Tax incentives reduce resources available for economic development

14Nov 2016
Muharram Macatta
The Guardian
Tax incentives reduce resources available for economic development

Anti-abuse rules can be either specific provision in the tax law to prevent certain behaviours that are deemed abusive, or general provisions under which behaviours can be classified as abusive based on a broad characterisation in the law.

Tax incentive policies also often aim at promoting specific economic sectors or types of activities as part of an industrial development strategy or to address regional development needs.

High-quality legal drafting and a robust administration are necessary to ensure effective anti-abuse provisions.

Indirect revenue costs arise from taxpayers abusing the tax incentive regime. For example, if tax incentives are only available to foreign investors, local firms may use foreign entities to route their local investments in order to qualify.

Similarly, if tax benefits are available to only new firms, taxpayers may reincorporate or set up new corporations to be treated as a new taxpayer under the tax incentive regime.

Other leakages occur where taxpayers use tax incentives to reduce the tax liability from non-qualified activities, for instance, by shifting taxable income to a related firm that qualifies for a tax holiday or that resides in a tax-free economic zone.

Preventing such losses requires proper anti-abuse rules and strong administrative capacity to enforce them. The primary motivation is usually to stimulate investment and—especially in low income countries (LICs)—attract foreign direct investment (FDI).

FDI inflows, for instance, are believed to not only bring capital and (high-wage) jobs to a country, but can also spur competition and increase the efficiency of domestic markets more widely, thus contributing to a country’s overall economic development.
Empirical growth regressions indeed generally find positive correlations between inward FDI and economic growth, although conclusions about causality remain contentious for a review of evidence on some large areas of the continent.

Tax incentive policies also often aim to promote specific economic sectors or types of activities as part of an industrial development strategy or to address regional development needs.

In this analysis, by a ‘tax incentive ’is meant any special tax provisions granted to qualified investment projects or firms that provides favourable deviation from the general tax code.

They can take several forms, such as tax holidays (complete exemption from tax for a limited duration), preferential tax rates in certain regions, sectors or for certain asset types or targeted allowances (tax deductions or tax credits) for certain investment expenditures.

Tax incentives are often found to be redundant in attracting investment in a developing country; that is, the same investments would have been undertaken even if no incentives had been provided.
In Tanzania, it is purported that more than 90 per cent of the investments would, it seems, have been made even without the incentives.
Effectiveness varies between countries and sectors. In some countries, tax incentives seem to have played an important role in attracting new investment and spurring economic growth.

Famous examples include Korea and Singapore, where tax incentives—offered as part of a broader strategy to attract investment—seem to have encouraged rapid industrialisation.

China is often quoted as an example of effective (tax) incentive policies. During its transition period between the mid-1980s and mid-2000s, it experimented with a wide range of industrial policy instruments, including tax incentives for special economic zones, reduced tax rates for FDI, and tax holidays for strategic industries. FDI inflows accelerated during this period and the country became a top destination for many multinationals.

Redundancy matters for efficiency too, since it implies a loss of government revenue from projects that would have been undertaken also without tax incentives.

Redundancy implies that the tax incentives are a mere cash transfer to the investor: a net social loss to the extent that the marginal cost of public funds exceeds unity (and an even greater loss in national terms if the investor is foreign).

On the other hand, for projects that would not have been undertaken without the incentive, there is no direct revenue loss—so long as taxation of the incentivized activity is not entirely eliminated, there may in fact be a net revenue gain from those projects.

To minimise the revenue cost of tax incentives, the goal would thus be to offer tax incentives only to those marginal investors who would not have invested otherwise.

A first step to understanding the public revenue forgone as a consequence of tax incentives is to calculate the implied tax expenditure.

Investment tax incentives are only one form of tax expenditure, by which is meant a provision in the tax code that deviates from some benchmark tax system in a direction favourable to the taxpayer.

A tax expenditure review quantifies the revenue forgone for each provision, including for investment tax incentives analyzed in this analysis. Conceptual complexities arise when performing a tax-expenditure review, including in defining the relevant benchmark to which tax incentives are to be compared.

Importantly, a tax expenditure review does not take into account either any effect of the incentive on investment or the leakage and abuse to which it can give rise to.

The former may imply an overstatement of actual revenue cost, since elimination of the incentive might lead to a reduction in the tax base and hence to less additional revenue (if the rate would still be positive) than a ‘static’ calculation implies. The latter implies an understatement. As methodologies differ, international comparisons of tax expenditures are usually difficult.

By offering temporary tax relief for profitable firms, tax holidays benefit industries that start making profits soon in the holiday period. This introduces a bias towards short-term projects with low upfront investment costs, which may be those least likely to generate spillover effects on the wider economy (of the kinds described above).

Such investment projects are known to “pack and go”, fleeing the host country as soon as the preferential treatment is removed. For industries with significant long-term capital needs, and for which spillover benefits may be greater, tax holidays could actually discourage investment.

Little otherwise taxable profit might be expected during the holiday period, and, to utilise depreciation allowances, a firm might be encouraged to postpone investment until after the holiday period in order to claim full deductions for its costs.

Tax incentives are sometimes restricted to new investments (or investors) that exceed some stipulated value of assets or those that create at least some stipulated number of new jobs.

This of course has significant appeal, for instance where investments can be transformational for a country or region or where financing and technical constraints hold up investment.

Limiting incentives to large investments can also reduce administrative costs for government. However, discrimination in favour of large foreign investments can also lead to manipulation, abuse and distortion.

For instance, sizes conditions are relatively easy to meet on paper, but extremely difficult to monitor and verify ex-post. If an investor increases the size of their planned investment or the number of new jobs simply to obtain a tax privilege, this implies an inefficient use of resources, so that marginal productivity increases can be very low or even negative.

Discrimination can also distort competition and restrict the growth of smaller domestic enterprises that do not enjoy incentives, even when they are more productive.

Many countries grant preferential tax treatment to certain sectors of the economy, which policy makers consider as most desirable and which are most likely to be influenced by tax.

Among the activities commonly preferred are tourism, ‘offshore’ financial centres, film production and manufacturing activities, with the idea that they bring more socially valuable spillover effects.

Incentives are also sometimes restricted to so-called “pioneer” industries, which can be defined in various ways, but are always viewed as of strategic value for the national economy. There is always a question, however, whether serving special interests aligns with serving the general public interest. For instance, investments in other economic sectors are placed at a competitive disadvantage and may under develop, even though they are more productive.

One major attraction of a temporary tax incentive is that its expiry provides for a natural point of evaluation, feeding into a periodic reconsideration of whether the incentive should be continued, reformed or repealed. Temporariness of a tax incentive can also be used as a counter-cyclical policy.

Indeed, when foreseen to be phased out in the near future, the investment effects of an incentive tend to be bigger than of permanent incentives.

Such provisions should be built into the law. In the absence of such provisions, firms may seek to roll-over a tax holiday, either by negotiating a new holiday period or by incorporating a new firm that may qualify for it. Tax holidays then become de facto permanent tax exemptions—a practice that should be avoided.

At the national level, there is generally scope to improve the design of tax incentives (for example by placing greater emphasis on cost-based incentives rather than profit-based ones and by targeting tax incentives better), strengthen their governance (for instance through more transparency, better tax laws and a stronger role of the Minister of Finance) and by undertaking more systematic evaluations.

At the international level, countries may gain by coordinating their tax incentive policies regionally, so as to mitigate the negative spillovers from tax competition.

The government by any possible means should bear the prime responsibility for the design and governance of tax incentives. It is critical that it can be held accountable by parliament, businesses, donors, relevant regional and international bodies, and the public at large…