Governments fund their programs in two ways. They can use the straightforward method of taxing and spending—money comes in and money goes out. Or they can use tax expenditures. These are tax credits, exemptions, or rate reductions which give direct benefits to a subset of taxpayers—often as an incentive to take a particular action—encouraging companies to invest, develop infrastructure, or set up in disadvantaged regions, or individuals to save for retirement, for example. Such tax expenditures overall are non-trivial amounts of money, estimated at 2 percent of GDP in Ghana, 2.5 percent of GDP in Kenya and Tanzania, and 5 percent of GDP in Brazil.
There are arguments for and against “spending through the tax system.” On one hand tax incentives are relatively easy to implement; they don’t require an outlay of cash and they make use of information that revenue agencies already collect. But on the other, loading the tax system with too many policy objectives conflicts with the drive for a coherent, simple, transparent tax system. Tax expenditures are harder to assess than on-budget spending and are prone to special interest lobbying and corruption, and vulnerable to of abuse. Despite decades of advice from international organisations to curtail tax incentives, they remain a popular tool for governments.
While tax expenditures can have different goals (such as reducing VAT on basic goods to make the tax system more progressive), this blog post focuses on tax expenditures used as investment incentives.