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This paper, summarised below, was prepared by the International Tax Dialogue Steering Group, with input from the UN Committee of Experts on International Cooperation in Tax Matters, and other stakeholders. The views expressed are however entirely those of the authors
Relevance to DRC research
This debate is highly relevant to DRC work on tax and governance. Tax exemptions on aid complicate local tax administration, and set a bad example: facilitating fraud and encouraging other demands for exemptions. They thus run counter to global tax reforms, supported by donors, that have had some success in simplifying taxes and reducing exemptions, with potential broader benefits for governance.
Summary
The paper deals with tax in relation to international assistance provided by governments and international organisations. It does not cover private charitable assistance, nor tax exemptions provided for diplomats, embassies and government officials as covered by the Vienna conventions and other treaties.
Current Practice
Tax exemptions relating to international aid involve substantial sums of money (for example in Tanzania in 2005 customs exemptions for donors accounted for 17% of the gross value of imports). Exemptions (from customs duties, VAT, excises) apply to the import of goods; local procurement of goods or services (VAT or sales tax); and persons working under aid financed contracts (income tax).
Recently, the World Bank, the ADB and the IDB have changed their policy to allow financing of reasonable, non-discriminatory taxes from concessional loans. The French Development Agency has included financing of taxes in certain aid agreements.
>Why might donors not want to finance taxes?
In theory donors should be content to pay taxes on the support they provide, since that is akin to a simple cash transfer. However donors may seek exemption because they:
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want the satisfaction of being able to demonstrate a direct link between the monetary amount of aid and the goods and services they deliver;
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actively oppose providing any aid to the government that can be used directly for general budgetary purposes -- on human rights or foreign policy grounds, or because of major flaws in the recipient's public expenditure management systems;
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fear the negative effect on domestic public support for aid of reducing the amounts spent on directly identifiable assistance;
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are concerned that the recipient's tax policy is unreasonable in some way (tax rates, aggressive assertion of tax jurisdiction , discrimination).
Reasons for change
Donors are reviewing current policy on tax exemption for two main reasons:
i) it leads to a number of problems for donors and recipients. These include an increase in transaction costs relating to international assistance (operating a special regime to meet donor requirements places unnecessary costs and burdens on weak tax administrations); facilitation of tax fraud (especially abuse of exemptions relating to VAT or customs duties); and economic distortions (e.g in favour of tax exempt imports over domestic purchases, or (exempted) capital inputs over (taxable) labour). More generally, tax exemptions complicate tax administration -- exacerbated by the diversity of requirements set by individual donors -- leading to uncertainty about the scope or application of exemptions, and pressure for new exemptions. Some donors regard this as particularly undesirable at a time when donors are pressing for simplification and reduction of exemptions within the wider tax system. Others argue that the administrative burden of dealing with tax exemptions could be addressed by increased technical assistance.
ii) Developments in a number of recipient countries have weakened some of the reasons for insisting on tax exemption. These include an overall reduction in tax rates; restrictions on tax jurisdiction and an increased number of double tax treaties; and improvements in public expenditure management. (While serious concerns about public expenditure management remain in many countries, these can be addressed on a case-by-case basis). Budget support has become an increasingly important part of overall aid flows, accounting for 20% in 2005. Fungibility means that even targeted (project) support may be difficult to distinguish from general budget support.
The paper suggests that it is hard to find a convincing rationale for a single donor who is simultaneously providing both targeted and general budgetary support to insist on tax exemption, since the same mix can be provided without any exemptions by reducing the level of general budgetary support. However, where donors are unwilling to provide general budgetary support, the reasons for insisting on tax exemption remain valid.
Options
The operational difficulties posed by exemption could in principle be resolved by measures -- such as a voucher system -- that levy tax, but pass the cost of this to the recipient government. But practical problems remain with administering such measures, and recent changes in the aid and tax environment mean that the case for exemption is likely to becoming increasingly weak.
Donors might apply the World Bank approach, whereby aid projects include financing of tax costs unless these are deemed excessive or discretionary (assessment of individual tax regimes could be shared among donors). Alternatively, donors and recipients might agree that some exemptions could be lifted. Guidelines might be drawn up to cover specific transactions which would remain tax-exempt, including response to humanitarian crises, and income of employees of aid organisations and non-resident contractors. Aid recipients could then conform their tax laws to such guidelines.
Conclusions and recommendations
Where donors have sufficient confidence in governance structures, there are good reasons for limiting tax exemptions on aid. While each donor must remain free to reach its own decisions, there is an emerging movement towards making aid subject to normal tax rules. The authors recommend that a group of donors and recipients, with ITD, should explore these issues further with a view to developing guidelines for a more co-ordinated approach. Where tax exemption remains, mechanisms should be adopted to minimise administrative burdens and reduce fraud, and all exemptions should be provided by law. Recipient countries should be encouraged to strengthen their public expenditure management systems, and review their tax/tariff structures; and should prepare and publish analyses indicating the tax forgone as a consequence of exemptions on foreign assistance.
Full Version of Discussion Paper>>
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