Britain’s fracking tax incentives: do they pass the test?

It’s funny, if you’ve only ever thought about an issue in terms of other places, when it suddenly it pops up in you back yard. Gives you a different perspective. So the announcement today that the Britain is going to create the “world’s most generous shale tax regime” [£] to encourage ‘fracking’ is a chance to think about all the pontificating I’ve done about tax incentives.

As far as I can tell, we don’t yet know the details of what is being proposed, only the headline. If there’s more today I’ll update this post. But the key message is a slashing of the corporation tax rate from 62% to 30%, and compensation for local communities hosting a well of £100,000 plus 1% of revenues.

Below I have posted two sets of recommendations on tax incentives, one from the OECD, and one from ActionAid’s new campaign. Looking through them, it seems most are unlikely to create any trouble, since these are statutory incentives that will be passed through legislation. But two thoughts emerge initially.

First, will there be a published, transparent analysis of the revenue expected to be foregone, and predicted benefits? This is usually done in the UK through a “tax information and impact note” attached to proposed legislation, but I wonder how detailed it will be, and whether there will be any way to test the assumptions about how much investment the incentives will bring in. Peter Lilley, a conservative MP with an industry background, said yesterday, “I think tax breaks are unnecessary for fracking, based on my knowledge of the oil and gas industry.”

Second, from the “most competitive in the world” headline, it seems these British incentives are not simply designed to tip the investment past the point at which it has a viable net present value, but quite explicitly to entice investment away from other countries. So it’s tax competition. Why isn’t there a statement that incentives should only be designed to make investments viable, as opposed to making already-viable investments more attractive than those in other countries? Is that too vague?

Furthermore, the recommendations generally talk about regional agreements to limit tax competition, but in this case that doesn’t seem relevant: I think it’s less about regional partners/competitors and more about other countries with shale gas potential. Maybe the recommendations should extend beyond regional proximity to cooperation between countries with similar resource endowments

Here are the ActionAid recommendations:

  • Eliminate all tax holidays.
  • Publicly review all tax incentives, assessing tax expenditure (the amount of tax foregone from incentives), ensuring incentives are well targeted and commensurate with the benefits expected to citizens.
  • Ensure that all phases of new incentives require parliamentary approval, and also that any new incentive offered is grounded in legislation which makes it available to all qualifying investors, foreign or domestic. This would effectively mean an end to discretionary tax incentives.
  • Publish a costing and justification for each incentive offered, followed by monitoring of conditions and a tally of costs and benefits, so the public can see the impact of tax incentives.
  • Grant the Finance Ministry (not solely the Investment Promotion Authority) powers over tax incentive decisions.
  • Refrain from entering into stability clauses (which lock in tax incentives long term) when negotiating new tax incentives and investment agreements.
  • Ensure that tax incentives are audited to check that the investment for which an incentive is offered has actually been carried out.
  • Co-ordinate statutory tax incentives with groups of neighbouring countries, in order to counter tax competition.

Here are the OECD principles [pdf]:

  1. Make public a statement of all tax incentives for investment and their objectives within a governing framework.
  2. Provide tax incentives for investment through tax laws only.
  3. Consolidate all tax incentives for investment under the authority of one government body, where possible.
  4. Ensure tax incentives for investment are ratified through the law making body or parliament.
  5. Administer tax incentives for investment in a transparent manner.
  6. Calculate the amount of revenue forgone attributable to tax incentives for investment and publicly release a statement of tax expenditures.
  7. Carry out periodic review of the continuance of existing tax incentives by assessing the extent to which they meet the stated objectives.
  8. Highlight the largest beneficiaries of tax incentives for investment by specific tax provision in a regular statement of tax expenditures, where possible.
  9. Collect data systematically to underpin the statement of tax expenditures for investment and to monitor the overall effects and effectiveness of individual tax incentives.
  10. Enhance regional cooperation to avoid harmful tax competition.

Tax incentives cost $138 billion…?

#taxpaysfor my PhDCongratulations to ActionAid on the launch of its new Tax Power campaign – an impressively internationalised version of the work ActionAid UK has been doing for five years now. I love the gallery of #taxpaysfor photos.

As part of the campaign launch, ActionAid asked me to help them come up with an estimate for the revenue foregone by governments in developing countries through corporate tax incentives. As the campaign briefing says, there is mounting evidence that such incentives are often ineffective at attracting the kind of investment that leads to sustainable economic growth. (This is distinct from the general rate of corporation tax, which is a whole other debate…) Certainly they are rarely put in place with any kind of cost-benefit analysis, which is why there’s so little reliable data out there.

We decided to come up with a ‘ballpark’ average figure for the revenue foregone as a share of GDP, and apply this to the total GDP of all developing countries. The scaling up part is obviously quite a simple approach, but I was quite pleased with the way we arrived at the average figure to begin with, so I thought I’d share it.

Data on ‘tax expenditures’ – that’s the revenue lost through tax incentives – is quite sparse, and where it does exist it’s plagued with inconsistencies. After quite a lot of hunting around, I managed to find about 20 developing countries where the government had published tax expenditure data, either directly or via a civil society organisation. I took the most recent year I could find in each case. I was particularly proud to have dug up a figure for Bhutan!

Tax expenditure reports can include the cost of everything from VAT exemptions to free trade zones, so it was essential to a) find something consistent and b) focus only on the kinds of expenditures that ActionAid is campaigning on. I’ve seen a few organisations cite massive figures for the cost of tax exemptions in a country where, if you go to the original source, you see that most of these go directly to ordinary people, not multinational companies. An IMF paper [pdf] says that tax expenditures probably amount to a couple of percent of GDP, but that refers to all types of exemption.

Although a few countries give one aggregate figure for direct taxes, which annoyingly makes personal and corporate income tax indistinguishable, there were 16 where I could find, or at least make a good guess at, the share of tax expenditures coming from corporate income tax (sometimes that involved running line-by-line through an itemised expenditure). So that’s the figure I used.

I ignored all other taxes from which companies get exemptions. I also excluded the expenditure on deferrals (i.e. accelerated depreciation) because in theory at least this just creates a timing difference – I presumed that in any given year the government foregoes some revenue in this way, but also receives some extra because of past deferrals. Maybe other tax brains out there can tell me if that was the right thing to do!

The data after all this processing is given in this Google spreadsheet.

I used some whizzy regression software from the LSE to check whether there was any connection between the proportion of revenue foregone and the amount raised, or GDP per capita, or the size of an economy, but I couldn’t find any meaningful relationship. That’s why it seemed like a simple average, 0.60% of GDP, would be the best way to go. Interestingly it’s pretty much the same as the figure for India, which is also by far the biggest economy in the sample.

When you think about it, rough though it is, that’s a huge ‘ballpark’ to be in.

“Tax, Law and Development”: recommended reading for campaigners

This spring, two academic books have come out that offer an opportunity to look at tax and development from different perspectives. “Critical Issues in Taxation and Development” edited by Clemens Fuest and George Zodrow is going to be the economists’ take, using “modern empirical methods” to answer a lot of “what is the effect of X on Y” questions. I haven’t got my hands on it yet, but in the meantime I’ve been reading “Tax, Law and Development” edited by Yariv Brauner and Miranda Stewart.

The contributors to Tax, Law and Development don’t follow a strict empirical approach, rather they give their own reasoned opinions on how various laws, policies and institutions in international tax affect developing countries, and how they might be changed for the better. This is a work of critical legal scholarship, a position staked out by its editors in the book’s introduction, which argues that “we cannot avoid the challenge of tax competition by calls to end taxation of mobile capital, even if this may be perceived to be a theoretical economic inevitability.”

The book covers “on the ground” issues such as tax expenditure reporting in India and fiscal federalism in China, as well as international tax justice topics such as tax treaties, information exchange and country-by-country reporting. Each reader will find different parts interesting, and so here I’m going to pick out a few chapters that were the most useful for me.

Quite a large chunk of the book covers tax incentives, reflecting how big an issue this is for tax and development policy. Brauner and Luis Eduardo Schoueri’s chapters demolish the idea that tax incentives are purely a domestic policy issue for developing countries, by looking at how they interact with tax treaties and national policy in developed countries.

A controversial mechanism through which this can occur is tax sparing, through which a developed country offers its tax residents a credit against its tax bill for the tax they would have paid in a developing country, even if that country waives the tax to encourage investment. This way the taxpayer gets to keep the benefit from the tax incentive, rather than it being captured by their home state. As Brauner points out, policy advice from developed country-dominated organisations such as the IMF and OECD has for some time been that tax incentives are a poor use of the money, yet by continuing to give tax sparing agreements in their treaties, these governments keep on encouraging it.

Schoueri’s paper also discusses matching credit, a quasi-incentive included in some tax treaties whereby a developing country agrees to lower its withholding taxes on inward investment, but the developed country at the other side continues to offer a credit as if withholding taxes were still levied at higher non-treaty rate. A mainstay of Brazil’s tax treaty network in the 1970s, this mechanism ensures that inward investors, rather than the treaty partner’s fisc, benefit from the lower rate.

Many countries – including, increasingly, the UK – exempt their residents’ overseas profits altogether, in which case tax sparing and matching credit may be less relevant considerations. Here Schoueri argues that the system currently has inbuilt a kind of distorting reverse tax sparing: when the residence country decides not to tax some of its residents by exempting their foreign income from taxation, the source country is prevented by tax treaties from claiming this untaxed income for itself. As described above, when it’s the source country that foregoes revenue, it can be captured by the residence state. Schoueri argues for a more symmetrical arrangement.

Tracy Gutuza’s chapter on the South African headquarters regime is also about the impact of a tax incentive on developing countries. This one was created by the South African government to compete with the tax haven of Mauritius as the base for multinationals’ holding companies when investing into the rest of Africa. Who can blame them, I wondered, when even the UK is joining in the race to the bottom? Nonetheless, it’s a cautionary tale about the need to look at the BRICS with a critical eye. The regime twice fell afoul of the OECD’s 1998 definition of harmful tax practices, and Gutuza argues that the resulting social pressure was enough for it to be withdrawn or modified in both cases…except that as of 2011 it’s back.

Towards the end of the book comes a series of chapters preoccupied with this kind of social pressure. Pasqual Pistone is concerned about the solidification of “a kind of global norm concerning the exercise of taxing jurisdiction” as legal fact, Heather Stewart the “hybrid mode of global tax governance” emerging from tax information exchange cooperation, and Allison Christians “whether awakening public attention to multinational tax planning will provoke sufficient political attention to compel paradigmatic change.”

The latter paper was an interesting read for me, because it devoted quite a bit of space to the drafting of a report within the OECD tax and development task force [pdf] in which I was a participant. It’s interesting that to the outside observer, basing her analysis on published documents, certain events in the process took on a much greater significance than they did to those of us involved at the time, while other occurrences that felt much more significant don’t get a mention because they took place in private. One could say that this demonstrates the limits of desk-based research, but actually it made me rethink my own understanding of what happened at the time, as well as of the importance of the written record.

This is another good reason for campaigners to read this book. Not just to expand their hinterland, but also to see how their movement and the issues they work on are seen from a different, and largely sympathetic, perspective.