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How are we paying for this economic crisis? EU’s new budget

Clara Volintiru and John D’Attoma

The EU is stepping up to the economic challenges posed by Covid19 with a recovery plan titled Next Generation EU of 750 billion euros. Together with the new multiannual EU budget it all rounds up at almost 2 trillion euro, which are to be dispersed through grants and loans to member states. As member states rally in solidarity, mutualizing debt, a looming issue persists: will the next generation foot the bill? Will it be worth the burden?

There is very little room for the austerity-based approach of the previous crisis which has left governments across Europe with little political capital. The continent shifts from the concept of European sovereignty to that of European solidarity, but leaders stumble on how to proceed with the European project. As always, it is a question of money: will countries pool together their resources and further the political union, or will they continue to stand apart, cautious of their national electorates’ reaction to what is characterized by many to be a “Hamiltonian moment” for Europe? Interestingly enough, recent polls show Europeans more inclined to support further integration, as the pandemic has convinced many of the need for more EU cooperation. And this is all about common action in the end – the ever-elusive convergence and cohesion across all member states, North and South, East and West. The move towards common action in the health sector in the context of the Covid19 could be the very thing to jumpstart the next phase of a more political EU.

Given the current context, with the motto of standing “together for Europe’s recovery”, Germany seems forced to take the lead and pay the bill, as the single largest economic power in the EU. But it is highly unlikely it will do so without a clear contingency plan on public finances at the national level.

Global public debt is expected to reach an all-time high, exceeding 101% of GDP, and the average overall fiscal deficit is expected to soar to 14 percent of GDP in 2020, according to the latest IMF projections. For many EU countries, the year could close with double-digit public deficits—for Spain and Italy for sure, but also likely for France, Poland and Romania.

Therefore, a new strategy to reign in public deficits is needed. Rather than slashing spending, another approach could be to strengthen tax administrations and fiscal collection through digitalization and tax administration reform. At the EU level, estimates placed the tax gap at approximately 825 billion euros per year, and in many EU member states tax gaps exceed healthcare spending. In contrast to Northern states, Southern and Eastern European countries have extensive tax gaps that could be addressed through digitalization and public administration reform. In many of the newer member states, tax revenues are only about a third of their GDP.

Even before the Covid19 pandemics, the tide was turning towards a new digital era for fiscal authorities. Governments play a pivotal role when it comes to digitizing payments in an economy—from tax collection to shifting government wages and social transfers into accounts, governments can lead by example and play a catalytic role in building a digital payments infrastructure and ecosystem where all kinds of payments—including private-sector wages, payments for the sale of agricultural goods, utility bills, school fees, remittances, and everyday purchases—are done digitally. This process yields better traceability of payments, thus countering fiscal evasion, and it has shown its merits in many European countries. However, such solutions are difficult to implement in contexts of ample subnational disparities of development as in the case of larger Central and Eastern European countries like Romania and  Poland or Southern countries with consolidated informal traditions like Italy or Greece.

Institutional capacity is clearly another driving factor of fiscal collection. In our large scale behavioral experimental study of Europe and America, we found that cross-national differences in fiscal compliance could be associated with institutional differences. It is time EU realizes that general conditionalities do little in the way of convergence, and realistic technical assistance packages should be geared towards meaningful institutional reform and harmonization of practices across the EU. This is particularly important for countries with a poor track record on state capacity in Eastern or Southern Europe. It is also useful for insulating these funds from political opportunism and clientelism in countries with authoritarian tendencies such as Poland and Hungary.

We understand that improving administrative capacity is not a panacea for the tax gap and that any reform plan must realistically account for a number of other factors, such as the number of SMEs in an economy, informal norms, political opportunism, and poor institutional capacity. And the stakes are literally much higher in the context of the unprecedented financial package put forth by the EU.

Clara Volintiru is an Associate Professor at the Bucharest University of Economic Studies (ASE) and a GMF Rethink.CEE fellow 2020.

John D’Attoma is a Lecturer at the University of Exeter Business School and a member of TARC.

 

The Chancellor’s summer economic statement

By İrem Güçeri, Centre for Business Taxation, Saïd Business School, University of Oxford

On Wednesday, the Chancellor announced a £159 billion package to tackle the challenges arising from the Covid-19 crisis. In this blog, I will discuss three of the Chancellor’s announcements: the Coronavirus Job Retention Scheme (CJRS) phase-out plan, the series of policies under ‘Supporting Jobs’,[1] and the VAT reduction for the hospitality sector.

The Office for National Statistics (ONS) has conducted a survey on the impact of Covid-19 on UK businesses which sheds some light on their state as we move from a phase of acute disruption due to the crisis to one of initial recovery,[2] and shows which policies have been used most. The latest results, for the first half of June 2020, show that 95% of respondents (in both ‘SME’ and ‘large’ categories) used the furlough scheme, and more than half the respondents benefited from VAT payment deferrals. The response in relation to the furlough scheme is in line with evidence from Norway: Alstadsaeter et al. (2020) find that the most important schemes during the initial phases of the Covid-19 crisis have been those that relate to employer-employee relationships and in general, support the labour force.

A paper I co-authored with colleagues at the CBT, as well as Michael Devereux’s earlier blog, argue that the transition out of the furlough scheme should come partially in the form of employment subsidies, and in combination with a partial furlough applying to workers on reduced hours. Return to work on reduced hours is now supported within the furlough scheme, a welcome adjustment in line with the idea of a gradual phase-out rather than an abrupt termination of the scheme. The £1,000 Job Retention Bonus for retaining workers from October through to January is broadly in line with the employment subsidy that we proposed. However, it is not clear that the size of the subsidy is high enough to induce businesses to re-employ furloughed workers. And the fact that it is a lump-sum also means that it will be more effective in helping the re-employment of lower paid workers.

For a worker employed full-time at the minimum wage, the three-monthly salary amounts to around £4,200, in which case the employment subsidy is below 25% – which may be too low to have a significant impact. But the rate of support falls further as pay increases, making it less likely that businesses will retain higher-skilled employees and employees in more skill-intensive jobs. Overall, the employment subsidy is a welcome development, but at the current rates of support, some businesses will inevitably lay off workers with job-specific skills from October onwards. Facilitating matches between the newly-unemployed skilled workforce and vacancies may entail substantial costs. After the layoffs, re-training will be very important for these workers to return to employment.

As these workers are laid off, the demand for such workers may not pick up quickly, given the uncertainty that still prevails in the economic environment. The package allocates £2.1 billion to the Kickstart scheme, targeted at 16-24-year olds from disadvantaged backgrounds, and another £1.6 billion to apprenticeships, other youth programmes and to expanding the Jobcentre Plus support for the unemployed.  Currently, what the package means for the newly-unemployed from October onwards is not spelt-out in great detail, especially for older, more experienced, and possibly higher-skilled employees.

Another major announcement is the temporary VAT rate cut for the hospitality sector from 20% to 5%. In his blog last week, Eddy Tam argued that VAT rate cuts may lead to higher demand by UK consumers, pointing to evidence from an earlier VAT rate cut during the 2008-09 recession. But this crisis is like no other. The Chancellor’s announcements on the VAT reduction and Eat Out to Help Out are very specific and may have arrived too soon.

They may have arrived too soon because the hospitality sector is still facing significant capacity constraints due to the requirement to be socially-distanced environments. That is a supply-side constraint, not a demand-side constraint. Increasing demand may then have little impact on the total size of business of the sector. Targeting the Eat Out to Help Out scheme to weekdays that are normally quiet seems like a small attempt to address this issue.

However the effects of the VAT rate cuts may also help businesses more directly. Studying a VAT rate cut for restaurants in France, Benzarti and Carloni (2019) find that 55% of the proceeds from the rate cut is absorbed by business owners, rather than the customers or the employees. In the current environment, that represents additional support for troubled businesses – even if the stated aim of the policy is to stimulate demand and employment. Second, experience shows that prices are more likely to respond to VAT increases, but they are found to be less respondent to VAT reductions in the same way (Benzarti et al., 2020). If this is the case, a temporary VAT cut might even result in higher prices after the policy ends.

The policies announced by the Chancellor on Wednesday are a welcome step in the direction of supporting a speedy recovery, to maintain otherwise viable UK businesses, and to protect and create jobs. But the Job Retention Bonus may not be of sufficient scale. And targeting very specific activities too soon may generate distortions and tighten government finances without improving the society’s overall welfare, especially if the current constraints are on the supply side rather than on the demand side.

[1] See https://www.gov.uk/government/publications/a-plan-for-jobs-documents/a-plan-for-jobs-2020.
[2] The caveat of this survey is its modest response rate, which remained at around 30% for its first 7 waves so far. Importantly, the responses come from ‘surviving’ businesses, and not from those who had to permanently stop trading.

References:

Alstadsaeter, A., Bjorkheim, J.B., Kopczuk, W., Okland, A. (2020) “Norwegian and US policies alleviate business vulnerability due to the Covid-19 shock equally well”, mimeo.

Benzarti, Y. and Carloni, D. (2019) “Who Really Benefits from Consumption Tax Cuts?

Evidence from a Large VAT Reform in France” American Economic Journal: Economic Policy, February 2019.

Benzarti, Y., Carloni, D., Harju, J, and Kosonen, T. (2020) “What Goes Up May Not Come Down: Asymmetric Incidence of Value-Added Taxes”, Journal of Political Economy, December 2020.

This blog was originally published by the Centre for Business Taxation (CBT)    (http://business-taxation.sbsblogs.co.uk/2020/07/13/the-chancellors-summer-economic-statement/

Recent relevant research from the Centre for Business Taxation:

Discretionary Fiscal Responses to the Covid-19 Pandemic, Michael P. Devereux, İrem Güçeri, Martin Simmler and Eddy Tam, Oxford Review of Economic Policy, June 2020.

Tax Policy and the COVID-19 Crisis, Richard Collier, Alice Pirlot, John Vella, Intertax, forthcoming.

COVID-19 Challenges for the Arm’s-Length Principle, Matt Andrew and Richard Collier, Tax Notes, Volume 98, Number 12, June 22, 2020.

Chronicle of a Crisis Foretold? Latin America in the time of Coronavirus: Revenues, Growth and Policy Responses.

By Matteo Pazzona, Brunel University London

According to the World Health Organization, Latin America is the current epicentre of the Covid-19 pandemic. While many countries have been able to control the spread of the virus, in Latin America the peak has yet to be reached. Some numbers might help signify the extent of the looming crisis. Brazil is the second country in the world in terms of deaths and confirmed cases. Peru, an early adopter of lockdown measures together with Chile, sits 8th in the inauspicious global ranking of contagions, with more than 240,000 confirmed cases. In Chile, the situation seems to be  out of control and it is the 5th country in the world in terms of cases per capita, although testing six times more than Brazil. Mexico adopted a late response and has now more than 22,000 deaths, a number which (as with all these numbers) is probably underestimated.  The virus could spread in the region thanks to the high number of informal sector workers, the high level of urbanization and weak health systems, which make the lockdowns measures difficult to enforce. There are success stories too: countries like Uruguay, Paraguay, Argentina, and Nicaragua show low levels of cases and deaths, for now at least. Argentina has around a tenth of confirmed cases and deaths compared to Peru, a country of similar population. In Colombia, the city of Medellin acted fast and with the help of technology was able to limit the spread of the virus.

The challenges ahead for governments, and particularly tax authoritiesin these countries, are considerable. The crisis will negatively impact tax revenues directly – through lower taxable income and consumption- but also a decrease in tax compliance, especially from the struggling segments of the population. Fiscal authorities will need to need to adapt their tax strategies to accomplish fiscal sustainability and promote economic recovery.  According to a recent report, in 2020 the region GDP will decrease by 7.4 %, the largest slump in the world. The two biggest economies, Brazil and Mexico, will have a negative growth of 7.6 % and 8.5 % respectively. The current crisis is happening after a period of low growth which started in 2014, caused mainly by the drop in commodity and oil prices. The current crisis leads to further drops: countries such as Brazil, Chile, Venezuela, or Peru are already experiencing a drastic reduction in exports which is likely to extend for many more quarters. The tourism industry, which represents a significant share of employment and revenues, has also been severely hit.

Besides, the economic structure of many Latin American countries is dominated by small companies (99% according to the OECD) which being less likely to have a financial buffer to survive the crisis, might go bankrupt rapidly. There has been also a significant decrease in remittances flow from migrants working abroad. According to the World Bank, the region will experience a 20% decline in the flow, the highest ever recorded. Financial volatility has also been a constant in the last months, with many currencies devaluating and significant capital flight. The pandemic will also lead to a surge in inequality and poverty, as reported by the World Bank. That is very unfortunate, especially because many countries had managed to decrease their levels in the last two decades. The current crisis will also be costly in terms of human capital accumulation, which will affect the most fragile sectors of the population. All this inevitably will have a significant impact on tax revenues, and the growth trajectory of the economies.

Latin American governments have implemented a wide range of welfare programs to sustain individuals and firms. They have helped vulnerable households through direct transfers or employment subsidies, among others. For example, Brazil extended the well-known and successful Bolsa Familia program and created a new transfer scheme for informal workers. Several countries, for example El Salvador, have helped directly or indirectly the firms through tax breaks, loan instalments, and public credit guarantees. However, the fiscal power of many countries is limited compared to richer ones and the fiscal space is further restricted by six consecutive years of soaring debt/GDP ratio, due mainly to the effects of low commodity prices on government revenues. The large share of the informal economy, 40% according to the OECD, further constrain the fiscal power of the region. Despite this, the countries that managed to create a fiscal buffer in the last years and have better access to the financial markets were able to implement more aggressive policies. For example, the fiscal COVID-19 related spending in Peru accounts for 12 % of the GDP, 10 % in Brazil, and 7 % in Chile according to IMF data. On the other hand, Mexico will spend between 0.6 % and 1% of the GDP in such measures (depending on the source used). These figures need to be taken cautiously because it is difficult to identify COVID-related expenditures from normal ones. Moreover, tax breaks or credit guarantees are not visible in fiscal accounts.

Fortunately, countries in Latin America will receive international financial help. The Inter-American Development Bank increased the loans to countries by $3,300 million, plus $5,000 to sustain the private sector. The World Bank Group committed to providing $160 billion to alleviate the health, economic, and social impacts of COVID-19 around the world and a big part of these funds will go to the region. The IMF has also secured a significant amount of money to help many countries in the region.

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