Tax Expenditures and Sustainability

What do 1.8 billion Euro given to Italian farmers (Tyson, 2014), 69.7 billion US$ provided to US homeowners (Marples, 2015), and 75 billion A$ allocated to support the retirement income system in Australia (Holmes and Gobbet, 2013) have in common? They are channeled through tax expenditures.

Tax expenditures are tax discounts based on preferential treatment. They include special credits, deductions and allowances, exemptions, and reduced tax rates that lower government revenue from the beneficiary corporation or individual. They are used widely by governments across the world. And they are significant.

In the EU, tax expenditures range from just under 1% of GDP in Germany and Portugal to more than 8% of GDP in Italy (OECD, 2010). The Australian government foregoes more than 115 billion A$ as a result of them (Holmes and Gobbet, 2013). And in the US, tax expenditures reduce federal government revenues by roughly 38% of total tax income (Marples, 2015).

Tax expenditures take many different shapes and forms and are introduced to pursue a broad array of policy goals. The possibility to deduct mortgage interest payments from personal taxable income to foster home ownership, as well as reduced VAT rates for certain goods and services to lower inequality in consumption are cases in point for that. Many countries concentrate their tax expenditures on either VAT (e.g. Poland and UK), personal income tax (e.g. Austria and the US), or both (e.g. France and Spain). When it comes to income taxation, corporate income tax expenditures are usually smaller than those channeled through personal income. Exceptions to this are Netherlands and Denmark, where corporate income tax expenditures account for a larger share of GDP than those on personal income (Astarita et al., 2014).

In spite of their broad use worldwide, tax expenditures remain at the center of controversial debates. Proponents argue that they internalize negative and positive external effects and support a variety of important long-term economic, social and environmental goals. Tax expenditures designed to promote job creation, strengthen innovation, reduce inequality, and foster the use of renewable energy are cases in point for them.

In contrast, critics point to the distortions resulting from the implementation of these instruments. They also highlight the lack of transparency that tax expenditures are associated with as it is often less clear how much support is given to a specific group or activity, if that support is provided through a reduction in taxes rather than, for instance, direct government spending. Indeed, although benefits provided through tax expenditures are considered government spending for budgetary purposes, they differ from direct spending in their visibility (Faricy and Ellis, 2014). Measurability and comparability issues due to data opacity (mainly at the local level) exacerbate this lack of transparency (Astarita et al., 2014).

While these opposing views may present irreconcilable theoretical differences, they converge in their support for abolishing those tax expenditures that are misaligned with broader policy objectives. Many tax expenditures that are currently in place are missing their goals. In fact, they sometimes even result in the opposite outcome to the one they were designed for.

Take tax expenditures for fossil fuels as an example. They include preferential tax treatments for both fossil fuel companies and consumers such as tax credits, exemptions on royalties, reduced tax rates, deferred tax liabilities and accelerated depreciation schemes. Their proponents argue that they boost economic development and contribute to energy security by keeping energy prices low. Many also suggest that the main beneficiaries of these measures are the more vulnerable sectors of society with limited access to energy.

The empirics paint a different picture. In contrast to the alleged social goals that they are meant to promote, there is strong evidence showing that tax breaks for fossil fuels are highly regressive. Instead of supporting lower-income sectors, they mostly benefit the largest consumers of energy and thus the richer households. As shown by Clements et al. (2013), the wealthiest 20% of households in low- and middle-income countries capture, on average, six times more in tax expenditures and subsidies for fuels (i.e. 43% percent) than the poorest 20% of households.[1] In addition, they lead to inefficiencies in capital allocation and, thus, reduce the potential of long-run economic growth (Bárány and Grigonyte, 2015). Tax incentives for fossil fuels also have significantly negative environmental effects as they increase both fossil-fuel production and consumption, and discourage investment in renewable energy and energy efficiency (Bridle and Kitson, 2014). Finally, they are costly. A recent IMF working paper shows that previous studies underestimated the real cost of fossil fuel subsidies. Post-tax energy subsidies are estimated at 4.9 trillion US$ accounting for 6.5% of global GDP (Coady et al., 2015).[2]

Such distortions are alarming. They provide a strong case for thorough reviews of tax expenditures. Making the right distinction between those that are effective and those that are not is not an easy feat, and driving reforms in view of strong opposition from those that profit from the status quo is a Herculean task. Nonetheless, reducing the misalignments between tax expenditures and a broad sustainability agenda is critical. Some tax expenditures may be useful. Some are not. The latter should be abolished.



Astarita, Caterina, Lovise Bauger, Serena Fatica, Athena Kalyva, Gilles Mourre, and Florian Wöhlbier (2014) ‘Tax expenditures in direct taxation in EU Member States.’ European Economy – Occasional Papers 207, Directorate General Economic and Financial Affairs (DG ECFIN), European Commission

Bárány, Ambrus, and Dalia Grigonyte (2015) ‘Measuring Fossil Fuel Subsidies.’ ECFIN Economic Brief 40, Directorate General Economic and Financial Affairs (DG ECFIN), European Commission

Beaton, C, I Gerasimchuk, T Laan, K Lang, D Vis-Dunbar, and P Wooders (2013) ‘A guidebook to fossil-fuel subsidy reform for policy-makers in Southeast Asia.’ IISD-GSI

Bridle, Richard, and Lucy Kitson (2014) ‘The Impact of Fossil-Fuel Subsidies on Renewable Electricity Generation.’ IISD-GSI

Clements, Benedict J, David Coady, Stefania Fabrizio, Sanjeev Gupta, Trevor Serge Coleridge Alleyne, and Carlo A Sdralevich (2013) ‘Energy subsidy reform: lessons and implications.’ Technical Report, International Monetary Fund

Coady, David, Ian Parry, Louis Sears, and Baoping Shang (2015) ‘How Large Are Global Energy Subsidies?’ IMF Working Papers 15/105, International Monetary Fund

Faricy, Christopher, and Christopher Ellis (2014) ‘Public attitudes toward social spending in the United States: The differences between direct spending and tax expenditures.’ Political Behavior 36(1), 53_76

Holmes, Anne and Hannah Gobbet (2013) ‘Tax expenditures: costs to government that are not in the Budget.’ Briefing Book. Key Issues for the 44th Parliament

Marples, Donald J. (2015) ‘Tax Expenditures: Overview and Analysis.’ Congressional Research Service Report

OECD (2010) ‘Tax Expenditures in OECD Countries.’ OECD Publishing

Tyson, Justin (2014) ‘Reforming Tax Expenditures in Italy: What, Why, and How?’ IMF Working Papers 14/7, International Monetary Fund

[1] As discussed by the authors, the distributional effects of fossil fuel subsidies vary considerably by product with subsidies to gasoline, natural gas and electricity being the most regressive ones and those to kerosene being progressive.

[2] These figures consider post-tax consumer subsidies, which “arise when the price paid by consumers is below the supply cost of energy plus an appropriate “Pigouvian” (or “corrective”) tax that reflects the environmental damage associated with energy consumption and an additional consumption tax that should be applied to all consumption goods for raising revenues” (Coady et al. (2015), p.4). They are much higher than pre-tax consumer subsidies (i.e., subsidies not including the “Pigouvian” tax) but should, nonetheless, be considered as a lower bound because the authors did not include producer subsidies in their analysis.