Stopping the leaks: a fresh look at tax breaks for foreign aid

By Rachel Morris, Policy Analyst – Financing for Sustainable Development (Development Co-operation Directorate), and Joseph Stead, Senior Policy Analyst – Tax and Development (Centre for Tax Policy and Administration), OECD

Faced with the worst economic downturn since World War II, developing country governments are scrambling to maximise resources to stay afloat. During the COVID-19 pandemic, developing countries took a massive hit to their government revenues: USD 689 billion fewer revenues were generated in 2019 compared to 2020.1  The poorest countries are now faced with an increasing gap to finance the Sustainable Development Goals (SDGs) due to higher financing needs and fewer resources to spend on recovery. In addition to declining government revenues, increasing pressures on available foreign aid mean that resources to avoid debt and climate crises are stretched2. With government revenues in developing countries expected to remain almost 20% below pre-pandemic levels, every penny counts, especially those coming from tax revenues. But tax exemptions can stand in the way of maximising tax revenues.

Resources lost to tax breaks granted to multinational corporations have long been a focus of efforts by OECD countries to boost domestic resources at home and in developing countries. There is growing evidence that tax breaks are low on the list of what attracts private investment in developing countries and ultimately results in sacrificing taxes. In many developing countries, over 70% of tax incentives are redundant3. The landmark agreement of over 135 member of the Inclusive Framework on Base Erosion and Profit Shifting to establish a global minimum tax of 15% for large multinational enterprises will make many of the most generous tax exemptions pointless.

However, policies governing tax exemptions for foreign aid require a fresh look. Official Development Assistance (ODA) remains a major source of financing in the poorest countries, reaching USD 185.9 billion in 2021, its highest level ever recorded, an 8.5% increase in real terms over 2020. However, nearly all developing countries grant tax exemptions for aid. This makes sense in certain cases. For example, when aid finances emergency projects during humanitarian crises. Some donors have concerns that within authoritarian regimes, taxes can slow down delivery of aid or cause it to fall into the wrong hands. However, aid also finances private contractors, including from the donor country’s own private sector. Markets can be distorted and confusion can arise over who should be tax exempt when profit-seeking companies also stand to benefit. While donors committed to review tax breaks requested  in the Addis Ababa Action Agenda, the volume and coverage of such exemptions has been largely unexplored – until now.

A new report commissioned by the Platform for Co-operation on Tax (PCT) highlights the challenges in African countries. The report provides estimates on the likely maximum potential revenues forgone by ODA tax exemptions, which are as high as 5% of GDP in aid dependent countries. Looking only at indirect taxes (e.g. Value Added Taxes), there are still several countries where revenues forgone are estimated to be over 1% of GDP. The report points at other issues in-depth in three countries, Benin, Cameroon and Kenya. For example, the high costs to administer exemptions is clear in Benin, where 17 staff administer such exemptions, compared to only 25 staff for large corporate taxpayers.

While not all donors agree to remove tax exemptions for aid, international consensus is building to improve – as a starting point – the transparency of how aid is taxed. Launched in 2022, the OECD’s Tax Treatment of Official Development Assistance (ODA) Hub is the first public resource to improve the transparency around the taxation of aid. The Hub includes country survey responses and links to additional resources. It presents approaches taken by 21 out of 30 DAC members which participated in the survey, representing over 80% of total bilateral ODA in 2020. The hub provides an accountability mechanism for the Addis Ababa Action Agenda commitment and sheds light on how policies and policy reviews are being carried out by DAC members.

The data on the new OECD hub shows how some DAC countries are reviewing their aid taxation policies to better support domestic resource mobilisation in developing countries. As shown in Figure 1, four DAC countries never or rarely request tax exemptions (Denmark, Greece, Norway, Slovak Republic) and three only require exemptions in certain cases (Finland, Netherlands, Sweden). For example, in 2016 the Netherlands stopped requiring exemptions on custom duties and VAT for goods and services provided under all new government-to-government ODA projects and programmes. Eight survey participants have carried out reviews of this practice over the past five years, and four participants are currently in the process of carrying out a review (including the European Commission, Canada, France, and Spain).

Figure 1. OECD Tax Treatment of Official Development Assistance (ODA) Hub Dashboard

Source: OECD Tax Treatment of Official Development Assistance (ODA) Hub.

Looking ahead, better transparency is still needed, especially of legal instruments, and at the recipient country level. While the progress in recent years is good, significant information is still missing. There are still significant challenges to monitor tax exemptions beyond indirect taxes.  The United Nations Committee of Experts on International Cooperation in Tax Matters recommended that such instruments be made public as part of their guidelines on the tax treatment of government-to-government aid projects.  There is also limited transparency of the legal instruments used to grant such exemptions. Only five of the donors reporting to the OECD hub have provided links to the treaties (or similar instruments) granting such exemptions.  Transparency is key to fully understanding how such exemptions work, including providing clarity on who is (and is not) entitled to claim them.

To learn more about the issues around the taxation of ODA funded projects, and all the other OECD work on tax and development please join to the OECD Tax and Development days on 15-16 February.

Click here for more information