses selected tax expenditure items in personal income taxation, namely making work
pay tax expenditures, tax expenditures for self-e mployed, pension related tax expenditures, tax
expenditures for self-employed and housing-related tax expenditures.
5.1. MAKING WORK PAY TAX EXPENDITURES
Among work-related tax expenditures ‘Making Work Pay ’ (MWP) policies play a determinant role.
This embraces different instruments such as tax cr edits, tax rate reliefs and exemptions for specific
individuals. Their aim is (i) to make work more attractive by providing a financial incentive to become
employed for those who are unemployed or inactive, thus promoting labour force participation; and (ii) to support those who are at risk of pove rty or social exclusion even when employed. As far as tax credits are
concerned, the UK – a pioneer in designing this system(
9) – announced in 2010 the transition to a
Universal Credit System, although the current model still relies mainly on the Working Tax Credit introduced in 2003. Other Member States introduced tax-related MWP measures in 2001: France ( prime
pour l ’emploi ), Belgium ( crédit d ’impôt pour les bas revenus d ’activité professionnelle ) and the
Netherlands ( arbeidskorting ). On the contrary, in Hungary the employee tax credit in 2008 ( adójóváírás )
was replaced in 2012 by an empl oyer-contribution relief for young, old and unskilled employees. When
turning to tax rate reliefs and tax exemptions, between 2011 and 2013 the need for budget consolidation
did not provide much scope for reducing the former and/or increasing the latter. In fact, most of the
Member States generally increased personal income taxes. Nonetheless, there were some exceptions.
Latvia gradually reduced the PIT rate from 2013 to 2015, and as of 2013, the UK has increased the
‘personal allowance’, i.e. the amount of income free of taxation.
Making Work Pay tax-related measures differ according to the eligibility and generosity
criteria.(
10) As regards eligibility criteria , tax credits are means-tested both at individual and household
level in the UK and France, and only at individual level in Belgium and the Netherlands. The potential
beneficiaries can be employees or self-employed in the UK, France and the Netherlands, while in
Belgium the measure is mainly for the self-employed.(11) The number of weekly worked hours is an
eligibility criterion in the UK. In terms of generosity, in France the minimum annual income required to
access the credit is EUR 3 743 while the maximum depends on household composition. Income brackets
are wider in the Netherlands, where there is no minimu m income required. The Member States also differ
according to the generosity criteria , e.g. the amount of tax credit or the refundability.(12) Another
characteristic is the waiting time to obtain the relie f. Furthermore, some credit rates depend on the
number of dependents, as in the UK or France and in so me cases incentives also depend on age, as in the
Netherlands.
(9) The UK introduced the Family Credit in 1988, replacing it in 1999 with the Working Family Tax Credit. The UK is presently in
a transitional period. Both the Working Tax Credit and the Child Tax Credit will be incorporated into the Universal Credit
System (together with the income-based Jobseeker’s Allowa nce, income-related Employment and Support Allowance, Income
Support and Housing Benefit); the process, started in April 2013 will go through differe nt pilot and trial stages, before being
rolled out nationally by 2017.
(10) Tax credits can have different eligibility criteria (e.g. the level of personal and/ or household income, employment status, o r the
number of hours worked) and different genero sity criteria (the extent of relief, th e possibility of obtaining a refund, the tim e it
takes to receive the credit). The generosity of the relief may also depend on the taxpayer’s situation (level of income, age,
household composition, number of dependents). For tax rate reliefs and exemptions, the only eligibility criterion is, in most o f
the cases, the income level.
(11) Also a part of the public sector is still covered. With the aim of strengthening the labor supply effect, for most wage earne rs the
PIT tax credit has been converted into a reduction of soci al contributions based upon the number of worked hours.
(12) Refundability implies that if the credit exceeds the amount of tax due, the difference is not lost (e.g. in the Netherlands t he
credits are not refundable).
European Commission
TAX EXPENDITURES IN DIRECT TAXATION IN EU MEMBER STATES
24 MWP tax expenditures are mainly assessed with respect to their impact on labour supply(13) as well
as on the income distribution (capacity to meet effi ciently social or st rategic objectives). The most
recent literature, although in some cases contrasting results are foun d, highlights some key messages:
• The effect of increasing the labour supply level can be substantial depending, inter alia, on the size of
the intervention (e.g. for the case of the UK Brewer et al. (2006)) attributed to the replacement of the
Family Credit and the Working Family Tax Credit (14) an increase in the employment rate of 5-10%
but for the case of France, several authors (e .g. Cazenave (2005), Arnaud et al. (2008))(15) agree that
the 2001 PPE scheme, as well as its successive modification, was too timid to achieve relevant change
in the employment rate).
• Despite the positive effect on the overall rate of employment, some negative incentives can occur for
secondary earners or in terms of the number of worked hours. For the case of France, Stancanelli
(2008) showed the PPE scheme to have a negative and significant impact on the employment probability of married women and, in some cases, a positive and significant one for unmarried women. For the UK, Brewer et al. (2006) found that the Working Family Tax Credit led to an increase
in the labour supply of single mothers while the la bour supply of coupled parents was gender-related,
with a slight decrease for mothers and a slight increase for fathers. Brewer et al. (2011) also found that
the new system of Universal Credit is likely to give a stronger financial incentive to work to the part-time or low-wage main earners, with higher earne rs and second earners having a weaker incentive.
From a comparative perspective, Bargain and Orsini (2006) presented a EUROMOD micro-simulation with the aim of applying a working tax credit simila r to the British Working Family Tax Credit, and,
alternatively, a purely individualised wage subs idy to Germany, Finland and France. The conclusion
points to a negative overall effect on female employment after the introduction of the working tax credit, and a positive effect on female employment after the introduction of the wage subsidy. These
results are valid in particular for France and to a lesser extent for Germany and Finland.
• In terms of distributional effect, MWP tax expenditure measures can have positive effects. The impact
may differ depending on the specific design of the measure. In the case of France, Thibault et al.
(2002) positively assessed the role of PPE in terms of redistribution; Bargain (2008) finds that the
different measures applied result in a decrease of the Gini Index for all the countries considered: France, Belgium, the UK and the Netherlands. Nevert heless, in case of the Netherlands where the tax
credits are not only targeted at lo w-wage workers it happens that th e income of work ers around the
median is increased relative to that of the poorest, leading to an in crease of the number of people at
risk of poverty. In contrast, the effect of poverty reduction is stronger in the UK and more limited in
France and Belgium. In case of the UK, Brewer et al. (2011) find that the bottom income deciles will
gain the most as a fraction of in come from the Universal Credit.
• MWP tax expenditure entails a cost in terms of foregone revenue compared to the benchmark system
which might justify an in-depth cost-benefit analysis in times of consolidation effort. In this respect,
also the behavioural-induced revenue effects need to be taken into acc ount. Barrios et al. (2014), in a
comparative study on five EU Member States (Fra nce, the UK, Spain, Slova kia and Hungary), show
that decreases in labour supply – particularly along the extensive margin – following a marginal reduction in MWP tax expenditures wash away at least one-fifth of the purely mechanical revenue
gain from the reform. The revenue gain erosion is relatively larger for the more targeted instruments (e.g., tax credits for the working poor), and increas es in the degree of individual heterogeneity with
respect to the calibrated labour supply elasticities.
(13) Both intended as number of employed and number of worked hours.
(14) In force until 2003.
(15) See also the literature mentione d in Immervoll and Pearson (2009).
5. Economic and distributive aspects of selected tax expenditures in personal income taxation
25 Compared to spending programmes, MWP tax expenditures present some pros and cons that
should be considered on a case to case basis.
• Some advantages over the unemployment benefits or the minimum wages include the capacity of
offsetting the ‘benefit dependence’ (unemployment and inactivity traps) and of avoiding an increase in
labour costs.
• On the other hand, drawbacks have been found in the complexity of their design as well as in the lack
of real-time effect due to the annual account ba sis for declaring income taxes (OECD, 2010a).
• Other relevant elements to consider are the budgetary implications (after positive behaviour
adjustment), error-proneness and the scope for fraud induced by the system. MWP tax expenditure
measures should also be designed taking into account the interaction with other factors such as social
contributions, benefits, whether there is a minimum wage, the features of the labour market demand side and the possible choices of those already employed in terms of worked hours.
5.2. TAX EXPENDITURES FOR SELF-EMPLOYED
Self-employment is becoming increasingly important in the EU. Traditionally, the self-employment
status is equated with entrepreneurship and considered to be a form of independent contracting, which is
based on a reduced form of legal liability compared to corporations. However, evidence suggests that
many of those classified as self-employed, in pr actise act more like wage-employees than fully-fledged
entrepreneurs.
A preferential treatment of self-employe d can be justified for several reasons. The rationale behind
preferential treatment for self -employed workers is linked inter alia to the fact that their income tends to
cumulate a higher degree of uncertain ty, as entrepreneurship activities are ri skier, and to the fact that it is
more difficult to receive funding when compared to other occupations.
Regulations that facilitat e easy access to self-employment creat e incentives for wage-employees to
move into self-employment. Labour market regulations and organisational changes also have a strong
impact on the level of this traditional form of non-standard employment. A multitude of advantages are
also built into the tax systems (e.g. deductions, credits, allowances for start-up costs, etc.) to support self-employment. Therefore, it is inevitable that efforts are made by some taxpa yers to be reclassified as self-
employed. This is also evident, when looking at the favourable system of allowable deductions existing in several Member States, which applies for example to operating expenses, equipment, the taxpayer’s
children and non-working spouse.(
16)
In addition to existing govern ment support schemes, tax systems in many Member States provide
strong incentives for individuals to start firms and become self-employed. Tax systems can be
instrumental in promoting self-employment. Tax incen tives for self-employed usually aim at treating self-
employed in a way comparable to the treatment provided to employ ees (e.g. deductions for health
insurance premiums and long care insurance premiums for self-employed etc.). However, the introduction of such tax incentives is likely to have contributed to an increase of self-employment, which has coincided with the declining relative productivity in starts up (OECD, 2011a).
Labour and tax regulations may also drive companies to shift from wage employees to self-
employed schemes. For example, industry-specific regulations (e.g. in construction, transport, guarding,
cleaning, insurance, media) and legal restrictions in the variability of wages usually play an important role
in the outsourcing decision. This could lead to an in crease in dependent self-employed, as companies try
(16) Travel expenses are also allowed as a deduction throughout the EU, while deductions for children and a non-working spouse are
only available in half of the Member States (Eur opean Commission: ‘Taxes in Europe’ database).
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TAX EXPENDITURES IN DIRECT TAXATION IN EU MEMBER STATES
26 to optimise their costs under the new labour and tax regulations. It would also act as an incentive for
companies to circumvent the labour market and social security protection laws, by replacing their wage-
employees with self-employed workers, but still ma intaining the same working relationship and link of
subordination as before.
Tax expenditures provided to self-employed may, in some cases, significantly incentivise labour to
shift from more productive employment to less productive self-employment. Tax incentives for self-
employed add to already existing tax incentives for SMEs or other supporting measures and contribute to
higher tax evasion among self-employed than among employees. Tax incentives for self-employed may give enhanced room for under-reporting of income and may affect taxation of worldwide income as well, by using specific rules to circumvent or to avoid taxation.(
17) Looking at undeclared work across OECD
countries, the majority is conducted on a self-employed basis, while waged employment for informal business accounts for a smaller share (Williams and Rennoy, 2008 and Johansson, 2005)(
18). In summary,
evidence supports the argument that the scope for underreporting of income and tax evasion is significant among self-employed and that high taxation of labour earnings can also encourage self-employed not to declare at least part of their earned income (OECD, 2008). Overall, this pref erential tax treatment may
result in the fact that rather low-productive self-e mployed activity is preferential from an individual
perspective to more productive employed activity.
The tax treatment of self-employed workers is rather different across Member States. Some
prominent examples of tax expenditures which only a pply for self-employed or maybe exploited better by
them include: working tax credits (if working full- time), housing benefits, capital allowances (e.g.
computers, machinery), deductions for the business use of a vehicle, deductions of donations, child tax
credits and child benefits, deduction for non-working spouses, jobseeker’s allowances (if working part-time), deduction on health insurance, pension credits , reduced social security contributions for self-
employed, and different tax support from local authorities.
Compared to direct spending programmes, tax expe nditures for self-employed need to be evaluated
on a case to case basis in order to justify th at relevant tax expenditure is the preferable tool. In
particular in this area, there is th e constant need to evaluate and asse ss the impact of the specific tax rules
on micro-economic efficiency, equity, simplicity and transparency as well as the administrability of the
rules. This evaluation will help target the promotion of real entrepreneurship facing a high degree of economic uncertainty and facing high risk taking to survive in a competitive environment. Such assessment will also avoid the circumvention of labour market laws and social security protection legislative by companies with potential revenue shortfall.
Tax expenditures targeted at self-employed should not necessarily be removed, especially if they
help foster entrepreneurship. Entrepreneurship yields high social returns, and it is generally accepted
that it should be taxed at a lower rate than the current marginal tax rate on labour (OECD, 2011 and
Gordon, 1998). However, without any good instruments to ex ante identify entrepreneurship among small
businesses and self-employed, it is difficult to evaluate tax incentives aiming at lowering the tax burden. Rather, it could be ensured that tax incentives do not lead to a discriminatory regime that encourages
firms to outsource their employees, resulting in th e substitution of wage-employees by ‘bogus self-
employed’.(
19) In that case, the prime motivation of the self -employed status is linked to the avoidance of
(17) For example self-employed may avoid paying income tax for worldwide earned income. According to OECD Model
Convention to avoid double taxation, self-employed are only payi ng income tax in their residence country, unless when they
have permanent establishment in the source country. However, self-employed may avoid to declare the income in their
residence country benefiting from limited possibilities for administrative co-operation and automatic exchange of tax information between countries.
(
18) These studies estimated that, for example, in Finland inco me from self-employed was underreported by 16-40%, representing 1-
3% of GDP; for the UK self-employment income was found to be about 1.3 to 1.5 times larger than the reported income; as
regards Sweden, self-employment income should be multiplied by a factor of 1.35 in order to arrive at true income.
(19) By ‘bogus self-employed’, we mean workers that are physically and functionally part of the business, although they work under
self-employment status.
5. Economic and distributive aspects of selected tax expenditures in personal income taxation
27 paying contributions for both employers and self-employed, resulting in a tax windfall, due to
underreporting of taxable income as well. Finally, some employers may, also, prefer this type of status, as fake self-employed individuals could be discharged without warning, are not entitled to holiday or sick pay, have reduced benefit rights and are al so denied access to employment tribunals.
5.3. PENSION RELATED TAX EXPENDITURES
Most pension income in EU is provided by statutory public pensions funded on a pay-as-you go (PAYG) basis, but private and funded systems are growing in importance.(
20) Payments from private pension
schemes were worth 1.6% of GDP or equivalent to a fifth of average public spending on retirement benefits in OECD countries in 2009.(
21) Many Member States have in the last decades introduced
compulsory private pensions and such funds have only to a small degree started to pay out pensions. Graph 5.1 shows how private pension payments can be ex pected to grow for select ed Member States over
the next 50 years. In Denmark and the Netherlands the private pension payments already are at quite a
high level and roughly close in size to public pension payments. It should be mentioned that UK is also among the countries with considerable private pension expenditures.(
22)
Graph 5.1: Private pension expenditure in 2010 and 2060 in selected Member States (as % of GDP)
Source: The 2012 Ageing Report (European Commission, 2012).
(20) The defining feature of a pay-as-you-go (PAYG ) pensions system is that – in each period – the social contributions paid by th e
working age population should finance the pens ion benefits paid to pensioners. In gene ral, no assets are set aside. In practice ,
additional transfers over the state budget and financed by general taxes often help fi nancing pension benefits. In a funded plan,
contributions are invested in funds towa rds meeting future retirement benefits.
(21) OECD (2013a): Pension at a Glance (covering data from 25 countries).
(22) UK has unfortunately not provided data on private pension expenditure in the context of the ageing report (2012). It should a lso
be mentioned that some Central and Eastern European countries have introduced reversals of pension reforms with partial or
full shifts of contributions to the public scheme and government appropriations of the assets in private pensions (e.g. PL and
HU).
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TAX EXPENDITURES IN DIRECT TAXATION IN EU MEMBER STATES
28 Population ageing challenges public pay-as-you-g o (PAYG) pension systems considerably and has
led several countries to create tax incentives for private pension savings . The motivation for such tax
incentives can be to smooth income over the life-cycl e, prevent old-age povert y or encourage long-term
saving in the economy to stimulate growth in the long run. It is typically argued that many people are
myopic and do not plan sufficiently for the future and measures are needed to correct for a possible under
provision of long-term needs.
Box 5.1: The tax treatment of pension savings and the benchmark for tax expenditures
The taxation of pensions can take place in three possible points in time, namely when:
1. contributions to the fund are paid (out of earned income)
2. investment income and capital gains accrue to the fund
3. benefits are received from the fund
TEE system ( taxed , exempt, exempt) and EET system (exempt, exempt, taxed )
In a TEE-system earned income financing contributions is taxed whereas returns to the fund and
pension payments are tax exempted. In an EET-system contribution payments qualify for a tax
deduction, returns to fund are tax exempt but pens ion payments are taxed. The tax treatment is in
both cases equivalent to a consumption tax, see chapter 3.1.1. With a flat PIT rate , these two systems are equivalent in effect and neutral between consumption
now and in the future. They deliver the same ne t present value of revenues to the government
although the timing is different. Revenues are deferred until retirement under EET, but received
immediately under TEE.
In a progressive personal income scheme , when a tax payer is confronted with different marginal
tax rates before and after retirement, a tax payer with higher marginal tax rate before retirement will benefit from the EET scheme.
TTE system (taxed, taxed , exempted) and ETT system (exempted, taxed, taxed)
In these models capital gains accrue to the fund ar e also taxed. This makes the tax treatment in the
two alternatives equivalent to a (comprehensive ) income tax, neutral between consumption and
saving but not neutral between consumption now and consumption in the future. This implies a disincentive to save. Otherwise the difference is as described above.
Inflation can increase the tax burden in TTE and ETT systems significantly when nominal returns
are taxed.
Low or non-existing taxation of returns to pension savings is regarded as tax expenditures under
an income tax benchmark, but not under a consumption tax benchmark. Pensions are savings for
future consumption and a neutral treatment of consumption over time is only respected by the
consumption tax systems (TEE and EET). However, such a treatment would generally provide a
tax advantage over other forms of saving such as interest bearing accounts, direct holdings of
equity, or intermediated products such as unit trus ts or investment trusts as these capital returns
are typically taxed. Owner-occupied housing is on the other side a form of saving that is often
even more generously treated with respect to taxation than pension savings.
5. Economic and distributive aspects of selected tax expenditures in personal income taxation
29 A generous tax treatment of pens ion savings in private funds may have considerable impacts on
government revenues and redistribution . Whether a generous treatment increases the overall saving
rates is questionable, a generous tax treatment could promote pension savings in the tax-favoured plans at
the expense of other forms of savings, and be costly in terms of revenue forgone, lead to tax avoidance and distortions. The distribution consequences may also be undesirable if higher income earners are better able to take advantage of tax reliefs. If a generous tax treatment of private pension savings is to encourage savings overall, the funds going into such accounts need to have come from individuals reducing their consumption levels as opposed to simply moving money from one form of saving to another. When rather the latter is the case, the preferential tax treatment would imply high budgetary cost while missing the
objective of the policy.(
23) A recent study on pension savings in Denmark found that a tax (or price)
subsidy is ineffective in raising total savings (Chetty et al., 2013). The study concludes that automatic or mandatory contributions to savings accounts are more effective in raising total savings than a tax subsidy.
There are 3 different occasions to tax pensions and several tax approaches can be taken. Box 5.1 on
the previous page describes the most common approaches for taxing private pension savings and lists
some important features of the different models. The box also points out the implication of the choice of benchmark for the assessment of tax expenditures in private pension savings.
A more generous treatment of pension savings th an the expenditure tax- benchmark (EET, TEE)
indicates a particular need for a re view of tax incentives for pensions . The tax treatment of pensions
in several (European) countries is often associated with the EET scheme (occupational pension schemes
for instance in the UK, Ireland and the Netherlands or private Riester pensions in Germany).
Nevertheless, preferential tax treatment for pension income exists beyond that for instance by lower rates or special tax free thresholds for pension income. On the other extreme, a less generous tax treatment than a pure comprehensive income tax could put an unjustifiable high tax burden on pension savings.
Under a deferred taxation scheme (EET, ETT) pensio n savers benefit from deductions at higher tax
rates from taxable income when wo rking compared to those applicab le to typically lower pension
income when retired . This leads to a reduced tax burden on the underlying labor income. Since
replacement rates (that is the ratio of gross pension in come to gross income when in work) are less than
100 per cent over most of the income range, the progressivity of the tax system leads to more generous
deductions of pension contributions compared to the taxation of benefits. This can, however, also be regarded as a form of ‘tax rate smoothing’ allowing an individual to spread out high income earned in shorter periods over time, not necessarily reducing th e tax burden compared to another taxpayer with
similar life earnings, which are more evenly distributed over time (Mirrlees et al., 2011). OECD (2013a) finds that taxes and contributions payable for a pensioner with pension income equal to workers average earnings amount to 16.9 %.(
24) The corresponding tax rate for pensioners with th e gross replacement rate
of an average earner is 10.9%. The difference illustrate s the impact of progressivity in income tax systems
and is often regarded as tax expenditure.
In practice, most countries use, in general, a rep orting approach for tax expenditures closer to the
income tax benchmark . Applied to private pension savings it means that any preferential treatment of
the returns to saving compared to the tax treatment of other types of income, could be regarded as tax
expenditure too. Some countries report tax breaks for private pension savings as tax expenditures. OECD (2013) includes data on tax expenditures for 9 EU Member States. These can be seen from Table 5.1
below. The UK, Ireland and Germany report the most substantial tax expenditures for private savings of
1.4, 1.2 and 0.9 % of GDP respectively. Additionally, in the Slovak Republic the tax expenditure is rather
(23) OECD (2005): Long-Term Budgetary Implication of Tax-Favoured Retirement Saving Plans shows that in the case where tax
incentives are assumed to lead essentially to saving diversion rather than creation, the net budgetary cost of tax-favoured
schemes remain large.
(24) The amount of taxes and contributions paid by workers is on average earnings considerably higher with 26.7 % in OECD. This
can be attributed to specific tax concessi ons for pension income but cannot be direc tly interpreted as such since no taxation o n
pension benefits might be justified by pre-paid pension tax models (TEE and TTE).
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TAX EXPENDITURES IN DIRECT TAXATION IN EU MEMBER STATES
30 considerable compared to the level of private pension payments. It needs to be further analysed which tax
design leads to these reported tax expenditures. One should also look more in detail into the tax treatment
of pensions in countries not covered in the table.
Table 5.1: Private pension payments and tax breaks in selected countries, 2009
Private pension paymentsTax breaks on private
pensions
(% of GDP) (% of GDP)
Austria 0.7 0.1 14%
Belgium 1.4 0.2 14%
Finland 0.3 0.1 33%
Germany 0.8 0.9 113%
Ireland 1.1 1.2 109%
Portugal 0.5 0.1 20%
Slovak Republic 0.3 0.2 67%
Spain 0.2
UK 4.6 1.4 30%Countrytax breaks as % of private
pension payments
Source: Pensions at a Glance 2013 (OECD, 2013a)
A wide range of pension related tax expenditures exist. These include among others: a) different types
of complete reliefs (e.g. for some or all pension inco me often below certain thresholds), b) lower rate on
pension income than ordinary labour income, c) specific tax allowances and credits (which exceed those available to taxpayers of working age) or d) no application of social security contribution to pensions. As mentioned above, many studies cons ider also the lower taxation of pension income compared to the
deductibility that applies to contribution in a defe rred pension scheme (EET, ETT) as tax expenditure.
Depending on benchmark, the missing taxation of capital gains accruing to pension funds is also often regarded as tax expenditure. For instance in the UK, the minimum personal tax-free allowance for
pensioners is higher than for those in working age and increasing in age.(
25) Also a tax-free amount of up
to 25% of pension payments to a maximum of £ 437,500 was given in 2010 for a lump sum outtake of pension savings. In Ireland, pension tax expenditures are at the top of the list of tax expenditures identified by a national Commission on taxation in 2009. The Commission suggested to reform and reduce the generous treatment of pension savings and some changes have been introduced in the recent years, including removing exemption for employers and employees PRSI on contribution to private pension schemes, limiting tax-free pension lump sum payments at EUR 200,000 and reducing the cap on tax-relieved contributions In the Slovak Republic neither pension contributions nor pension benefits are taxed for a substantive part of the pension system (only a supplementary, voluntary private pension is taxed as of 2011).(
26) Private pension schemes are as a general rule taxed ETT in Denmark. Capital gains
are however taxed at 15%, compared with an aver age of approximately 29% for assets in taxable
accounts. Denmark limited the generosity of the tax treatment for high end earners in 1999 by abolishing
deductibility for the top income tax rate (Chetty et al., 2013).
Considering that one of the main motivations for pension-related tax expenditures is to increase
overall savings, analyses of whether the target is reached at a reasonable cost or whether other
measures could be more efficient would be worthwhile . Differences in public spending also influence
the take up and potentially need for tax expenditures in a policy area (e.g. take-up of private pension
incentives will in part depend on the layout and gene rosity of public pension systems) (Bauger, L.,
(2014). A high level of private pension payments seems to be driven more by (quasi) mandatory schemes and less by tax expenditures; however the total revenu e cost of even smaller tax expenditure for private
(25) In 2011-12: £9,940, compared to £7,475 for those of working age. The allowance rose to £10,090 for those aged 75 and over
(for those with an annual income below £100,000)
(26) National authorities.
5. Economic and distributive aspects of selected tax expenditures in personal income taxation
31 pensions can be considerable for countries with an extended coverage of private pensions. Generous tax
expenditures can also be very costly and inefficient when they are applied to increase low levels of
private savings. Last but not least, it should be also considered whether the taxation of pension savings is
too low generous compared to other investment options and thereby creating undesirable distortions as
well as whether the distributional features are effici ent and equitable. It seems questionable whether tax
incentives are an efficient and appropriate measure in correcting for a lack of rationality by some individuals in long-term consumption needs.
5.4. TAX EXPENDITURES FOR EDUCATION
Investment in education and training and its impact on a country ’s human capital stock is a key
ingredient for economic growth . At macro level, increases in formal educational attainment have
contributed to economic growth across the OECD. At the micro level, higher levels of education are associated with lower rates of unemployment, high er wages and non-economic benefits to the society
(OECD, 2012).
Tax systems can play an important role in en abling, complementing or hindering education
policies. Targeted tax measures related to education are important in this respect. They directly influence
the expected returns to skills developments and may influence the supply and demand for skills in the
labour market. In this context, low marginal rates en courage education, as otherwise a poverty trap could
emerge and lifelong learning might not provide the necessary return.
A tax system that is neutral with respect to fi nancing agents does not influence who finances
education and skill investments. This can be achieved if the cost of employee training is deductible for
CIT tax purposes when financed by employers and deductible for PIT purposes when financed by
individuals. It is, therefore, important to look at the treatment of spending on training in PIT and CIT in parallel. For VAT the neutrality of the tax system can be improved by zero rating the costs of education.
The concept of benchmark tax system, for defining education tax expenditures is again rather
difficult to identify. Education tax expenditures are generally defined as tax measures that result in a
favourable rather that ‘neutral’ tax treatment of human capital. More specifically tax expenditures on
education are defined as the loss of public revenue as a consequence of the introduction of the incentives.
In general, state intervention is justified to offset socially undesirable underinvestment in education and
skills, improving social equity.
Differences in the tax treatment of expenditures on education and training can be observed among
EU Member States, but it is widely recognised that the tax system can play an important role in
reducing education and training costs (CEDEFOP, 2009). (
27) Tax expenditures for education are low
in most OECD Member countries for which data are available (28) and only account for a small
percentage of total public expenditure on education and training (CEDEFOP, 2009). Education
allowances, tax credits, special deductions and SSCs incentives are examples of commonly used incentives to encourage private skills investment. Training expenses in the interest of the enterprise can in general be deducted from earnings as a cost of doing business. In addition, tax incentives for individuals are present in the major ity of Member States. Table 5.2 and 5.3 contain examples of tax incentives
(27) Comparisons in this note are limited to tax incentives, classifi ed as tax expenditures, directly linked to the cost or financ ing of
education. However, a more detailed analysis should ideally include private education schemes used to stimulate human capital
formation. For example an alternative to providing tax incentiv es to stimulate employer-sponsored training are tax-like schemes
that require employers to finance a minimum level of training indirectly by contributing to a training fund. While these
measures do not rely on tax expenditures to stimulate employer-p rovided training, they encourage employers to increase their
training investments only up to a minimum level etc.
(28) Examples (as % of total tax revenues): Canada (2004): 1.25 %, Netherlands (2006): 0.58%, Korea (2006):1.64 %, Spain (2008):
0.05 %, UK (2008): 0.01 %, USA (2008): 1.32%. See OECD (2012).
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TAX EXPENDITURES IN DIRECT TAXATION IN EU MEMBER STATES
32 (classified as tax expenditures in the majority of Member States concerned) in personal and corporate
income taxation.
Table 5.2: Tax incentives for education in personal income taxation
M-S Tax measure Criteria-characteristics
AT Tax allowance for education expenses Education related to current occupation
BE Tax allowance for education expensesEducation linked to current professional activity (as part of
the standard deduction for work related expenses).
CZ Refundable tax creditFixed amount per child-student, depending on the age andacademic
program
DK Tax allowance for education expenses Professional training
EE Tax allowance for education expensesFixed amount per student depending on the age andacademic
program
Exemption of Public grants
Deductibility of IT education expenses for employee
FRTax credits for expenses on secondar yand tertiar y
education. Earnings by apprentices and students during
holida ys are exem pt from income taxation.
FI Tax allowance for education expenses Linked to professional training
Tax allowance for education expenses Work-related-vocational training, change of profession
Child and training tax allowances-refundable tax credit Fixed amount per child enrolled in vocational training
IE Non-refundable tax credit for educational expenses Funding of tuition fees for professional courses
IT Non-refundable tax credit for educational expenses Direct costs of education
LU Tax allowance for education expenses Vocational training
NL Tax allowance for education expenses Direct costs of education
Tax allowance and non- refundable tax credit for
educational ex pensesProfessional training expenses and fees paid to professionalassociations
Regional/local non-refundable tax credits Educational and training expenses
SE Tax allowance for education expensesDirect cost of education, increased living expenses as a
result of education
UK Tax allowance for education expenses Professional education, tuition and enrolment feesES
DE
PT
Source: OECD, 2012
Tax expenditures for human capital formation us ed by Member States are often criticised for
favouring large enterprises, high skilled indivi duals and groups already with best access to
education and training. By its very nature it is very hard to design a rational education policy that
doesn’t benefit the most talented. Compared to targeted spending programmes, they often appear too broad and insufficiently targeted. Moreover, in some cases tax expenditures for training may cause distortions compared to other investments (e.g. company expenditure on education can be generally deducted from earnings as a cost of doing busine ss while company expenditure on equipment can be
depreciated over their lifespan). Therefore, it is pr eferable that tax expenditures on education may be
supplemented by other policies in pl ace, so that the final mix of state intervention is reinforcing and not
resulting in contradictions and inefficiencies.
5. Economic and distributive aspects of selected tax expenditures in personal income taxation
33
Table 5.3: Tax incentives for education in corporate income taxation
M-S Tax measure Criteria-characteristics
Tax deduction-Full expensing Refundable tax credit Employee training cost
Refundable apprenticeship tax credit Fixed amount for tax credit per apprentice
SCC-exemption for apprentice wages
Tax deduction-Full expensing
CIT-additional allowance for apprentice wages (20%)
Employee training cost that is related to the business
activities of the em ployer
Fixed incentive bonus
DK Tax deduction-Full expensingEmployee training costs if training contributes to the
turnover of the business
EE Tax deduction-Full expensingDirect cost of vocational training, retraining o f
employees that have been laid off.
FR35% tax credit on increment for small companies;
Separate tax credits for self-employed and takinga
pprenticesWork related
FI Tax deduction-Full expensingEducation linked to updating of professional skills (basic
education is excluded )
Work-related-vocational training
IE Tax deduction-Full expensingTraining costs if incurred wholly and exclusively for the
purposes of the trade
Tax deduction-Full expensing or depreciation (20% to
100% )
SSC-rate reduction for apprentices
LU Non-refundable tax credit (10%)Vocational training expenses. Unused credits can be
carried forward for u p to ten years
PL Tax deduction for employer contribution to training fundContributions not used for their intended purpose within
2 years must be added back to taxable income
PT Tax deduction-Full expensingEmployee training expenses including fees, enrolmentcosts etc.
SK Tax deduction-Full expensingVocational training connected with the businessactivities, costs of technical secondar
y school
SI Tax deduction-Full expensing Training expenses including part-time school
Tax deduction-Full expensing Employee training
Non-refundable tax credit for IT training5% tax credit in respect of the costs of employee training
in new ICT
SSC-exemption in respect of young traineesSSC exemption limited to young people without formal
qualifications
SE Tax deduction-Full expensingEmployee training costs related to income. Partialdeduction if recreation elements are included in the costs
UK Tax deduction-Full expensingTraining for the purpose of trade. The timing o
f
deduction follows the accrual method.ITDirect costs of education or depreciation in no more than5 years in a straight-line basis ''placement'' and ''training''
contract for apprentices
NL Tax deduction-Full expensing Direct costs for employee training
ESAT
BE Employee training cost
CZ Tax deduction-Full expensing
DE Tax deduction-Full expensing
Source: OECD, 2012
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TAX EXPENDITURES IN DIRECT TAXATION IN EU MEMBER STATES
34 5.5. HOUSING RELATED TAX EXPENDITURES
Housing related tax expenditures are provided within the personal income tax framework. It relates
to the fact that many Member States want to promote home ownership as it is seen to bring benefits to the overall community. The definition of the tax expenditure will, as in most other cases, depend on the definition of the benchmark.
According to optimal tax theory, capital taxation id eally aims at neutral tax treatment of different
investments . This implies that returns from residential property would be taxed as other capital income.
Accordingly, the return or imputed rent from th e house, less depreciation allowances and interest
payments (i.e. the net return), would be subject to income tax.(
29) A tax on imputed rents could generally
be approximated through a recurrent annual tax on the property. In both cases, it is important that the
value of the tax base is regularly updated in order to properly tax the return.
A tax on imputed rents and/or a recurrent propert y tax are thereby essential to balance the tax
subsidy provided through interest rate deductibility . Hence, the absence of taxation of imputed rents
would constitute tax expenditure if the benchmark is a neutral tax treatment across the return on different
types of capital assets. The benchmark rate would then depend on the rate of taxation of other forms of capital returns.
Alternatively, if housing is regarded as a form of expenditure, the tax treatment should not impose
a tax wedge between pre-tax and post-ta x returns on the marginal investment . This implies that
households pay their housing investments with taxed income, and are not taxed on the subsequent return
on the housing investment (this is a tax-exempt-exempt (TEE) regime). Allowing mortgage interest deductibility in this context subsidies housing investments, and as a result the post-tax returns will exceed the pre-tax returns. Thus, using this benchmark, the mortgage interest deductibility would be regarded as
tax expenditure. All in all, a tax system with mortgage interest deductibility but without or with a too low
tax on the return on housing provides a subsidy to owner-occupied housing. This subsidy is a form of tax expenditure either in the form of the lack of a tax on imputed return or through the granting of mortgage interest deductibility.
The favourable tax treatment of home ownership is based on the assumption that it generates
positive externalities for society, which often justifies state intervention . It can be vehicle for wealth
accumulation as the owner will take a longer term view on his consumpti on behaviour and promote
savings. Better outcomes for children of homeowners as well as more engagement in the local community
are other positive externalities that motivate public policies favouring homeownership. However, it is
often difficult to clearly isolate the positive impact of homeownership as the relationships might be casual or suffer from endogeneity bias(
30). A drawback of homeownership is also that it tends to reduce labour
mobility.(31)
Subsidising home ownership through a tax relief does not go without risks in terms of a loss in
economic efficiency through misallocation of resources and a bias toward debt . This policy
encourages households to invest too much in housing in relation to other assets. Tax subsidies through the
deductibility of mortgage interest payments also favour household debt accu mulation particularly in
housing price booms, with potentially adverse effects on bank solvency or liquidity in cyclical troughs and consequent risks of credit constraints for firms and households.
(29) In a comprehensive income tax system, this corresponds to PI T. In a dual income tax system, the tax on personal capital incom e
is applied. Capital gains from housing transactions should also be taxed as other capital gains in order to achieve neutrality vis-
à-vis other assets.
(30) Factors that are supposed to affect homeowne rship depend themselves on the homeownership.
(31) See Andrews and Caldera Sanchez (2011) for an overvie w of benefits and costs of homeownership (box 1).
5. Economic and distributive aspects of selected tax expenditures in personal income taxation
35 Tax subsidies through the deductibility of mortgage interest payments also risk being a regressive
policy and being detrimental to social equity . First, no clear relationship has been found between the
degree of tax relief and the aggregate homeownership rate in a cross-country comparison of OECD-
countries. Second, as the tax subsidy normally takes the form of a deduction against earned income, and not the form of a tax credit, it is worth more for high-income earners. This is consistent with the finding that homeownership inequality, defined as the ratio of the homeownership ratio in the top income quartile to the ratio in the second quartile, appears to be high er in countries with generous tax subsidies (Andrews
et al. 2011).
To the extent that reduced interest costs are capi talised into higher house prices, a tax policy with
interest rate deductibility would co ntribute to higher house prices. Capozza et al. (1996), Harris
(2010) and Agell et al. (1995) find that a removal or a reduction of the interest rate deductibility would
lower house prices significantly in the U.S. and Sweden respectively. Recent empirical results also
indicate that demand shocks (e.g. through financial deregulation) have a greater likelihood to be
capitalised into real house prices when the country provides generous tax reliefs for mortgage cost payments (Andrews, 2010).
Alternative reforms exist to achieve the ob jective of housing related tax expenditure. To achieve a
neutral treatment of different forms of capital returns, the tax on imputed rents need to be increased and
brought into line with the tax on other returns. Alternatively, following the expenditure benchmark, the possibility to deduct mortgage interests in the income taxation could be phased out.
Compared to alternative reforms and spending programs tax expenditures on housing are, by their
nature, more general in scope and can often be us ed also by households that do not really need
these tax subsidies . As a consequence, the foregone revenue will normally be larger than the cost of the
corresponding grant. In addition social objectives can generally be better and more efficiently attained by direct subsidies (subject – rather than object – related subsidies). Direct grants can be designed so as to better target specific households, limiting possible distortions (i.e if the distortion is at the margin the intra-marginal subsidy is non-distortive).
As regards the current situation across the EU, ma ny Member States allow tax deductibility of
mortgage interest payments while the taxa tion of the imputed rate is too low. The low taxation of
imputed rates is often due to low rates, a too low value of the tax base, i.e. the value of the house assessed
for tax purposes, or a combination of the two. The result of these tax expenditures is that the systems favour debt creation and result in a debt bias in the taxation of housing. As a result, housing tax systems may have contributed to increases in housing prices, debt leverage and household over-indebtedness (Keen et al., 2010). Of the 14 countries that we re singled out under the macro-economic imbalance
procedure as having private debt above the scoreboard threshold (133 % of GDP) in 2012, 9 currently apply or have applied mortgage interest deductibility (Belgium, Denmark, Ireland, Spain, Luxembourg, the Netherlands, Portugal, Finland and Sweden).(
32)
Around half of the Member States’ tax systems favo ur mortgage debt financing of homeowners in
2013. Nine Member States (Belgium, Estonia, Italy, Luxembourg, the Netherlands, Finl and, the Czech
Republic, Denmark and Sweden) have a tax system that favours housing investment and household indebtedness, though to va rying degrees. Greece, Irela nd, Portugal and Spain(
33) have undertaken or are
undertaking reforms to phase out interest deductibility, either generally or for new mortgage contracts. Bulgaria strictly limits deductibility to young families, which can be regarded as a targeted form of
(32) COM (2013) 790 final, 13.11.2013.
(33) ) In Spain, e.g., tax expenditures linked to the acquisition of a house are no longer in force in general, A transitory regim e is
applied to those houses bought prior to 1 January 2013. On the other hand tax expenditure had been limited to 15% of the total
amount disbursed to make the acquisition, not only the interests paid in mortga ge, with a maximum amount deductible of
€ 9040 per annum.
European Commission
TAX EXPENDITURES IN DIRECT TAXATION IN EU MEMBER STATES
36 support (34). In most of the other countries, reforms are under way to reduce the debt bias in housing tax
system by trimming the scope of tax deductibility of mortgage interest payments. In some cases, these
reforms can already be judged as rather limited and/ or back-loaded. Overall, these reforms would still
need to be evaluated in order to judge whether these tax expenditures still create a bias towards debt in the tax system or whether the systems can be regarded sufficiently neutral vis-à-vis different forms of investments.
(34) Other policy instruments which do not encourage indebt edness would be preferable to support home-ownership.
6. ECONOMIC ASPECTS OF SE LECTED TAX EXPENDITURES
IN CORPORATE INCOME TAXATION: THE NATIONAL AND
THE INTERNATIONAL DIMENSION
37 This section focuses on tax expenditures in corporat e income taxation and look s into special corporate
income tax regimes, reduced rates for SMEs and tax incentives for R&D.
6.1. SPECIAL CORPORATE INCOME TAX REGIMES
The international dimension , especially in the EU context, has to be considered in applying the
concept of tax expenditure s to corporate taxation. CIT tax expenditures may have an impact on tax
competition, creating a need for co-ordinated action in order to achieve certain policy objectives such as
fiscal consolidation, reducing the continuing distortions in the single market, pr eventing excessive losses
of tax revenue (e.g. due to double non-taxation or to profit shifting away from the jurisdictions where the profit creating activities take place) or getting tax stru ctures to develop in a more employment friendly
way.
In the past, tax regimes have been assessed against the EU Code of Conduct criteria and State Aid
rules in order to identify and eliminat e the harmful elements for tax competition. As a result, many
of these specific measures have been put on standstill and rolled back. However, a number of tax regimes,
containing tax expenditures elements, have been a ssessed as non-harmful against the EU Code of
Conduct criteria, and are in force in EU Member States. Furthermore, new CIT tax expenditures have
been introduced through tax regimes favouring mainly R&D (e.g. concentrating mainly on providing tax
incentives for intellectual property (IP)). In recent years a number of Member States has introduced ‘patent box regimes’ that explicitly reduce the rate of corporate tax levied on the income derived from patents and in some cases from other forms of intellectual property. Patent box regimes vary in the tax rate they offer and in their design (from 0% in Malta to 15.5% in France). The definition of the tax base, and specifically the treatment of expenses, differ si gnificantly across Member States and can be more
decisive for the effective tax burden than the patent box tax rate itself. Such regimes may produce large
tax shields that can be used to offset tax liabilities for other forms of income.(
35) In particular, since the
establishment of the EU Code of Conduct Group for Business Taxation (1998)(36) in the Council and
based on the assessment(37) of tax measures and on the overview of regimes previously examined by the
Group, four main type of CIT regimes, with tax expenditure elements potentially harmful for competition have been identified (see Table 6.1).
These regimes can affect significan tly business location and economic activity in the Single Market .
Examples are favourable tax treatments that result in a reduction of tax liabilities for certain subset of
businesses and/or in investment outlays. These tax regimes are introduced at national level. However, the interaction of domestic tax rules, in some cases, can lead to gaps, frictions and distortions (double non-
taxation, profit shifting etc.).
(35) For an overview of ‘patent box regimes’ in the EU, see Evers et al. (2014).
(36) Conclusions of the ECOFIN Council 98/C 2/01, 1.12.1997 and Commission Services Brussels (29-02-2000) -SN 4901/99
(37) Tax measures have been assessed against the following criteria: 1. Whether advantag es are accorded only to non-residents or i n
respect of transactions carried out with non-residents, or 2. Whether advantages are ring-fenced from the domestic market, so
they do not affect the national tax base, or 3. Whether advantages are granted even without any real economic activity and
substantial economic presence with in the Member State offering such tax advant ages, or 4. Whether the rules for profit
determination in respect of activities within a multinationa l group of companies departs from internationally accepted
principles, notably the rules agreed upon within the OECD, or 5. Whether the tax m easures lack transparency, including where
legal provisions are relaxed at administrative level in a non-transparent way.
European Commission
TAX EXPENDITURES IN DIRECT TAXATION IN EU MEMBER STATES
38
Table 6.1: Types of Corporate Income Tax regimes, with international dimension in EU Member States
Regime Usual Characteristics Outcome
Harmful:
− Tax base is not determined by the actual interest income, but by a (fixed) mark-up on the
operational ex penses (cost- plus)
− Requires being part of an international group or only applies to international (offshore)
financin g income
− Does not allow or require (domestic) presence or real commercial activities
− Beneficial treatment restricted to financial services carried out with non-residents
− Deduction for deemed expenses allowed (e.g. contribution to risk reserve or management
charge)
− Exemption via deemed or standard profit allocation to foreign branch
− Deduction of deemed interest expenses by branch to foreign head office
− Combined with limitation in deduction of domestic interest expenses
− Special treatment available only via advance ruling
Harmful:
− Privileged treatment for royalties not available if deducted domestically
− Only applicable to foreign source royalties
− Patent boxes: targeting income from IP rather than R&D investment (risk of distorting
investment choices and locations )
Non-harmful:
− Royalty income relates to a registered patent
− Royalty income relates to a self-developed intangible
− Definition of eligible intangibles excludes models, design, trademarks or copyrights
− Patent / intangible must continue to be supervised, monitored and maintained
− The amount of royalties that can enjoy beneficial tax treatment is capped
− Self-development may be outsourced
− Applies to genuine royalty income and to "embedded royalties"
− Lower tax rate is determined as a percentage of the general tax rate
− Regime only available upon request
Harmful:
− The avoidance of withholding tax
− The avoidance of limitations in deductibility
− Accelerated depreciation
− Certainty in advance
Harmful:
− It is not limited to economic sectors requiring genuine economic activity (production, R&D,
etc.) or are not ex plicitly listed
− Financial, banking and insurance activities allowed without a connection to eligible ones
− No clear conditions concerning the (economic) substance required (e.g. creation of new jobs,
establishment of premises , machiner y, etc.)
− No limitation in time for enjoying the benefits
− The relocation of domestic activities is disallowed
− Dealings principally with non-residents in the special economic zones
− Accelerated depreciation is allowed in some cases
− Minimum percentage of foreign investmentFree or special economic zones([1])base
reduction/
reduced ratesPrivileged treatment of interestbase reductionPrivileged treatment of royaltiesbase
reduction/
reduced ratesIntermediate
financing or
licensingbase reduction
(1) In some cases dependent or associated territories, outermost regions and small islands operate special or free economic
zones as well.
Source: Commission Services
Although special tax regimes might be justifie d as a measure for the government to address
regional differences they are no t necessarily efficient from a general economic perspective. In fact, a
6. Economic aspects of selected tax expenditures in corporate income taxation: the national and the international dimension
39 large literature on tax competition emphasises that governments tend to underestimate the revenue losses
associated with a lowering of taxes (Buettner, 2014). In addition, when a special tax regime is found to violate State aid rules or the criteria of the EU Code of Conduct for Business Taxation – which means
mainly that the relevant measure lacks transparency , departs from internationally accepted principles and
standards, and is not compatible with a sound functioning of the Single Market, ‒ governments could
alternatively attempt to attract foreign businesses th rough more general business tax incentives instead,
which might serve as a substitute to the special tax regime. This might also open up further profit-shifting opportunities for multinationals and result in revenue losses.(
38)
6.2. REDUCED RATES FOR SMES AND COMPANIES OPERATING IN SPECAIL REGIONS OR SECTORS
A large number of Member States favours specific types of companies by granting them reduced
corporate income tax rates or special regimes . In most cases, the reduced rates are provided for small
and medium-sized enterprises (SMEs), for companies operating in economically-distressed regions or for companies operating in sp ecific economic sectors. Th e preferential treatment of SMEs may find its roots
in the general perception that corporate taxation coul d be regressive, in the wish to address possible
market imperfections, such as difficulties in accessing finance in the form of term debt and equity,
asymmetric information about the investment envir onment abroad, absence of large economies of scale
for SMEs or their lack of resour ces to optimise their tax burden. Therefore, taxation plays a more
important role in the cost structure of SMEs as compared to large enterprises.
Compared with alternative spending programs, of ten included in special investment laws, using the
tax system to correct these possible economic distortions does not se em to be the first-best solution .
Strong evidence of specific market failures or spill over effects should be required before a specific tax incentive is considered. Instead, considerations of political economy may lie behind the choice to provide SMEs with reduced CIT rates, even though the latter can encourage entrepreneur s to incorporate for tax
purposes and discourage companies to grow (Mirrlees et al., 2011). In addition, such a tax expenditure policy may reduce differences between the effici ent and non-efficient companies, which would
consequently affect thei r investment decisions.
More than one third of EU Member States provide tax incentives for SMEs in the form of reduced
corporate income tax rates . As can be seen in Table 6.2, ten Member States applied reduced rates in
2013 based on specific profit levels. In most cases, additional conditions re lated to the level of turnover or
staff size are applied.
(38) Fundamental CIT reforms, such as the introduction of an Allowan ce for Corporate Equity (ACE) have to be seen differently as
they reduce the distortion caused by the tax-favour ed treatment of debt compared to equity.
European Commission
TAX EXPENDITURES IN DIRECT TAXATION IN EU MEMBER STATES
40
Table 6.2: Reduced corporate income tax rates for small businesses, 2013
CountryStandard
rateReduced rates forSMEsEligibility criteria for reduced rates / thresholds for lower rates
Companies tha
tfulfil a number of conditions relating to the activities of the company,
the shareholding of the company, the rate of return of distributed profits and the
remuneration of their mana gers benefit from reduced rates.
The effective CIT rate can be substantially reduced by the allowance for corporateequity, the effective tax rate being only half of the nominal tax rate when the return onequity before tax is twice the nominal interest rate, i.e. 3.242 % for SMEs (2013).
profits of up to €
5
31% profits between €25,000 and €90,000
34.5% profits between €90,000 and €322,500
25%Companies with a turnover below €10 million. Only on a taxable base of up to
€300,000.*
20%In 2009-2012: micro-enterprises with a turnover less than €5 million, employing fewerthan 25 employees and maintaining or increasing employment. Only on a taxable base o
f
up to €300,000.
Largely independent businesses with an annual turnover no greater than €7.63 millionand on the
part of the profit tha t
does not exceed €38,120
21% 20% Taxable base up to €15,000
NL 25% 20%On the first €200,000 of taxable income. Income derived from locally-created R&D istaxed at a rate of 5%
Micro-enterprises with a turnover less than LVL 70,000, employing up to 5 employees
(if
turnover above, excess taxed at 20%)
LT 15% 5% Companies with a taxable profit less than LTL 1 million, employing up to 10 employees
HU 19% 10% On the first HUF 500 million of profits per annum, without any specific limitations
UK 24% 20%Companies with tax-adjusted profits under GBP 300,000. Marginal relief is available on
profits between GBP 300 000 and GBP 1.5 millionFR 33.33% 15%
LU+ 5% solidarity tax
LV 15% 9%BE33%
24.25%
+ 3% austerity surcharge on income tax rate
ES 30%
Notes: * As of 2011, companies in Spain that grow above the limits applicable for small companies can benefit from the
lower rate for three years after losing their small-business status.
Source: Commission services, national authorities.
In some Member States companies operating in speci fic, often economically-distressed, regions may
also benefit from reduced tax rates . This is meant to encourage critically needed entrepreneurial
business development and influence the decision of companies to locate and perform their activities
within an economically-depressed area. Table 6.3 indicat es those Member States which grant tax relief to
companies solely on the basis of their location, (often) independently of their economic activity.
Specific sectors of activity are sometime s also granted a favourable tax regime. Such tax regimes
affect the tax rate to which those sectors are in principle subject to, resulting in lower tax revenues. (39)
For instance, many Member States provide a specific corporate tax regime for the shipping sector
(‘tonnage tax’) under which the taxable income is determined based on the volume transported (tonnage
of vessels) rather than the income generated.
(39) Some Member States, like Hungary, also apply surcharges to specific sectors.
6. Economic aspects of selected tax expenditures in corporate income taxation: the national and the international dimension
41
Table 6.3: Reduced corporate income tax rates and special tax regimes for specific regions and sectors
CountryStandard
RateReduced rates for economically-distressed regionsSpecial tax
regimes for
specific sectors
BE33% +
austerity
surchar geSh
DE 31% Sh
IE 12.5% Sh
EL 26% Sh
Canary Islands (4%)
Ceuta and Melilla (15%)
FR 33.3% Overseas departments (0% for newly-created companies) Sh
IT 31% Sh
CY 12.5% Sh
MT 35% Sh, In
NL 25.5% Sh
Azores (17.5%)
Madeira (20%)
SI 17% Koper and Maribor (10%) Sh, In (0%)
FI 26% Sh
BG 10% High unemployment regions (0% only for manufacturing) (Sh, Ag)
CZ 19% In (5%)
DK 25% Sh
LV 15% Free Economic Zones (3%) Sh
LT 15% Free Economic Zones (0%) Sh
HU 19% Tr (0%)
PL 19% Sh
UK 24% Sh, Tr (0%)ES 30% Sh
PT 25%
Note: The list of economic sectors is non-exhaustive. ‘Sh’ refers to the shipping sector (tonnage tax), ‘Ag’ refers to the
agricultural sector, ‘In’ refers to investment companies, and ‘T r’ refers to trusts. In Spain special rates of (28%) for Basque
Country and (20%-27%) and Navarra are applied.
Source: Commission services
6.3. TAX INCENTIVES FOR R&D
Tax codes provide a number of incentives to promote R&D .(40) Public support to business undertaking
R&D finds its economic rationale in the market failu res (knowledge spill-overs and appropriability of the
results), which might keep innovation activities below their socially optimal level from a growth-
promoting perspective.(41) In this respect, in terms of the taxonomy set out above, public support satisfies
the microeconomic efficiency principle and responds to the need to reach strate gic objectives. Moreover,
the tax relief instruments are often combined with meas ures of more direct support, such as grants and
loans. As documented in OECD (2013), while differen ces still exist in the policy mix across countries, the
recent trend has been towards granting more generous ta x incentives in the context of a cut-back of direct
subsidies.
(40) A study on R&D tax incentives has recen tly been commissioned by the European Commission. The study reviews existing
instruments in place in the EU Member States and evaluates thei r effectiveness using on the basis of the results available in t he
literature.
(41) The Europe 2020 strategy sets a 3% target for R& D expenditure (both private and public) over GDP.
European Commission
TAX EXPENDITURES IN DIRECT TAXATION IN EU MEMBER STATES
42 Tax incentives for R&D can take different forms . Such incentives can, fo r instance, concern the
income generated by the R&D process, provide special treatment of technology acquisition, be targeted at
specific types of expenditure, or take the form of withholding tax credits for wages of employees engaged in R&D activities. Nonetheless, the most common types of tax reliefs are based on standard instruments of the tax codes, such as allowances and tax cred its for R&D-related capital expenditure. Special or
accelerated depreciation rules for fixed assets used in R&D activities are also common (Andrews and
Criscuolo, 2013). The latter can have the total volume of the outlays for innovation activities as a reference, or be designed to promote the increm ental expenditure above a certain threshold, or
alternatively be a combination of two.
The potential benefits and limitations of these tax incentives should be discussed in comparison
with the alternative available tools. (
42) In general, those take the form of direct subsidies to R&D
private spending. Direct subsidies can be targeted to specific categories of firm s/projects and be assigned
on a competitive basis, rather than in an automatic way like reliefs embedded in the tax system. Precisely
for that, however, they might be more costly to administer than tax incentives, ceteris paribus.
By lowering the marginal cost of the investment, tax incentives can increase business expenditure in
innovative activities . The economic literature has found significan t effects, both at the macro and at the
micro level. For instance, Bloom et al. (2002) find a unit elasticity of R&D expenditure to the cost of
capital in the long term, whereas the lower effects in the short term – around ten times – confirms the
strong complementarity of this expenditure with the demand for highly skilled labour. Micro-level studies
on the experience of single countries are too numerous to cite (see for instance Mulkay and Mairesse
(2013), Ientile and Mairesse (2009) for France, Lokshin and Mohnen (2007, 2009) for the Netherlands,
Guceri (2013) for the UK). Although the estimated impacts differ depending on the time period, the type of analysis and the institutional setting, they corroborate the view that fiscal incentives positively impact R&D expenditure.
There are risks and unintended consequences associated with tax incentives for R&D. A first issue is
the one of re-labelling of other ‘standard’ expenditure as R&D outlays in order to benefit from the more
generous fiscal treatment (Hall and Van Reenen, 2000) . Secondly, there is a conc rete risk that, if the
supply of highly skilled workers is rigid, at least in the short term, fiscal incentives will result in increased prices (in the form of wages for scientists) rather than in larger volumes of R&D (Goolsbee, 1999). The presence of that and similar imperfections can a lter the relative efficiency of different fiscal
instrument.(
43) Thirdly, by providing an implicit subsidy, tax incentives might promote projects with low
productivity which potentially would not have been viable otherwise, or might not generate the highest social return. Related to that, such tax reliefs might affect the dynamics of firms’ growth by favouring incumbents rather than new entrants. All in all, they would slow down the reallocation of resources across
firms within industries, particularly the R&D intensive ones (Bravo-Biosca et al., 2012). All these issues will ultimately soften the link between R&D and productivity which provides the rationale for government intervention in promoting innovative activities.
The design of the R&D tax incentives needs to be ca refully considered, particularly in times of large
remaining fiscal consolidation needs . Furthermore, as underlined in OECD (2013b), the stability of
these R&D tax incentives is essen tial for their efficiency: R&D involves long-run investments which
should not be weakened by funding uncertainty. As it is apparent from the discussion above, while tax
(42) Some types of R&D-related ta x benefits have impacts on cro ss-border strategies used by multinationals to reduce their tax
payments. For instance, a special treatment of (income from) patents in CIT creates room for profit shifting, rather than
incentivising innov ative outlays. If the incentive is granted regardless of whether the inte llectual property for which the pat ent is
granted is acquired or devel oped by the tax payer himself.
(43) For instance, simulations with an endogenous DSGE model by Ro eger et al. (2008) concluded that wage subsidies in the R&D
sector are more efficient than tax credits reducing the cost of R&D capital. However, the results may be reversed in the
presence of crowding out in the form of higher wages for high skilled workers and of a positive mark-up in the intermediate
goods sector.
6. Economic aspects of selected tax expenditures in corporate income taxation: the national and the international dimension
43 reliefs for R&D might prove effective in stimulating firms’ innovative activities, they might entail risks
that could increase their social cost beyond what is (more or less) immediately visible in terms of
foregone revenues. In this respect, the costs for administering the schemes and the compliance cost
associated with taking-up the benef its need to be taken into account as well. For instance, tax credits for
the incremental expenditure seem to provide an adequate tool both in terms of fiscal costs and in terms of effectiveness in promoting only additional investment, that is, in minimising the risk of supporting activities which would have been undertaken even without the fiscal incentives. However, they might imply larger administrative and compliance costs (particularly for small and young firms) than the more standard credits based on the total volume of expenditure. At the same time it is acknowledged that in some specific cases of tax cuts targeted at R&D, ta x expenditures proved to be an efficient instrument
resulting in a decreased administrative burden. All in all, the need for evaluating and monitoring such incentives, in combination with the other public support measures potentially available, is essential.
While tax incentives targeted at R&D expenses ca n successfully encourage innovation by lowering
the marginal cost of investment, other schemes focusing on mobile income rather than real
economic activities might o ffer opportunities for increa sed harmful tax competition. Some Member
State have introduced in recent years ‘patent boxes’ which target income from intellectual property. Such schemes could have negative effects on tax revenues (Griffith et al., 2011) and distort the geographical location of patents rather than increasing the under lying research and innovation activities (Dischinger
and Riedel, 2011). This aspect is being examined by the Code of Conduct on Business Taxation and it is also under examination in the OECD BEPS project.(
44) Moreover, Commission services are gathering
information on patent boxes in several Member States under EU State rules. (45) In summary, the need for
evaluating and monitoring such incentives in combination with other public support measures potentially available, is essential.
The interaction of R&D tax incentives with other policies, in terms of complementarity and/or
substitutability, needs to be taken into account . In this respect, the use of targeted subsidies and loans
has been advocated as a more effective instrument to promote R&D from small and young firms, which
are likely to be financially constrained and thus in need of upfront cash-flow to undertake an R&D
project.(
46) Likewise, targeted grants provided on a competitive basis enable the authorities to select
projects with high social returns. The drawback of such targeted schemes is again the larger
administrative and compliance costs comp ared to a system of general tax reliefs. All in all, cost-benefit
analyses would most likely point to a mix of instruments to be used to support R&D, whereby the relative importance of tax incentives depends not only on th e specific policy goals but also on the underlying
economic environment.
(44) http://www.oecd.o rg/ctp/beps.htm
(45) ) See http://europa.eu/rapid/pre ss-release_IP-14-309_en.htm
(46) R&D tax incentives can envisage carry-over and immediat e cash refunds provisions to support loss-making firms.
7. CONCLUDING REMARKS
45 In times of fiscal consolidation, the issue of the economic efficiency of tax expenditures ranks high
on the tax policy agenda. Reported tax expenditures add up to a non-negligible share of GDP in many
EU Member States and to an even larger share of collected revenue. In the last decade, the size of
reported tax expenditures in direct taxation has increased significantly. The economic downturn has led
Member States to introduce or extend tax expend itures both to support low-income earners and to
encourage investment and business activity. On the other hand, some Member States may consider
reducing the amount of tax expenditures somewhat to help meet consolidation targets.
The issues of definition, measurability and comp arability hamper sound cross-country quantitative
analyses. As pointed out in the paper, differences in le vels of reported tax expenditures across Member
States may reflect differences in recording prac tices as well as differences in tax policies.
Reporting tax expenditure regularly and systematically plays an important role in increasing the
transparency of tax systems an d assisting tax reforms efforts. Member States not reporting their tax
expenditures regularly should consider doing so, by producing and releasing this information in some
form, in compliance with the Directive on requireme nts for budgetary frameworks of the Member States,
adopted in December 2011. Such information can give insights about the scope for increasing economic efficiency and about avenues to support fiscal consolidation. Tax expenditures should be part of the budgetary process and simultaneously subject to regular evaluation.
A careful assessment of the efficiency of tax expenditures requires identifying relevant policy areas
and examining how tax expenditures could – or not – help meet given economic objectives in these
areas. Tax expenditures could be justified and enhance positive spill-overs, but the decision whether to
introduce or keep tax expenditures in place should be based on a clear analysis of costs and benefits. A
case-by-case analysis with the focus on specific groups of tax expenditures associated with specific economic issues is needed in order to identify po licy options. Such a ‘bottom-up/thematic’ approach by
economic issue is more fruitf ul than a comprehensive analysis of tax expenditures.
The economic relevance of tax expenditures in each area could be assessed against a small number
of criteria. These will help develop policy options for st rategic and prudent management of individual
tax expenditure items. A first group of criteria covers various facets of the microeconomic efficiency. The
second group of criteria reflects the capacity to me et social or strategic objectives defined by the
government with the best instruments available, wh ich are not necessarily tax expenditures. The last
group of criteria relates to the efficient functioning of fiscal policy. Based on these criteria, the paper aims at identifying i) possible risks attached to their us e and ii) dimensions to watch so as to ensure the
economic efficiency, alongside with arguments in favour of specific tax expenditure items. Such an
evaluation will help limit the use of tax expenditure s to cases where market failures exist and where
obvious administrative advantages over comparable spending programs can be identified. Some first policy conclusions for several relevant policy areas are summarised in Table 7.1. These conclusions should be read cautiously because the actual effects of specific policies depend greatly on the particular
context in which they are applied in individual Member States.
European Commission
TAX EXPENDITURES IN DIRECT TAXATION IN EU MEMBER STATES
46
Table 7.1: Evaluation of tax expenditures in some major areas
Arguments in favour Points to watch Reasons to remove tax expenditures
• Internalising externalities • Revenue impact • Too expansive: potentially large revenue
shortfall
• Reducing distortions generated by taxation
(second best approach) • Complexification of tax systems • Design too complex
• Possible desired distributional effects • Administrative and compliance costs • Scope for fraud
• Rent-seeking behaviour • Alternative measures more efficient
• Lack of transparency of (new) tax measures
• Capacity for offsetting benefit "dependence’
(unemployment and inactivity traps)• Could be costly if not targeted to the most vunerable
(although positive behaviour-induced revenue effects via job creation)• Complexity of design and risk of fraud
• Lack of real-time effect
• Interaction with other factors (e.g. social
contributions, benefits, features of the labour market demand side, etc.)
• Foster entrepreneurship • Target entrepreneurship facing a higher degree of
uncertainty• Circumvention of labour market and social security protection laws by companies
• Contributing factor to ‘bogus self-employed’
• May be necessary to smooth income over the
person’s lifetime and prevent old-age poverty• Possible unjustifiable tax advantages over other forms
of savings and risk of tax avoidance• Considerable windfall losses (substitution of
comparable savings)
• Encourage saving in general, improving long-
term growth• Risk of substituting other forms of equivalent saving,
resulting in high revenue costs without sufficiently
increasing the overall pension savings rate• Unintended redistributive outcomes (in
particular, advantages for high earners from deductions due to higher tax rates; greater take-up
at higher income levels)
• Can be necessary to encourage private pension
savings to compensate for reduced public pension benefits• Risk of substantially supporting high earners
• Increase quality of opportunity • Possibility of creating perverse redistribution
consequences favouring highly educated/high-income individuals and large businesses • Possible deadweight effects, especially on large businesses and highly qualified individuals
• Encourage skills development • Possible negative impact on tax measures for higher
education if tax incentives are not considered
supplementary measures
• Promote lifelong and adult learning • Must be particularly clear about the types of activities
and the individuals supported to avoid distortions and
uncertainties
• Positive externalities (e.g. create wealth,
encourage saving)• Misallocation of resources, resulting in higher house
prices• C
ontribute to housing prices boom
• Encourage housing investment • Effects on banks’ solvency and liquidity • High debt bias in housing taxation
• Could stabilise housing market • Regressive policy
• Encourage home ownership
• Social reasons
• Address possible market imperfections (e.g. the
financing of SMEs, the absence of large
economies of scale, a lack of resources, etc. )• Cause distortions (e.g. preferential tax treatment
discourages companies from growing)• Eligible activities are not limited to economic sectors requiring genuine economic activity
• Influence companies’ decision to locate in an
economically depressed area• Special tax rules for SMEs may conflict with each
other (e.g. tax equity vs system simplicity; improving
revenue collection vs giving SMEs incentives to grow; encouraging vs discouraging SMEs to grow)• Rules for profit determination deviate from internationally accepted principles (e.g. within a multinational group of companies)
• Encourage investment in specific economic
sectors• Hinder the smooth functioning of the single market (mistmaches, possibility of tax competition)
• Positive impact on R&D expenditure and other
innovative activities• Possible re-labelling of other ‘standard’ expenditure
as R&D outlays• Overlap with other public support measures
• Possibly less administrative costs (compared
with targeted subsidies)• May result in increased wages if the supply of highly
skilled workers is rigid• As a general scheme, it is not targeted to the
most productive projects
• Interaction of tax incentives with other policies, in
terms of complementarity and/or substitutabilit
y
• Possibility of aggressive tax planning and use of cross-
border strategies by multinationals (e.g. profit-shifting and tax base erosion in the case of intellectual property income
)For SMEs and special
economic zonesFor R&DGeneral arguments
applying to all tax Making Work PayFor self-
employed • May complement non-tax policy instruments to
reach the government's objectives
•Generating poverty traps or threshold effects (in
case of mean-tested advantages)• Avoid increasing labour costs, while stimulating
labour supplyPension-related For education Housing-related
Source: Commission services
ANNEX
47
Table A.1: Top statutory tax rates in personal and corporate income taxation, in %
1995 2000 2005 2010 2013 2014 1995 2000 2005 2010 2013 2014
BE 60,6 60,6 53,7 53,7 53,7 53,7 40,2 40,2 34,0 34,0 34,0 34,0
BG 50,0 40,0 24,0 10,0 10,0 10,0 40,0 32,5 15,0 10,0 10,0 10,0
CZ 43,0 32,0 32,0 15,0 22,0 22,0 41,0 31,0 26,0 19,0 19,0 19,0
DK 65,7 62,9 62,3 55,4 55,6 55,6 34,0 32,0 28,0 25,0 25,0 24,5
DE 57,0 53,8 44,3 47,5 47,5 47,5 56,8 51,6 38,7 30,2 30,2 30,2
EE 26,0 26,0 24,0 21,0 21,0 21,0 26,0 26,0 24,0 21,0 21,0 21,0
IE 48,0 44,0 42,0 47,0 48,0 48,0 40,0 24,0 12,5 12,5 12,5 12,5
EL 45,0 45,0 40,0 49,0 46,0 46,0 40,0 40,0 32,0 24,0 26,0 26,0
ES 56,0 48,0 45,0 43,0 52,0 52,0 35,0 35,0 35,0 30,0 30,0 30,0
FR 59,1 59,0 53,5 45,8 (50.3) (50.3) 36,7 37,8 35,0 34,4 36,1 38,0
HR 42,9 41,3 53,1 50,2 47,2 47,2 25,0 35,0 20,0 20,0 20,0 20,0
IT 51,0 45,9 44,1 45,2 47,3 47,9 52,2 41,3 37,3 31,4 31,4 31,0
CY 40,0 40,0 30,0 30,0 35,0 35,0 25,0 29,0 10,0 10,0 12,5 12,5
LV 25,0 25,0 25,0 26,0 24,0 24,0 25,0 25,0 15,0 15,0 15,0 15,0
LT 33,0 33,0 33,0 15,0 15,0 15,0 29,0 24,0 15,0 15,0 15,0 15,0
LU 51,3 47,2 39,0 39,0 43,6 43,6 40,9 37,5 30,4 28,6 29,2 29,2
HU 44,0 44,0 38,0 40,6 16,0 16,0 19,6 19,6 17,5 20,6 20,6 20,6
MT 35,0 35,0 35,0 35,0 35,0 35,0 35,0 35,0 35,0 35,0 35,0 35,0
NL 60,0 60,0 52,0 52,0 52,0 52,0 35,0 35,0 31,5 25,5 25,0 25,0
AT 50,0 50,0 50,0 50,0 50,0 50,0 34,0 34,0 25,0 25,0 25,0 25,0
PL 45,0 40,0 40,0 32,0 32,0 32,0 40,0 30,0 19,0 19,0 19,0 19,0
PT 40,0 40,0 40,0 45,9 56,5 56,5 39,6 35,2 27,5 29,0 31,5 31,5
RO 40,0 40,0 16,0 16,0 16,0 16,0 38,0 25,0 16,0 16,0 16,0 16,0
SI 50,0 50,0 50,0 41,0 50,0 50,0 25,0 25,0 25,0 20,0 17,0 17,0
SK 42,0 42,0 19,0 19,0 25,0 25,0 40,0 29,0 19,0 19,0 23,0 22,0
FI 62,2 54,0 51,0 49,0 51,1 51,5 25,0 29,0 26,0 26,0 24,5 24,5
SE 61,3 51,5 56,6 56,6 56,7 56,9 28,0 28,0 28,0 26,3 22,0 22,0
UK 40,0 40,0 40,0 50,0 45,0 45,0 33,0 30,0 30,0 28,0 23,0 21,0
EU arithmetic 47,2 44,6 40,4 38,6 39,4 39,4 35,0 32,0 25,3 23,2 23,2 23,1
EA arithmetic 47,7 45,9 41,0 41,1 43,8 43,8 36,2 33,9 27,4 25,0 25,5 25,5Top personal income tax rate Adjusted top corporate income tax rate
Note: The PIT rate reflects the statutory tax rate for the highest income bracket. It does not differentiate by source of incom e
and therefore surcharges and deductions for specific income so urce are not taken into account. Regarding CIT, the ‘basic’
(non-targeted) adjusted top rate is presented here; some countries apply small profit rates or special rates, e.g., in case the
investment is financed through issuing new equity, or alternative rates for different sectors. Such targeted tax rates can be
substantially lower than the standard statutory top rate. Existing surcharges and local taxes are included. For details of the calculation of the top PIT and CIT rates, see European Commission (2014).
Source: Commission services
European Commission
TAX EXPENDITURES IN DIRECT TAXATION IN EU MEMBER STATES
48
Table A.2: References to national publications on tax expenditures
Country Publisher (in english) Publisher (in national language(s)) Document(s)Year of
publication
BE The Belgium Chamber of RepresentativesChambre des Représentants de
Belgique/Belgische Kamer van
VolksvertegenwoordigersAnnexe au Budget des Voies et Moyens de l’année budgétaire 2013, Inventaire
2011 des exonérations, abattements et réductions qui influencent les recettes de l’État, doc 53 2521/002./Bijlage tot de Rijksmiddelenbegroting voor het
begrotingsjaar 2013, Inventaris 2011 van de vrijstellingen, aftrekken en
verminderingen die de ontvangsten van de Staat beïnvloeden, doc 53 2521/002
DK Ministry of Taxation Skatteministeriet list on homepage of the ministry
DE Ministry of Finance Bundesministerium der Finanzen Dreiundzwanzigster Subventionsbericht
EE Ministry of Finance Rahandus-Ministeerium Stability Programme 2013
EL Ministry of Finance Υπουργείο Οικονομικών Κρατικός Προϋπολογισμός 2014, Νοέμβριος 2013
ES Ministry of Finance and Public Administration Ministerio de hacienda y administraciones
publicasPresupuestos Generales del Estado. Memoria de beneficios fiscales
FR Ministry of Finance Ministère de l'Economie et des Finances Dépenses fiscales, annexe au projet de loi de finances 2013
Ministry of Finance and Ministry of Social Affairs and
HealthMinistère de l'Economie et des Finances et Ministère des Affaires Sociales et de la SantéProjet de loi de financement de la Sécurité sociale – Annexe 5 : Présentation des mesures d’exonérations de cotisations et contributions et de leurs compensations
IT Ministry of Economy and Finance Ministero dell'Economia e delle Finanze Bilancio dello Stato. In particolare gli allegati A e B "Effetti Finanziari delle
Disposizioni Vigenti Recanti Esenzioni o Riduzioni del Prelievo Obbligatorio" della Tabella N.1 "Stato di Previsione dell'Entrata"
LV Ministry of Finance Finansu MinistrijaInformatīvais ziņojums
„iedzīvotā
ju ienā kuma nodokļ a atvie glojumi
HU Ministry of National Economy Nemzetgazdasági Minisztérium Törvényjavaslat magyarország 2013. évi központi költségvetésér ől
NL House of Representatives of the States-General Tweede Kamer der Staten-GeneraalNota over de toestand van ’s rijks financiën and Toelichting op de belastinguitgaven
AT Ministry of Finance Bundesministerium für Finanzen Förderungsbericht 2011
PL Ministry of Finance Ministerstwo Finansów Preferencje podatkowe w Polsce
PT Ministry of Finance Ministerio das Finanças Despesa fiscal 2013
SK Ministry of Finance Ministerstvo financií Slovenskej republiky Návrh rozpo čtu verejnej správy na roky 2014-2016
SE Ministry of Finance Finansdepartementet Redovisning av skatteutgifter 2013
Ministry of Finance Valtiovarainministeriö/ Finansministeriet Valtion talousarvioesitys 2013/ Statens budgetproposition 2013
Government Institute for Economic Research (VATT) Valtion taloudellinen tutkimuskeskus (VATT) Verotuet Suomessa 2009–2012
UK Her Majesty's Revenue and Customs(HMRC) Her Majesty's Revenue and Customs(HMRC) Various documents available on the homepage
Country Publisher (in english) Publisher (in national language(s)) Document(s)Year of
publication
BG Ministry of Finance Министерство на финансите Presentation of reporting in english on the homepage 2011
DE Fifo Köln, Copenhagen Economics and ZEW Fifo Köln, Copenhagen Economics and ZEW Evaluierung von Steuervergünstigungen. Band 1-3 .2 0 0 9
IE Ministry of Finance Ministry of Finance Commission on Taxation 2009
FR Ministry of Finance Ministère de l'Economie et des Finances Com ité d'évaluation des dépenses fiscales et des niches sociales 201 1
Senate's services for public budget Servizio del bilancio del Se nato Esenzioni e riduzioni del prelievo obbligatorio. Una analis i del bilancio per il 20112010
Ministry of Economic and Finance Ministero dell'Economia e delle Finanze Gruppo di lavoro sull’erosione fiscale. Relazione Finale2011
FI Government Institute for Economic Research (VATT) Valtion taloud ellinen tutkimuskeskus (VATT) Valmisteluraportit 5. Verotuet Su omessa 2009 2010Non-Regular publications Regular publications
FI
IT
Source: Commission services
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