Tax Breaks: The Origins, Limits and Effects

Although we talk about tax breaks almost as often as about the weather, tax breaks are frequently confused with tax rules that set more favourable conditions for taxpayers. We can see this by doing a small experiment and answering the following questions: Is the 24-percent income tax rate that is charged on entities without the status of legal persons a tax break as compared to the 29-percent rate imposed on corporations or not? Are tax-deductible investments a tax break or not? As a rule, exemption of investments is often considered a tax break, whereas different tax rates applied to corporations and to business without the rights of legal persons are regarded as a tax rule. We will see that the opposite is true.
The essence of a tax break is not explicit by itself. Very frequently, but by no means correctly, the distinction between a tax break and a tax rule is explained in the following manner: if something is taxed, it’s a tax rule, if not, then it’s a tax break. As I noted, this way of thinking is defective. Non-taxation can, and often is, a tax rule, not a tax break. So how to tell a tax break from a tax rule?
In explaining this difference, first let us look at the principles of taxation. In most countries taxation principles are enshrined in the constitution. The supervision of compliance with the constitution helps to ensure that taxes are not imposed or changed ad hoc, violating the established principles of taxation. In Lithuania, taxation principles are defined in a governmental programme for revising the tax code. However, it is often ignored. The equality principle stipulated in the programme states that tax rules cannot differ depending on the type of activity or the status of a taxpayer. This principle means that tax rules should be the same for all taxpayers. Any violation of this principle is a tax break – a privilege for a selected group of taxpayers.
A tax break is a privilege granted to a taxpayer by distinguishing him from other taxpayers according to certain criteria. A tax favour is a privilege bestowed on a taxpayer but not on some specific type of income because income does not all by itself, and any taxpayer can receive it. So a lower income tax for small enterprises is a tax favour, while exemption of investment in computing taxable profit – a provision that is traditionally considered a tax favour – is not. In the first case, a privilege is granted to a specific type of companies as compared to others; while tax-deductible investments are allowed for all businesses.
Other examples of tax breaks include lower tax rates for companies producing agricultural products, for healthcare establishments funded from the state budget, VAT exemptions granted to healthcare services provided by state-owned companies, certain types of companies engaged in building residential facilities, etc. Tax favours abound in the laws on the real estate tax, land tax and road tax.
In order to understand the implications of tax favours, one must analyse their origins. Historically, taxes appeared as a means of collecting revenues to the state budget. As economic relationships developed, it was discovered that taxes could be used to regulate the economy, or to turn lives in a desired direction. To that end, a whole range of taxes and tax breaks were devised. True, it is possible to regulate by taxes. It is also possible to create and destroy entire businesses this way. But must it be done? The goal “to regulate” cannot be fair and just, as no individual will ever know how the world is to develop or what colours and shapes it is to take. Any situation we have is the result of voluntary actions of many individuals. And this result is the best when it is created by unconstrained and unaffected individuals. It is the result of the market and not of certain persons’ individual will.
The effect of tax favours is manifold. First and foremost, they pervert and distort business conditions and competition. By providing a particularly attractive tax environment for selected groups, tax breaks direct resources in one direction, creating a shortage in one area and a surplus in another. Tax favours may touch off undesired or unexpected results. This is what happened to small businesses: a lower income tax rate for small businesses induced companies to split into units of sub-optimal size in order to save money. Contrary to the popular belief, tax favours are not difficult to administer. Because a tax favour is mostly often an exemption or a lower tax rate, a company does not face difficulties in administering the tax. Tax breaks only increase the costs and reduce efficiency of tax administration. This is largely due to the fact that tax favours create and increase opportunities for tax evasion.
Tax breaks do not have any effect on the state budget. The amount of budget revenues is determined by tax rules, so by granting tax favours, the government voluntarily defines that portion of income which it intends to expropriate to meet its needs. It is downright wrong to think that all income that people and enterprises earn belongs to the state budget, and their exemption from taxation- is damaging to the budget. Tax favours should be eliminated, not for the sake of the budget, but for the sake of equality and market relationships.
Tax breaks create an illusion that they reduce the tax burden. If adoption of a tax favour is not accompanied by an adequate decrease in government expenditures, budget revenues will have to be generated from other sources anyway. Recipients of tax breaks are wrong to think that this burden does not fall on them. The phenomenon of the tax incidence dispels this illusion. The tax incidence means that those who pay taxes and transfer them to the state budget do not necessarily carry the tax burden. A tax can be shifted onto others in the form of higher prices or lower salaries. Therefore, those who enjoy tax breaks should not object to their removal because a decrease in the tax burden is only an illusion. In fact, the tax burden can fall on them as heavily in the form of higher prices of resources.
To prevent these evils, it is necessary to do away with privileges. However, it’s no good eliminating tax breaks so that the conditions of the recipients of these tax favours are “worsened” to match the general conditions. Removal of tax breaks should not be accompanied by an increase in the tax burden, that is, it should be followed by a reduction in the tax payable by all taxpayers (e.g. a reduction in the general tax rate). Abolishing tax breaks in this way is the surest path to business growth.