TAX INCENTIVES Alex Easson and Eric M. Zolt* OVERVIEW………………………………………………………………………………………………………… 1 I. THE CASE FOR AND AGAINST TAX INCENTIVES…………………………………… 6 A. Convention Wisdom ……………………………………………………………………………….. 6 B. Advantages of Tax Incentives…………………………………………………………………… 9 C. Disadvantages of Tax Incentives…………………………………………………………….. 10 1.
Different types of costs associated with tax incentives ………………………… 10 2. Estimating the costs of tax incentives………………………………………………… 13 D. Sunset provisions and evaluation of success of specific tax incentive initiatives ………………………………………………………………………………………………….. 14 II. TYPES OF TAX INCENTIVES ………………………………………………………………….. 15 A. Objectives of Tax Incentives…………………………………………………………………… 5 B. Targeting of Incentives………………………………………………………………………….. 15 C. Forms of Tax Incentives ………………………………………………………………………… 18 D. Economic Effects of Tax Incentives…………………………………………………………. 24 III. COMMON DESIGN ISSUES……………………………………………………………………… 25 A. Eligibility Criteria………………………………………………………………………………… 5 B. Operational Features of Incentive Provisions ………………………………………….. 27 1. Depreciation Rules …………………………………………………………………………. 28 2. Loss Rules …………………………………………………………………………………….. 29 3. Relevance to Investment Credits and Allowances……………………………….. 29 C. Matching the Tax Incentive to the Target Investment ………………………………… 30 IV.
IMPLEMENTATION AND COMPLIANCE ISSUES……………………………………. 30 A. Monitoring Compliance ………………………………………………………………………… 30 B. Common Abuses …………………………………………………………………………………… 31 V. CONCLUSION …………………………………………………………………………………………. 34 VI. APPENDIX ………………………………………………………………………………………………. 35 I. OVERVIEW
This module examines the use of tax incentives to encourage investment and growth in developing countries. The conventional wisdom is that tax incentives, particularly for foreign direct investment, are both bad in theory and bad in practice. Tax incentives are bad in theory because they distort investment decisions. Tax incentives are bad in practice because they are often ineffective, inefficient and prone to abuse and corruption. ____________________________________________________________ _____ Alex Easson is a Professor of Law, Queens University, Kingston, Canada and Eric M.
Zolt is the Director of the International Tax Program, Harvard Law School and a Professor of Law, UCLA School of Law. * 1 2 WORLD BANK INSTITUTE Yet almost all countries use tax incentives. In developed countries, tax incentives often take the form of investment tax credits, accelerated depreciation, and favorable tax treatment for expenditures on research and development. To the extent possible in the post-WTO world, developed countries also adopt tax regimes that favor export activities and seek to afford their resident corporations a competitive advantage in the global marketplace.
Many transition and developing countries have an additional focus. Tax incentives are used to encourage domestic industries and to attract foreign investment. Here, the tools of choice are often tax holidays, regional investment incentives, special enterprise zones, and reinvestment incentives. Much has been written about the desirability of using tax incentives to attract new investment. The empirical evidence on the cost-effectiveness of using tax incentives to increase investment is inconclusive.
In some cases, it is relatively easy to conclude that a particular tax incentive scheme has resulted in little new investment, with a substantial cost to the government. In other cases, however, tax incentives have played an important role in attracting new investment that contributed to substantial increases in growth and development. This module follows the approach of much of the recent scholarship examining tax incentives. It does not focus on the normative question of whether countries should use tax incentives.
Instead, this module seeks to examine (i) the costs and benefits of using tax incentives, (ii) the relative advantages and disadvantages of different types of incentives, and (iii) the important considerations in designing, granting, and monitoring the use of tax incentives to increase investment and growth. Role of Government. One place to start thinking about tax incentives is to consider what role governments should play in encouraging growth and development. Governments have many social and economic objectives and a variety of tools to achieve those objectives. Tax policy is just one alternative. Governments use taxes to raise revenue to fund expenditures, to affect the distribution of income in a society, and to influence behavior. All taxes distort. Taxes on income reduce returns to capital and labor. Trade taxes reduce the level of imports and exports. Taxes on consumption reduce spending. Sometimes governments use taxes to correct market failures. Tax incentives may be used to help correct market failures and to encourage investments that generate positive market externalities.
Here, government officials want to distort investment decisions — they seek to encourage those investments that, but for the tax incentive, would not have been made and that may result in such benefits as transfers of technology, increased employment, or investment in less-desirable areas of the country. As discussed below, taxes are just one part of a complex decision as to where to make new domestic investment or commit foreign investment. Governments have a greater role ____________________________________________________________ _____ 1 See generally, Bird, “The Role of the Tax System in Developing Countries”, 7 Aust.
T. F. 395 (1990). 2002] TAX INCENTIVES 3 than focusing on relative effective tax burdens. Governments need to consider their role in improving the entire investment climate to encourage new domestic and foreign investment rather than simply dole out tax benefits. Thus, while much of the focus on tax incentives is on the taxes imposed by government, it is also important to examine the expenditure side of the equation. Investors, both domestic and foreign benefit from government expenditures and a comparison of relative tax burdens requires consideration of relative benefits from government services.
Definition of tax incentives. At one level, tax incentives are easy to identify. They are those special exclusions, exemptions, or deductions that provide special credits, preferential tax rates or deferral of tax liability. Tax incentives can take the form of tax holidays for a limited duration, current deductibility for certain types of expenditures, or reduced import tariffs or customs duties. At another level, it can be difficult to distinguish between provisions that are deemed to be part of the general tax structure and those that provide special treatment.
This distinction will become more important as countries may be limited in their ability to adopt targeted tax incentives. For example, a country can provide a 10 percent corporate tax rate for income from manufacturing. This low tax rate can be considered simply an attractive feature of the general tax structure as it applies to all taxpayers (domestic and foreign) or it can be seen as a special tax incentive (restricted to manufacturing) in the context of the entire tax system.
Zee, Stotsky and Ley also define tax incentives in terms of their effect on reducing the effective tax burden for a specific project. 2 This approach compares the relative tax burden on a project that qualifies for a tax incentive to the tax burden that would be borne in the absence of a special tax provision. This approach is quite useful in comparing the relative effectiveness of different types of tax incentives in reducing the tax burden associated with a project. What has changed in recent years? Tax incentives may now play a larger role in influencing investment decisions than in past years.
So while tax advisors may have been correct in concluding that the past use of tax incentives has been largely ineffective, this may no longer be true. Several factors may explain why tax considerations may be more important in investment decisions. 3 First, tax incentives may be more generous than in past years. For example, the effective reduction in tax burden for investment projects may be greater than in the past as tax holiday periods increase from two years to ten years or the tax relief provided in certain enterprise zones expand to cover trade taxes as well as income taxes.
Second, the last ten years have seen substantial trade liberalization and greater capital mobility. As non-tax barriers decline, the significance of taxes as an important factor on ____________________________________________________________ _____ Zee, Stotsky & Ley, “Tax Incentives for Business Investment: A Primer for Tax Policy Makers in Developing Countries”, IMF (2001). Easson, “Tax Incentives for Foreign Investment, Part I, Recent Trends and Countertrends”, 55 Bulletin for International Fiscal Documentation 266 (2001). 3 2 4 WORLD BANK INSTITUTE nvestment decisions increase. Stated somewhat differently, investments decisions, particularly as to certain types of projects, may be more tax sensitive than in past years. Third, business has changed in many ways. There have been major changes in firms’ organizational structure, in production and distribution methods, and the types of products being manufactured and sold. Services and intangibles, such as different types of intellectual property, are a much higher portion of value-added than in past years and these factors are very mobile.
Fewer firms produce their products entirely in one country. Firms contract out to third parties some or all of their production. With improvements in transportation and communication, it is not unusual for component parts to be produced in several different countries with the resulting increased competition for production among several countries. Finally, there has been a substantial growth in common markets, customs unions and free trade areas. Firms can now supply several national markets from a single location.
This will likely encourage competition among countries within a common area to serve as the host country for firms servicing the entire area. What tax incentives cannot accomplish. While tax incentives can make investing in a particular country more attractive, they cannot compensate for deficiencies in the design of the tax system or inadequate physical, financial, legal or institutional infrastructure. In some countries tax incentives have been justified because the general tax system places investments in those countries at a competitive disadvantage as compared to other countries.
It likely makes little sense, however, to use tax incentives to compensate for high corporate tax rates, inadequate depreciation allowances, or the failure to allow companies that incur losses in early years to use those losses to reduce taxes in later years. The better approach is to bring the corporate tax regime closer to international practice rather than granting favorable tax treatment to specific investors. Similarly, tax incentives are likely a poor response to the economic or political problems that may exist in a country.
For example, if a country has inadequate protection of property rights or a poorly functioning legal system, it is necessary to engage in the difficult and lengthy process of correcting these deficiencies rather than providing investors additional tax benefits. Tax competition and globalization. Countries no longer have the luxury of designing their tax systems in isolation. With increased mobility of capital and labor, countries must design tax systems considering the tax regimes of other countries in the region as well as international practices.
Countries need to consider the tax regimes of the home countries of its major foreign investors to determine whether the tax benefits granted foreign investors are reduced or eliminated by taxes imposed by the investor’s country of residence. It is also important to consider the tax regimes of other countries in the region from various perspectives: (i) that their residents may be potential investors, (ii) that they are competitors for foreign investment, and (iii) that their residents may be potential consumers of products produced in the country. 002] TAX INCENTIVES 5 Tax competition has received increased attention, in part attributable to the efforts of the OECD and the European Union (EU). The OECD published its first report on tax competition in 1998. 4 Two year later, the OECD published a second report that identified 47 “preferential tax regimes’ among its member countries with a mandate to eliminate such regimes by 2003. 5 The report also identified 35 tax haven regimes among nonmember countries against which the OECD has raised the possibility of counter measures.
The OECD efforts have focused on tax competition with respect to geographically mobile activities such as financial and other service activities. Whether the OECD will expand its focus to include tax competition targeted at all types of investment, such as tax incentives for manufacturing facilities, is uncertain. The European Union took a broader approach by adopting a Code of Conduct for its member states. 6 The Code requires member states to refrain from certain types of tax competition that may affect the location of business activity within the European Union.
A European Union group identified 66 special tax regimes and members were required to eliminate the tax incentives to conform to the Code. Also important in the EU, are the “State Aid Rules” that restrict or prohibit state assistance to industry. 7 The scope of the state aid prohibitions is broad enough to cover many types of tax incentives. Finally, the World Trade Organization (WTO) will likely continue to play a role in the design and use of tax incentives. The WTO will continue to serve as a forum to resolve disputes between countries over unfair trade practices, such as those that grant prohibited export subsidies.
The WTO will also likely require countries to reduce or eliminate certain types of tax incentives as a condition for admission to the WTO. Two different views have emerged on the tax competition debate. One view contends that measures to limit tax competition are necessary to prevent a “race to the bottom” that will result in countries having limited ability to tax income from capital. This reduction in tax capacity will limit the ability of governments to fund social programs for its residents. 8 An alternative view finds tax competition, like any other type of competition, to be good.
The competition will force governments to be more efficient. 9 Some in this group seek to recast the tax competition debate as efforts by certain countries to form a “cartel” to set and maintain minimum tax rates. Finally, in thinking about tax incentives, it is important to appreciate that there are different types of tax competition. The competition for investment may be global, among countries in a particular region, or even among states within a particular country. The ____________________________________________________________ _____ 4 5 6 7 8 9
OECD, Harmful Tax Competition: An Emerging Global Issue (1998). OECD, Towards Global Tax Co-operation, Report to the 2000 Ministerial Council Meeting (2000). Communication from the Commission to the Council: Towards Tax Co-ordination in the European Union, A Package to Tackle Harmful Tax Competition, Doc. COM (97) 495 final. EC Treaty, Arts. 87-89. See Schon, “Taxation and State Aid Law in the European Union”, 36 Common Market L. Rev. 911 (1999). Avi-Yonah, “Globalization, Tax Competition, and the Fiscal Crisis of the Welfare State”, 113 Harv. L. Rev. 573 (2000). Roin, “Competition and Evasion: Another Perspective on International Tax Competition”, 89 Georgetown L. J. 543 (2001). 6 WORLD BANK INSTITUTE costs and benefits of attracting different types of investment vary greatly. Countries may seek to compete for different types of investments, such as headquarters and service businesses, mobile light assembly plants, or automobile manufacturing facilities. The effectiveness of particular types of tax incentives likely depends of the type of investment that policy makers wish to attract. Tax cooperation.
As discussed above, several international organizations have worked to improve cooperation among member and non-member countries. While the EU and the OECD have received the most attention for their efforts, organizations such as MERCOSUR and the Southern African Development Community have also considered the question of tax competition. Regional approaches may offer a good opportunity for cooperation. A range of alternatives exists. Countries could consider proposals to harmonize capital income tax rates as a means of preventing tax competition among member countries.
Countries may also consider different types of cooperation with respect to tax incentives. A group of countries could follow the European Union approach and adopt a Code of Conduct that prohibits certain types of incentives or limits the ability to adopt new incentives. Countries could also agree on a set of tax incentives that each could offer investors but require individual countries to meet certain guidelines with respect to those incentives. For example, a group of countries could agree to offer tax holidays to investors but require that oliday periods should not exceed three years. Finally, countries could agree to not allow tax holidays but allow different types of tax incentives, such as “super” depreciation or investment tax credits. II. THE CASE FOR AND AGAINST TAX INCENTIVES A. CONVENTION WISDOM Traditional advice from tax advisors. The conventional wisdom is that tax incentives often erode the tax base without any substantial effects on the level of investment. 10 Representatives of the World Bank and the IMF have traditionally advised against the use of tax incentives. 1 In some countries, the IMF has required elimination of certain tax incentive regimes as a condition of receiving additional financing. It is not easy, however, to separate criticism of the tax incentive regimes adopted by countries from criticism of all tax incentives. Advisors have recognized that certain welldesigned tax incentives targeted at encouraging investment in new machinery and investment in research and development have been successful in increasing investment. ___________________________________________________________ _____ See, e. g. , Shah (ed. ), Fiscal Incentives for Investment and Innovation, pp. 1-30 (1995); OECD, Taxation and Foreign Direct Investment: The Experience of the Economies in Transition (1995); and United Nations, The Determinants of Foreign Direct Investment: A Survey of the Evidence (1992). 11 10 Chua, Tax Incentives, in Tax Policy Handbook, pp. 165-68 (1995). 2002] TAX INCENTIVES 7 There does appear to be a shift among tax advisors from recommending against he use of tax incentives to assisting in improving the use and design of tax incentive regimes. Review of empirical evidence. Several economic studies have examined the effect of taxes on investment, particularly foreign direct investment. While it is not easy to compare the results of different empirical studies, scholars have attempted to survey the various studies and to reach some conclusions as to the effect of taxes on levels of foreign investment. Useful surveys are included in the Ruding report,12 Hines,13 and Mooij and Ederveen. 4 These surveys note the difficulty of comparing the results of different studies because the studies contain different data sources, methodologies, and limitations. The studies also report different types of elasticities in measuring the responsiveness of investment to taxes. Part of the difficulty in determining the effect of taxes on foreign investment is getting a good understanding of the different types of foreign investment and different sources of funding for foreign investment. Foreign investment consists of both portfolio and direct investment.
While different ways to distinguish portfolio and direct investment exist, a common approach is to focus on the foreign investor’s percentage ownership of the domestic enterprise. For example, if the foreign investor owns a greater than 10 percent stake in an enterprise, the investment is likely to be more than a mere passive holding for investment purposes. Foreign direct investment can be further divided into direct transfers from a parent company to a foreign affiliate through debt or equity contributions and reinvested earnings by the foreign affiliate.
The different forms of foreign investment are also important, as the different components might respond differently to taxes. Types of foreign investment include: (i) real investments in plant and equipment; (ii) financial flows associated with mergers and acquisitions; (iii) increased investment in foreign affiliates; and (iv) joint ventures. The different studies have also emphasized the importance of the investor’s home country’s tax system in estimating the influence of tax incentives offered by the host country in attracting investment. 5 As discussed in Section III(d)_, countries generally tax their corporate taxpayers on their foreign source income under one of two alternatives: (i) the “credit” method whereby corporate taxpayers are taxed on their world-wide income and receive a foreign tax credit against their domestic tax liability for foreign income taxes paid on the foreign source income; or (ii) the “exemption” method, whereby the corporate taxpayers are generally taxed on only their domestic source income and can exempt certain foreign source income in computing their tax liability.
In theory, foreign ____________________________________________________________ _____ Commission of the European Communities (CEC), Report of the Committee of Independent Experts on Company Taxation (1992) (Ruding Report). Hines, Tax Policy and the Activities of Multinational Corporations in Auerbach (ed), Fiscal Policy: Lessons from Economic Research (1997) and Hines, “Lessons from Behavioral Responses to International Taxation”, 54 Nat. Tax J. 305 (1999). Mooij & Ederveen, “Taxation and Foreign Direct Investment: A Synthesis of Empirical Research”, paper presented at the OCFEB Conference, Tax Policy in the European Union (2001). 5 14 13 12 Hines, “Tax Sparing and Direct Investment in Developing Countries”, (NBER Working Paper No. 6728) (1998). 8 WORLD BANK INSTITUTE investors from countries that adopt the credit method are less likely to benefit from tax incentives, as the tax revenue from the favored activities may be effectively transferred to the investor’s revenue service from the tax authorities in the host country. In practice, however, because foreign investors have different alternatives to structure their foreign investments, the effect of the different tax approach is likely to be relatively small.
Finally, scholars have noted that taxes may affect decision as to the source of financing rather than the level of investment. 16 Investors have several alternatives on how to fund new ventures or expand existing operations. Taxes likely play a role in the choice of whether to make new equity investment, use internal or external borrowing, or use retained earnings to finance investments. In those cases where there has been a serious examination of the results of tax incentive regime, there are successes and failures. 7 A good review of the results of incentives is set forth in a 1996 United Nation’s study. 18 The UN study concludes that “as other policy and non-policy conditions converge, the role of incentives becomes more important at the margin, especially for projects that are cost-oriented and mobile. ”19 Steven Clark of the OECD reaches a similar conclusion. 20 He concludes that “Empirical work using improved data measuring FDI offers convincing evidence that host country taxation does indeed affect investment flows.
Moreover, recent work finds host country taxation to be an increasingly important factor in locational decisions. “21 Cost-effectiveness of tax incentives. Even where tax incentives succeed in attracting investment, the costs of the incentives may exceed the benefit derived from the new investment. This is difficult to substantiate, as problems exist in estimating the costs and benefits of tax incentives. One method of cost-benefit analysis is to estimate the cost (in terms of revenue foregone and/or direct financial subsidies) for each job created.
For example, a 1996 study of incentives granted in the United States and in Western Europe between 1983 and 1995 found the cost of the incentive to vary from US $13,000 to over $250,000 per new job, with the cost rising steadily over that period. 22 Although the study does not give a true measure of efficiency, since it measures only the cost – and not the worth – of the jobs created, it does demonstrate the sharp rise in the cost of incentives over the past decade. The cost of jobs, however, varies widely according to the country ____________________________________________________________ _____
Auerbach, “The Cost of Capital and Investment in Developing Countries”, in Shah (ed) Fiscal Incentives for Investment and Innovation (1995). See Chia & Whalley, “Patterns in Investment Tax Incentives Among Developing Countries”, Ch. 11 in Shah, (ed. ), Fiscal Incentives for Investment in Developing Countries (World Bank) (1992). 18 19 20 21 22 17 16 United Nations, “Incentives and Foreign Direct Investment”, UN Doc. UNCTAD/DTCI/28 (1996). Id. at pp. 44-45. Clark, “Tax Incentives for Foreign Direct Investment: Empirical Evidence on Effects and Alternative Policy Options”, 48 Canadian Tax Journal 1139 (2000).
Id. at p. 1176. UNCTAD – Incentives and Foreign Direct Investment (United Nations: New York, 1996) at pp. 29-30. 2002] TAX INCENTIVES 9 and to the industrial sector,23 and the more “expensive” jobs may bring with them greater spill over benefits, such as technology transfer. Role of non-tax factors. Deciding whether and where to invest is a complex decision. It is not surprising that tax considerations are just one factor in these decisions. Scholars have listed several factors that influence investment decisions, particularly those of foreign investors. 4 These include: (1) (2) (3) (4) (5) (6) (7) (8) (9) Consistent and stable macroeconomic and fiscal policy; Political stability; Adequate physical, financial, legal and institutional infrastructure; Effective, transparent and accountable public administration; Skilled labor force and flexible labor code governing employer and employee relations; Availability of adequate dispute resolution mechanisms; Foreign exchange rules and the ability to repatriate profits; Language and cultural conditions; Factor and product markets — size and efficiency.
When scholars surveyed business executives, taxes were often not a major consideration in deciding whether and where to invest. 25 Businessmen did note that in choosing between countries in the same region, taxes were an important consideration. Recent scholarship.
The recent scholarship either acknowledges a limited role for tax incentives in correcting market failures or accepts the political realities of the continued use of tax incentives and seeks to improve the decision-making of policy makers both in the initial decision as to whether or not to adopt tax incentive regimes and the decision on the relative merits of different types of incentives. 26 This module follows this approach in seeking to discuss ways to improve the design of tax incentives and reduce the potential for abuse. B. ADVANTAGES OF TAX INCENTIVES
If properly designed and implemented, tax incentives may be a useful tool in attracting investments that would not have been made without the provision of tax benefits. As discussed below, new investment may bring substantial benefits, some of which are not ____________________________________________________________ _____ According to a 1991 U. N. study, experience in export-processing zones (mostly in developing countries) suggests about US $5,000 per worker, though this can vary from about $1,000 per worker in textiles to more than $100,000 in the chemical industry Id. 24 25 26 23
Easson, Taxation of Foreign Direct Investment: An Introduction (1999). OECD, note 11 supra. Easson, “Tax Incentives for Foreign Direct Investment, Part 2, Design Considerations”, 55 Bulletin for International Fiscal Documentation 365 (2001) and Zee, Stotsky & Lee, note 3 supra. 10 WORLD BANK INSTITUTE easily quantifiable. As discussed in Section III(b)__, a narrowly targeted tax incentive program may be successful in attracting specific projects or specific types of investors. That governments often choose tax incentives over other types of government action is not surprising.
It is much easier to provide tax benefits than to correct deficiencies in the legal system or to dramatically improve the communications system in the country. Also, tax incentives do not require an actual expenditure of funds by the government. One alternative to using tax incentives is to provide for grants or cash subsidies to investors. Although tax incentives and cash grants may be similar economically, for political and other reasons, it is easier to provide tax benefits than to actually provide funds to investors. Different types of benefits. Tax incentives may yield different types of benefits.
The benefits from tax incentives for foreign investment follow the traditional list of benefits resulting from foreign direct investment. 27 These include increased capital transfers, transfers of know-how and technology, increased employment, and assistance in improving conditions in less-developed areas. Foreign direct investment may generate substantial spillover effects. For example, the choice to locate a large manufacturing facility will not only result in increased investment and employment in that facility, but also at firms that supply and distribute the products from that facility.
Economic growth will increase the spending power of the country’s residents that, in turn, will increase demand for new goods and services. Increased investment may also increase government tax revenue either directly from taxes paid by the investor (for example, after the expiration of the tax holiday period) or indirectly through increased tax revenues received from employees, suppliers, and consumers. One can provide a general description of the general types of benefits of additional investment resulting from tax incentives.
It is difficult, however, to estimate the benefits resulting from tax incentives with any degree of certainty. Sometimes the benefits are hard to quantify. Other times the benefit accrues to persons other than the firm receiving the tax benefits. C. DISADVANTAGES OF TAX INCENTIVES 1. DIFFERENT TYPES OF COSTS ASSOCIATED WITH TAX INCENTIVES In considering the costs of tax incentive regime, it may be useful to examine four different types of costs: (i) revenue costs; (ii) resource allocation costs; (iii) enforcement and compliance costs; and (iv) the costs associated with the corruption and lack of transparency. 8 Revenue Costs. The tax revenue losses from tax incentives come from two primary sources: first, foregone revenue from projects that would have been undertaken even if ____________________________________________________________ _____ 27 28 Easson, note 27 supra. Zee, Stotsky & Lee, note 3 supra. 2002] TAX INCENTIVES 11 the investor did not receive any tax incentives; and, second, lost revenue from investors and activities that improperly claim incentives or shift income from related taxable firms to those firms qualifying for favorable tax treatment.
As discussed below in Section III(b)__, policy makers may wish to target tax incentives to achieve the greatest possible benefits for the lowest costs. The goal would be to offer tax incentives only to those investors who at the margin would invest elsewhere but for the tax incentives. Offering tax incentives to those investors whose decisions to invest are not affected by the proposed tax benefit results in just a transfer to the investor (or in some instances, to the foreign investor’s government) from the host government without any gain.
It is very difficult to determine on a project-by-project basis which projects were undertaken solely due to tax incentives. Similarly, it is hard to estimate for an economy as a whole what the levels of investment would be with or without a tax incentive regime. For those projects that really would not have been undertaken without tax incentives, there is no real loss of tax revenue from those firms.
Indeed, to the extent that the firms become regular taxpayers or to the extent that these operations generate other tax revenue (such as increased profits from suppliers or increased wage taxes from employees) there are revenue gains from those projects. An additional revenue cost of tax incentives results from erosion of the revenue base due to taxpayers abusing the tax incentive regimes to avoid paying taxes on nonqualifying activities or income. 29 As discussed in Section V(b)__, this can take many forms. Revenue losses can result where taxpayers disguise their operations to qualify for tax benefits.
For example, if tax incentives are only available to foreign investors, local firms or individuals can use foreign corporations through which to route their local investments. Similarly, if tax benefits are available to only new firms, then taxpayers can reincorporate or set up many new related 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 example, assume that a firm qualifies for a tax holiday because it is engaged in a type of activity that the government believes merits tax incentives.
It is likely quite difficult to monitor the firm’s operation to ensure the firm does not engage in additional non-qualifying activities. Even where the activities are separated, it is very difficult to monitor related party transactions to make sure that income is not shifted from a taxable firm to a related firm that qualifies for a tax holiday. Resource allocation costs. If tax incentives are successful, they will cause additional investment in sectors, regions or countries that would not otherwise have occurred. Sometimes this additional investment will correct for market failures.
Other times, however, the tax incentives will cause allocation of resources that may result in too much investment in certain activities or too little investment in other non-tax favored areas. ____________________________________________________________ _____ 29 See sectionV(b)___ for a discussion of different types of taxpayer abuses. 12 WORLD BANK INSTITUTE It is difficult to determine the effects of tax provisions in developed countries where markets are relatively developed. It is more difficult to determine the consequences of tax provisions in developing countries where markets do not approach the competitive models.
As such, where markets are imperfect, it is not clear whether providing tax incentives to correct market imperfections will make markets more competitive. 30 Enforcement and compliance costs. As with any tax provision, there are resource costs incurred by the government in enforcing the tax rules and by taxpayers in complying. The cost of enforcement relates to the initial grant of the incentive as well as the costs incurred in monitoring compliance with the qualification requirements and enforcing any recapture provisions on the termination or failure to continue to qualify.
The greater the complexity of the tax incentive regime, the higher the enforcement costs (as well as compliance costs) may be. Similarly, tax incentive schemes that have many beneficiaries are harder to enforce than narrowly targeted regimes. It is also difficult to get revenue authorities enthusiastic about spending resources to monitor tax incentive schemes. Revenue authorities seek to use their limited administrative resources to improve tax collection. The revenue authorities may prefer auditing fully taxable firms rather than those operating under a tax holiday arrangement.
Tax incentives also impose administrative costs on taxpayers. The administrative costs will vary by type of incentive as well as the qualification process, monitoring and reporting requirements. Opportunities for corruption. Several recent scholars have focused on the possibility of corruption and other rent-seeking behavior associated with the granting of tax incentives. As discussed below in Section IV(a)__, there are several different approaches to providing the qualification requirements for tax incentives.
The relative merits of automatic and objective approaches versus discretionary and subjective approaches are discussed in greater detail in that section. What is clear is that the opportunity for corruption is much greater for tax incentives regimes where officials have wide discretion in determining which investors or projects receive favorable treatment. The potential for abuse is great where no clear guidelines exist for qualification. ____________________________________________________________ _____ 30 Lipsey & Lancaster, “The General Theory of Second Best”, 24 Rev. Econ. Stud. 11 (1956-1957). 2002] TAX INCENTIVES 13
Transparency and Tax Incentives Howell Zee nicely adopts the transparency concepts from the anticorruption literature to tax incentives regimes. Zee examines transparency and tax incentives along three dimensions: Legal and regulatory dimension. That tax incentives have a statutory basis in relevant tax laws and any changes to the regime be effected through the formal amendment process; Economic dimension. That the rationale for granting any incentives be clearly set forth and that the costs and benefits of a proposed incentives scheme be determined based on clearly stated assumptions and methodologies; Administrative dimension.
That the qualifying criteria be simple, specific and objective to minimize the discretion afforded officials that grant the incentives and to provide guidance to tax authorities charged with monitoring and enforcing the tax incentive regime. 2. ESTIMATING THE COSTS OF TAX INCENTIVES Tax expenditure analysis. All the OECD countries and several other countries require estimates to be prepared as to the revenue impact of certain existing and proposed tax provisions.
For those countries that do not have a formal tax expenditure requirement, it makes good sense to go through the exercise in deciding whether to adopt or retain a tax incentive regime. Behavioral assumptions. All revenue estimates are based on a set of assumptions as to responses of taxpayers to particular tax law changes. In assessing the performance of tax incentive schemes, the objective is to determine the amount of incremental investment resulting from tax incentives and to be able to determine the costs and benefits associated with attracting that investment.
This requires making assumptions as to such items as: (i) the amount of investment that would have been made without the tax incentive program; (ii) the amount of “leakage” from the tax base due to taxpayers improperly claiming the tax incentives or from shifting income from taxable to related tax-exempt (or lower-taxed) entities; (iii) the tax revenue gained from either activities from taxpayers granted a tax incentive after the incentive expired or from the activities generating other sources of tax revenue. Tax incentive budget.
In many countries, the tax authorities do not have sole responsibility or discretion in designing and administering tax incentives programs. As discussed in Section V__, different government agencies, such as foreign investment agencies or ministries of international relations, have a role in designing investment 14 WORLD BANK INSTITUTE regimes, approving projects and monitoring investments. These agencies’ major objective is in attracting investments; they are often less concerned with protecting the tax base. One approach that merits consideration is to set a target monetary amount of tax benefits to be granted under a tax incentive regime.
This would require both the tax authorities and other government agencies to agree on both a target amount and a methodology for determining the revenue costs associated with a particular tax incentive regime. Recent South African Legislation on Tax Incentives South Africa has adopted a “Strategic Investment Program” as part of a larger package of tax incentives that seeks to encourage investment into South Africa from both local and foreign investors. The key features of the Strategic Investment Program include: 1. A tax expenditure budget of 3 billion rand in the form of tax allowances over a period of four years starting August 1, 2001; 2.
Specification of the qualifying industry sectors that includes all manufacturing activities except tobacco and tobacco related products; computer and computer related activities; and research and development activities; 3. Specification of qualifying requirements that includes an investment in new qualifying assets equal or exceeding 50 million rand; increase production and employment within South Africa; no substantial displacement of jobs within South Africa; demonstrating long-term commercial viability; and that the project does not currently benefit from other government incentive programs; 4. Clear criteria for valuating and scoring investment projects, a process for application and approval, and publication requirements for approved awards to ensure transparency for awarding tax incentives. D. SUNSET PROVISIONS AND EVALUATION OF SUCCESS OF SPECIFIC TAX INCENTIVE INITIATIVES The costs and benefits of tax incentives are not easy to evaluate and are hard to quantify and estimate. Incentives that may work well in one country or region may be 2002] TAX INCENTIVES 15 ineffective in another context. Tax incentive regimes in many countries have evolved from general tax holidays to incentive regimes that are more narrowly targeted.
It therefore may make sense (i) to limit the duration of tax incentive regimes to reduce the potential costs of unsuccessful or poorly designed programs by including a specific “sunset” provision as part of the original legislation; (ii) to design incentive regimes to require information reporting by beneficiaries to investment agencies and to specify what government agency has responsibility for monitoring and enforcing qualification and any recapture provisions; and (iii) to require an evaluation be made as to the costs and benefits of specific tax incentive regimes and to specify the timing of the evaluation and the parties responsible for conducting the review. III. TYPES OF TAX INCENTIVES A. OBJECTIVES OF TAX INCENTIVES Countries grant special tax privileges to attract additional investment. However, if the objective were simply to increase the total stock of all types of investment, the best policy would likely be to adopt an “investor-friendly” general benchmark tax system.
Tax incentives are, by definition, departures from the benchmark system that are granted only to those investors or investments that satisfy the prescribed conditions. These special tax privileges may be justified only if they attract investments that are both particularly desirable and that would not be made without such tax benefits. Thus, the first question in designing a tax incentive system is “what types of investment are the incentives intended to attract? ” B. TARGETING OF INCENTIVES Incentives may be broadly targeted; for example, all new investment, foreign or domestic, or they may be very narrowly targeted, and designed with one particular proposed investment in mind. 31 Advantages of and Disadvantages of Targeting.
The targeting of incentives serves two important purposes: (i) it identifies the types of investment that host governments seek to attract; and (ii) it reduces the cost of incentives because it reduces the number of investors that benefit. This raises the question of whether a government should treat some types of investment as more desirable or beneficial than other types. Should a government seek to attract and target tax incentives at particular types of investments and not others, or should investment decisions be left solely to market forces? Justifiable doubt exists about the ability of politicians to “pick winners,” particularly in countries making the transition ____________________________________________________________ _____
For example, a Ukrainian provision favoring new foreign investment in the motor industry exceeding $50 million was introduced specifically for the benefit of Daewoo. 31 16 WORLD BANK INSTITUTE to a market economy. Also, there are some types of investment that, while not prohibited altogether, may not deserve encouragement in the form of tax benefits. Ideally, incentives should be given only for incremental investment; that is, for investments that would not otherwise have occurred but for the tax benefits. Even if that is not possible, targeting likely reduces the number of free riders. One downside of a selective approach is that the more precisely an incentive is targeted, the greater the distortion it creates.
This distortion takes two forms: investment decisions are changed to take advantage of incentives, thus resulting in a misallocation of resources, and competition is distorted between those firms that enjoy the incentives and those that do not. Discretionary or Automatic Targeting. An initial question is whether the granting of tax incentives should be discretionary, or should be automatic once the prescribed conditions are met. This question is discussed in Section IV. For the reasons given there, it seems advisable to limit discretion. But if qualification for incentives is made largely automatic, it becomes necessary for the qualifying conditions to be spelled out clearly and in detail. Foreign or Domestic Investment. In developing countries, tax incentives are primarily intended to attract foreign direct investment.
An important question is whether tax incentives should be restricted to foreign investors or made available equally to domestic investors. Restricting tax incentives to foreign investors reduces the potential revenue loss. Domestic investors often have little or no real opportunity to invest elsewhere, and therefore do not need special incentives to encourage them to invest at home. However, such a restriction may be objected to on the following grounds. First, discrimination in favor of foreign investors distorts competition. It may restrict the growth of domestic enterprises, or even prevent the development of a domestic sector. It is also likely to cause resentment.
Second, discrimination in favor of foreign investors is often ineffective, because domestic investors may engage in “round-tripping” to disguise domestic investment as coming from foreign sources (discussed in Section V). New Investors. The most common form of investment incentive is the tax holiday, which by its nature, is targeted at new investors. The rationale may be that once a new investor has been “captured” its subsequent investment decisions will be made solely according to its business needs and will not be influenced, or will be less influenced, by tax considerations. In practice, restricting incentives to new investors tends to be ineffective and may be counter-productive.
An existing investor that plans to expand its operations will often incorporate a new subsidiary or form a related corporation to undertake those operations such that the new entity qualifies for a new tax holiday. Large Investments. Countries use tax incentives to attract investment — so there often exists a view of “the more, the better”. This view is reflected in provisions that restrict the granting of incentives to “large” investments, i. e. , those exceeding a stipulated amount. The amount varies greatly from country to country and is sometimes further restricted to particular types of investment. Often, imposing a dollar threshold effectively limits the incentive to foreign investors, without formally discriminating against domestic 2002] TAX INCENTIVES 17 nterprises. This results because few, if any, domestic investors possess sufficient capital to meet the qualifying threshold. In principle, it is difficult to justify a qualification based on a particular threshold. It may be that two investments, each of $3 million, would be more beneficial to the host country than a single investment of $5 million. Only in very marginal cases is an investor likely to increase the size of its planned investment in order to obtain a tax privilege. Investors are more likely to change how an investment is financed or to inflate the value of the assets contributed to meet qualification requirements. Sectoral Targeting.
Many countries grant preferential tax treatment to certain sectors of the economy, or to certain type of activities. Sectoral targeting has many advantages; (i) it restricts the benefits of the incentives to those types of investment that policy makers consider to be most desirable; and (ii) it also makes it possible to target those sectors that are most likely to be influenced by tax considerations. Among the activities commonly preferred are: Manufacturing. Several countries restrict investment incentives to manufacturing activities or provide for those activities to receive preferential treatment (e. g. , China, Ireland). This may reflect a perception that manufacturing is somehow more valuable than the provision of services, perhaps because of its mployment creating potential, or a view that services (with some exceptions) tend to be more market-oriented and therefore less likely to be influenced by tax considerations. “Pioneer” Industries. Some countries adopt a more sophisticated approach and restrict special investment incentives to certain broadly listed activities or sectors of the economy. Malaysia and Singapore, for example, grant special tax incentives to “pioneer” enterprises. Generally, to be accorded pioneer status, an enterprise must manufacture products that are not already produced domestically, or engage in certain other listed activities that are not being performed by domestic firms and that are considered to be especially beneficial to the host country. Specific Sectors.
Increasingly, countries have introduced incentives narrowly targeted at particular types of investment, especially technologically advanced industries. Other common targets are infrastructure development, film production, tourism, and “offshore” financial centers. 32 Location Incentives. Many countries provide tax incentives to locate investments in particular areas or regions within the country. Sometimes the incentives are provided by regional or local governments, in competition with other parts of the same country. In other cases, the incentives are offered by the central government, often as part of its regional development policy, to promote investment in less-developed regions of the country or in areas of high unemployment. Employment Creation.
One benefit of foreign direct investment is creating new employment opportunities and, not surprisingly, incentives are frequently provided specifi_____________________________________________________ ____________ 32 This type of incentive may result in a country being labeled a “tax haven” under the OECD harmful tax competition initiative. 18 WORLD BANK INSTITUTE cally to encourage job creation. Policy makers could provide for tax incentives for investment in regions of high unemployment, or they could tie the tax incentive directly to employment, with the creation of a stipulated number of new jobs being made a condition for qualifying for the tax holiday or other incentive. Technology Transfer. Foreign direct investment often results in the transfer of technology.
Even critics of tax incentives concede that tax incentives may be useful to promote activities such as research and development (R&D), if only as a way of correcting market imperfections. Countries attempt to attract technologically-advanced investment in several ways: (i) by targeting incentives at technologically-advanced sectors; (ii) by providing incentives for the acquisition of technologically-advanced equipment; and (iii) by providing incentives for carrying out R&D activities. Export Promotion. The experience of many developing countries is that export promotion, and the attraction of export-oriented investment, is the quickest and most successful route to economic growth.
It is therefore hardly surprising that competition to attract such investment is especially fierce, and investment incentives are frequently targeted at export-oriented production. Additionally, incentives targeted specifically at export-oriented investment tend to be more effective than most other forms of tax incentive, due to the higher degree of mobility of such investment. However, an important factor to be considered is that such incentives may constitute an export subsidy and thus be contrary to WTO rules. C. FORMS OF TAX INCENTIVES Designing tax incentives requires two basic decisions:- one, determining the types of investment that qualify; two, determining the form of tax incentive to adopt.
Tax incentives for investment take a variety of forms. The most commonly employed are: (1) (2) (3) (4) (5) (6) (7) (8) (9) reduced corporate income tax rates; tax holidays (i. e. , reduction of or exemption from tax for a limited duration); investment credits or allowances; tax credit accounts; accelerated depreciation of capital assets; favorable deduction rules for certain types of expenditure; deductions or credits for reinvested profits; reduced rates of withholding tax on remittances to the home country; personal income tax or social security reductions for executives and employees; (10) sales tax or VAT reductions; (11) reduced import taxes and customs duties; 2002] TAX INCENTIVES 19 12) property tax reductions; (13) creation of special “zones. ” Reduced Corporate Income Tax Rates. Countries may provide exemptions from, or reduced rates of, corporate income or profits tax to particular types of activity. Some countries provide a reduced rate of tax for certain types of investment (e. g. , the reduced rate for manufacturing in Ireland). 33 Other countries provide reduced tax rates for investment in particular locations or regions (e. g. , the reduced rate for investment in special economic zones and other designated regions of China). Tax Holidays. In developing countries, tax holidays are by far the most common form of tax incentive for investment.
A tax holiday may take the form of a complete exemption from profits tax (and sometimes from other taxes as well), of a reduced rate of tax, or of a combination of the two (e. g. , 2 years exemption, plus a further 3 years at halfrate). The exemption or reduction is granted for a limited duration. Tax holidays can vary in duration from as little as one year to as long as 20 years. In determining the length of the tax holiday, a clear trade-off exists between the attractiveness to investors and the revenue cost to the host country’s treasury. Most studies have concluded that short tax holidays are of limited value or interest to most potential investors and are rarely effective in attracting investment, other than short-term, “footloose,” projects.
Substantial investments often take several years before they begin to show a profit, by which time the tax holiday may have expired. Short tax holidays are of the greatest value to investments that can be expected to show a quick profit and are consequently quite effective in attracting investment in export-oriented activities such as textile production. Since that sector is highly mobile, however, it is not uncommon for a firm to enjoy a tax holiday in one country and, when it expires, to move its entire operation to another country that is willing to give a new holiday. Consequently, the benefit of the investment to the host country may be quite limited.
Tax holidays have the apparent advantage of simplicity for both the enterprise and the tax authorities. A common misperception is that, if no tax is payable during the holiday period, no formalities should be required, such as information or tax returns, and there should be no compliance or administrative costs. In practice, however, it is usually still necessary (and desirable) to require the filing of a tax return during the holiday period. In particular, if the enterprise is allowed to carry forward losses incurred in the holiday period or to claim depreciation allowances after the end of the holiday for expenditure incurred during the holiday, the enterprise will obviously need to file a return or at least keep appropriate records.
Additionally, tax holidays are especially prone to manipulation and provide opportunities for tax avoidance and abuse (discussed in Section V). Another disadvantage is that the revenue cost of tax holidays cannot be estimated in advance with any degree of ____________________________________________________________ _____ 33 This special rate is being eliminated because of EU rules. 20 WORLD BANK INSTITUTE accuracy, nor is the cost related to the amount of the investment or to the benefits that may accrue to the host country. Finally, tax holidays exempt profits without regard to the level or amount of profits that are earned. For potential investments that investors believe will earn above market returns, tax holidays will result in a loss of tax revenue without any benefits.
Because of the high return, investors would have undertaken these projects even without the availability of tax incentives. 34 Investment Allowances and Credits. As an alternative, or sometimes in addition, to tax holidays, some governments provide investment allowances or credits. These are given in addition to the normal depreciation allowances, with the result that the investor may be able to write off an amount that is greater than the cost of the investment. An investment allowance reduces taxable income, whereas an investment tax credit is set against the tax payable; thus, with a corporate income tax rate of 40 percent, an investment allowance of 50 percent of the amount invested equates to an investment credit of 20 percent of that amount.
Investment allowances or credits may apply to all forms of capital investment, or they may be restricted to specific categories, such as machinery or technologically advanced equipment, or to capital investment in certain activities, such as research and development. Sometimes, countries limit eligibility to contributions to the charter capital of the firm. This approach may encourage investors to increase the relative amount of equity capital rather than related-party debt capital in the firm’s initial capital structure. Investment allowances and credits seem preferable to tax holidays in almost every respect: (i) they are not open-ended; (ii) the revenue cost is directly related to the amount of the investment, so there should be no need for a minimum threshold for eligibility; and (iii) their maximum cost is more easily estimated.
One objection to the use of investment allowances and credits is that they favor capital-intensive investment and may be less favorable towards employment creation than tax holidays. They may also distort the choice of capital assets, possibly creating a preference for short-lived assets so that a further allowance or credit may be claimed on replacement. Tax Credit Accounts. Tanzi & Zee propose an interesting approach to offering tax benefits to potential investors that allows taxing authorities to determine with great certainty the revenue costs of the tax incentive program. 35 This approach provides each qualifying investor a specific amount of tax relief in the form of a tax credit account (say, for example, potential exemption for $100,000 of corporate income tax liability).
The investor would be required to file tax returns and keep books and record just like any other taxpayer. If the investor determines it has $60,000 of tax liability in year one, it would pay no tax, but the amount in its tax account would be reduced to $40,000 for ____________________________________________________________ _____ 34 35 Tanzi & Zee, “Tax Policy for Emerging Markets: Developing Countries”, IMF Working Paper No. 35 (2000). Id. 2002] TAX INCENTIVES 21 future tax years. The tax credit account has the advantage of providing transparency and certainty to both the potential investor and the government. The tax credit account may be regarded as a sort of hybrid – a cross between a tax holiday and an investment tax credit.
It resembles a tax holiday, except that the tax exemption period, instead of being a fixed number of years, is related to the amount of income earned: i. e. the exemption applies to the first $x earned. This has two important advantages: the cost of the incentive to the host government is known, and there is no strong built-in advantage for those investments that make quick profits. The tax credit account also resembles an investment tax credit in that the amount of the credit is a fixed sum: where it differs is that the amount is not determined by the amount of the investment. It consequently does not provide a preference to capital-intensive investments. Accelerated Depreciation.
As already noted, an investment credit or allowance is provided in addition to any amount of depreciation that may be claimed. The term “accelerated depreciation” generally refers to any depreciation scheme that provides for writing off the cost of an asset, for tax purposes, at a rate faster than the true economic depreciation. Many countries use some type of “declining balance” method of depreciation or other type of accelerated depreciation as part of their benchmark tax system. For those countries, however, that do not generally provide accelerated depreciation, a tax incentive can provide for deducting the cost of acquisition more quickly than would be allowed under the normal “benchmark” depreciation schedules.
The cost of accelerated depreciation, in terms of tax revenue foregone, is normally less than that of tax holidays or investment allowances/credits, since it is only the timing of the tax payable, and not the amount of tax, that is affected. That, of course, can still be a substantial benefit to established businesses that are planning to increase their investment, but in the case of most initial investments, where there may be no profit for several years, accelerated depreciation will be of no benefit. Favorable Deduction Rules. Policy makers may influence investment by providing favorable rules for deducting certain types of expenditures. These include accelerated depreciation provisions and rules that allow the immediate expensing of capital outlays.
A somewhat different type of incentive is the double (or multiple) deduction of preferred expenditures (e. g. , for re-training employees or for promoting tourism). 36 A double ded