Stimulus packages are central to rebooting world economies. Tax expenditures within those packages, if well designed, can enhance the targeting of policy measures and ensure they reach those in need as well as help achieve a broader sustainability agenda.
The economic shock triggered by the current pandemic is unprecedented. The number of victims of COVID-19 has already hit half a million and continues to rise. At the same time, the impact on economic output is massive. According to recent OECD estimates, global economic activity is expected to fall by 6% in 2020 in a single-hit scenario and 7.6% in case of a second outbreak.
In response, governments worldwide have been deploying an extraordinary policy toolkit to mitigate the downturn and strengthen economic growth in the recovery phase. Short-term containment measures have been and remain crucial to weather the current storm. Stimulus packages will be a central pillar of rebooting our economies and thus shaping their future structure.
Fiscal policy is at the heart of those responses. In that context, direct government spending as well as overall tax cuts have been gaining significant attention. In contrast, tax expenditures – i.e. tax breaks that benefit particular groups of taxpayers – are adopted with little scrutiny, in spite of their significant price tag and impact.
The lack of debate about tax expenditures is striking, but not new. In fact, limited transparency and accountability is an alarming feature of tax expenditures worldwide. The current context is likely to exacerbate this opacity since an overwhelming number of ad hoc policy measures are being discussed and implemented, without being sufficiently probed. For instance, the CARES Act passed in the US includes a set of controversial tax breaks that are “tucked into the federal economic rescue law” and benefit rich individuals and large companies.
Tax expenditures, if well designed, on the other hand, can enhance the targeting of measures and ensure they reach those in need.
Tax breaks for households
Since the beginning of the coronavirus crisis, there has been a broad consensus about the need to spend big and spend now. Households, particularly those worse off, were among the first target groups of many containment policies. Against this background, some governments have implemented ambitious direct cash transfers. In the US, for instance, households under a certain income threshold were eligible to receive stimulus checks of up to $1,200 per adult and up to $500 per child. A second stimulus check for US households is currently on the table as part of the HEROES Act. Similar provisions were implemented in other countries, including Korea and Japan.
Whereas broad cash transfers do a good job, at least in theory, to provide timely support to a large segment of the population and are easy to administer, they can end up putting taxpayers’ money in the pockets of people who do not need help. The introduction of conditionalities (e.g. income thresholds, targeting of specific activities, etc.) to target the transfers can slow them down, which is highly detrimental in the current situation.
The use of tax credits can mitigate this challenge by making cash transfers universal and getting the money back through the tax system from those that were not in need of help. Designing a universal cash transfer as a pre-paid refundable tax credit that would need to be repaid by the well-off would allow effective and timely targeting of those in need as well as reducing the misallocation of scarce resources, hence increasing the progressivity of the measure.
Transitioning to a more sustainable economy
The impressive amounts of taxpayers’ money that are being spent to mitigate the economic impact of the pandemic and reboot the economies have significantly heated up debates by putting several sustainability dimensions on the table. European Central Bank President Christine Lagarde has explicitly mentioned the need and opportunity to transition to a greener post-crisis economy.
The French government has recently taken a step in that direction by announcing that a €7 billion state loan for Air France is contingent on the airline to scrap some domestic flights as a step towards becoming “the most environmentally respectful airline”.
Tax expenditures can also play a role to align the economy with the broad sustainability agenda. As part of the Relaunch Decree, the Italian government has expanded tax benefits for building renovations and energy requalification projects, which can now go up to 110%. Moreover, public health costs, economic stimulus and other expenditures associated with the pandemic make fossil fuel subsidies unaffordable, particularly for middle-income oil exporters, where fossil subsidies range from 2-15% of GDP. Hence, the impact of COVID-19 could reduce the resistance to fossil fuel subsidies reform since governments could build a clear case regarding the need for additional resources to improve healthcare systems and mitigate the economic effects of the pandemic. In addition, the current oil price will significantly mitigate the pass-through to consumer prices, which will further increase the likelihood of such a reform to be accepted by society.
Tax benefits and the informal sector
The use of tax benefits to support the poor in developing economies is not straightforward. Besides the lack of resources in many tax administrations, a crucial feature in many of these countries is the large share of the informal sector. Informal workers are particularly vulnerable to the collapse of economic activity because they work in jobs without social insurance.
“Informality” narrows the tax base, which further reduces fiscal space and significantly reduces the effectiveness of any tax benefit aiming to provide assistance to the poor, since informal workers – who are twice as likely as formal workers to belong to poor households – do not pay personal income taxes and very often are not even registered with the tax administration.
The best way to support the informal sector is to expand the coverage of existing social assistance programmes (e.g. by relaxing eligibility criteria) to increase benefit levels, or to set up new transfer schemes. An International Monetary Fund proposal suggests the cost of these measures to be covered by a “solidarity levy”, i.e. a temporary tax hike for high-income earners such as the one implemented in Colombia, which target high-income public servants.
There is no one-size-fits-all approach to weather the COVID-19 storm the world is going through. Policy responses need to be country and context specific to increase their effectiveness. This said, the devil is in the details and, hence the use of tax expenditures should be better scrutinized. This holds true in any context, but particularly in times of COVID-19 where governments desperately need to make the best use of the scarcely available resources to support those in need and reboot the economy.
A longer version of this insight blog was originally published on the Council on Economic Policies (CEP) page.