Causes, Benefits, and Risks of
Business Tax Incentives
IMF Tax Policy Seminar for Asian and
Pacific Countries on Tax Incentives
Tokyo, June 9-11, 2009 Financed by JSA
Today’s presentation
“Views are my own and do not necessarily represent those of the IMF”
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An overview of tax incentives
Empirical evidence on tax incentives
An Overview of Tax Incentives
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Introduction
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Tax incentives are controversial:
Economists generally skeptical
 But remain popular, especially in developing
countries
 Is there a need to reconsider/reinforce
advice?
 At least more research needed!
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Definition
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“Any measure that provides for a more
favorable tax treatment of certain
activities or sectors compared to what
is available to general industry.”
Alternative definitions exist, but not
practicable
Implication:
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Tax cuts / generally available depreciation
schemes not considered tax incentives.
Typical incentives
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Tax holidays
Special zones
Investment tax credits / allowances
Accelerated depreciation
Reduced tax rates
Exemptions from various taxes
Financing incentives
…
Reasons for tax incentives
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Address externalities
Regional development
Political economy
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Tax competition
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Doing something
Fragmented policy making
…
Incentives allow differentiation between more and
less mobile capital
Tax competition
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Countries attempt to attract capital or taxable
profits, by reducing taxes on capital
Theoretical result: small open economies
should not levy source-based capital income
taxes
But:
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Capital imperfectly mobile
Tax system complicated (bases, rates, incentives)
Economic rents – location- or company-specific
Economic rents
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Location-specific, e.g., natural resources.
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Regional, e.g., scenery.
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Regional cooperation, however, could allow taxation without
capital leaving the regions.
Firm-specific, e.g., patents.
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Such rents can be taxed and there should be no interaction with
other governments.
a positive rent (present discounted value (PDV) net of tax)
should be enough for an investment to be worthwhile.
Such rents are subject to full tax competition.
Even if a project's PDV for a discrete investment project remains
positive after taxation, investment will not take place, if after-tax
PDV higher in another country.
Complexity of tax system
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Tax incentives permit countries to
discriminate between more and less
mobile capital
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Other reforms may also achieve this
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This may even be beneficial (Keen 2002,
Janeba and Smart 2003)
Base-broadening rate-cutting
Intermediate conclusions
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Tax incentives appear rational response
to tax competition
Does not mean they are best response
 Even incentives with domestic intent, can lead
to tax competition
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Need to consider details of the costs
and benefits of tax the different
incentives
Evaluation of tax incentives
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Costs
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Revenue forgone
Nil if only apply to new activity and no crowding out
 Full, if no new net activity
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Administrative/compliance costs
 Rent-seeking behavior/corruption
 Distortions (unless desired)
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→ Very hard to assess
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Evaluation of tax incentives
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Benefits
Additional investment/growth (but what is
counterfactual?)
 Better quality of investment
 Externalities reduced
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→ Even harder to assess
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Cost-benefit analysis
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Partial equilibrium approach can be
very misleading:
A study of an incentive reveals that x new
plants were set up, which would not have
occurred otherwise
 But other investment possibly crowded out
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As usual (infrastructure limits, labor market, etc.)
 Additionally: Because of higher taxes needed on
other industry
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Cannot always be calculated, but needs to be
mentioned
Principles for choosing tax incentives
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General principles for good tax policy
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Transparency / simplicity
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Include in tax laws
Predictability
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Rules rather than discretion
Enforceability / robustness to evasion
 Economic efficiency?
 Equity?
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Tax holidays
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Very popular
Particularly harmful
Most attractive to short-term, footloose,
rapidly profitable investment
 Unknown cost
 Encourage rent-seeking behavior (renewals)
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Possible, but difficult, to make
theoretical case
Investment allowances
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Same effect as investment tax credits
(algebra)
Directly contingent on investment
Distort choice of capital goods
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Short rather than long-lived capital
Physical rather than financial or intangible capital
Useful only to profitable businesses (unless
refundable)…
… but not very valuable to most profitable
ones
Accelerated depreciation
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Similar impact as allowances/tax
credits
But more limited:
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Timing advantage only
Time-value of money
 Help for cash-constrained, but profitable business
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Reduced tax rates
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If limited in time, similar to tax holiday
If applied to well-defined sectors, can
play a useful role
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Attract profitable investment
Special zones
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Characteristics differ, hard to make
general assessment
Some reduce compliance cost only,
e.g., zones for international trading
companies
Some provide tax exemption. Revenue
cost can be enormous (profit shifting)
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Especially if zones not geographically
concentrated
Financing incentives
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E.g., reduced withholding tax rates on
dividends. No impact if:
Investor located in residence-based country
and repatriates all profits
 Investor able to avoid withholding tax anyway
 Marginal source of finance retained earnings
or debt
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Comparison of main incentives
30
EMTR
(percent)
Tax holiday
25
20
15
Reduced tax
rate
10
5
Cash-flow tax
0
8
7
6
5
4
3
2
Years of tax holiday left at time of investment
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1
0
Comparison of main incentives
30
EATR
(percent)
25
Cash flow-tax
20
Tax holiday
15
Reduced tax
rate
10
5
0
8
7
6
5
4
3
2
Years of tax holiday left at time of investment
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1
0
Revenue loss on existing capital
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Some incentives (esp. investment
allowances, tax holidays) apply only to
new capital, hence greatest impact for
money
But: this argument always holds. So tax
base continuously made more narrow.
End up with inefficient tax system.
Conclusions from theoretical
considerations
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Most popular incentives have important
drawbacks
Alternatives suggested by economists not
attractive enough for competitiveness
Case for incentives remains weak, but where
they are employed:
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Need to be effective (attractive to profitable, mobile
capital)
Costs and benefits need to be weighed, including
general equilibrium/indirect effects.
Best choices of tax incentives
Case for tax
incentives
Characteristic
Best choice of incentive
I Strong
a. Internationally
particularly mobile
activity
If perfectly competitive industry: investment allowances;
if firm-specific rents: permanently reduced tax rate
b. Positive externalities
Ideally subsidy/tax credit based on activity (e.g., R&D).
Otherwise as Ia.
a. Regional rents
Regional tax coordination. Failing that: Ia.
b. Unattractive location
Address weakness directly (improve governance,
infrastructure…). Failing that: Ia
May be best to wait. However, if eventual tax cuts
inevitable, possible benefit from being first mover.
II. Ambiguous
c. Tax cut could spark
reactions in other
jurisdictions
III. Weak
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a. Location-specific
rents
b. None of the above
Instead of incentive, additional neutral rent tax could be
charged.
Instead cut overall tax rate or remove other overall
disincentive to invest.
Empirical Evidence on Tax Incentives
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Motivation
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Little evidence in literature
Case studies
 Calculation of effective tax rates
 Econometric evidence:
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General tax competition
 Effect of taxes on investment
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But not on the role of tax incentives
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→
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Some specific incentives (R&D tax credits)
Need evidence on typical incentives
used by developing countries
New econometric evidence
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Set up a panel database of tax
incentives in developing countries
Investigate two questions:
1.
2.
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Do countries use tax incentives for tax
competition?
Are tax incentives effective in attracting
investment or boosting growth?
Data Source
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Price Waterhouse guides “Corporate
taxes, worldwide summaries”
Period: 1985-2004
49 Countries:
22 African
 19 Latin American
 8 Caribbean
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Do countries use tax incentives to
compete for investment?
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Specification
yit   (WNT y)it  X it   i   it
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Need spatial econometric techniques,
because of endogeneity of main variable
Specifically: use maximum likelihood
estimation on a spatial lag model
Reject alternative specification of spatial
error model
Results
Dependent Var y:
CIT rate
Wy (ρ)
Gov. consumption
Expenditure
0.277*** 0.363***
(0.096)
(0.100)
-1.429*
-0.554
(0.851)
(0.526)
-0.634*** 0.036
(0.104)
(0.064)
0.518
-0.716
(1.105)
(0.701)
0.346***
0.078
(0.080)
(0.053)
0.110
(0.116)
-0.002
(0.028)
0.027***
(0.003)
-0.070*
(0.037)
0.004
(0.003)
Observations
Likelihood
404
397
-1017.58 -820.131
404
350.6247
GDP per capita
Population
Openness
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Holiday
Inv. allow.
Robust standard errors in parentheses, *** p<0.01, ** p<0.05, * p<0.1.
Estimation method: Maximum likelihood on a spatial lag model.
Results interpretation:
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We find evidence of strategic
interaction on CIT and on tax holidays
Possible mechanisms:
Spillover model: mimicking behavior
because of yardstick competition
 Resource flow model: compete for mobile
tax base, i.e. capital/investment
 Aligned tax policies: (in)formal coordination
or common intellectual trends
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Are tax incentives effective in attracting investment
or boosting growth?
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Specification
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Dynamic panel data model:
Inv it  Inv i ,t 1  Tax it   X it    t   i   it
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Panel data bias (lagged dependent variable)
Use system GMM estimator
Also consider within-groups estimator, as data set relatively
long (very similar results)
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Results: system GMM
Dependent Variable
Lagged. Dep. Var.
CIT
Holiday
Inv. allowance
GDP
GDP per capita
Inflation
Openness
Gov. consumption
expenditure
Constant
FDI
Private
Investment
Growth
0.488***
(0.065)
-0.045***
(0.016)
0.102***
(0.034)
-0.380
(0.404)
-0.001
(0.001)
0.058
(0.086)
0.000***
(0.000)
0.215
(0.174)
0.020
(0.034)
2.583***
(0.754)
0.634***
(0.074)
0.014
(0.032)
0.083
(0.051)
-0.699
(0.456)
0.001
(0.002)
0.240
(0.211)
-0.000***
(0.000)
-0.004
(0.285)
-0.060
(0.047)
5.232***
(1.657)
0.244**
(0.095)
-0.064*
(0.032)
0.021
(0.038)
-0.292
(0.590)
-0.004***
(0.001)
-0.106
(0.078)
0.000
(0.000)
0.666***
(0.233)
0.022
(0.053)
0.244**
(1.229)
Observations
700
675
716
Number of countries
43
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Hansen J test
12.70
18.81
13.17
P-value
1.000
1.000
1.000
Robust standard errors in parentheses, *** p<0.01, ** p<0.05, * p<0.1.
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Results interpretation:
FDI
Pr. investment
Real growth
CIT rate
-
(-)
-
Holiday
+
0
0
Inv. allowance
0
0
0
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Why is FDI affected, but not investment and growth?
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Why are tax holidays effective, but not investment
allowances?
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FDI qualifies more for tax incentives than private fixed
investment
FDI consists of more mobile capital than total private investment
Financial investment more affected than real investment
Foreign investment crowding out domestic investment
=> investment spillovers apparently not important
Holiday more interesting for highly profitable investment
=> especially high profit investment is attracted
Conclusions from empirical evidence
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Strong evidence on strategic policy
interaction on CIT rate and holidays
Tax holidays and CIT cuts effective in
attracting FDI, but tax holidays do not boost
total investment or growth
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Explains reluctance to replace tax holidays by
investment allowances
Suggests resource flow model interpretation of
interaction: countries compete on tax instruments that
are effective in attracting FDI !
Conclusion from econometrics
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New empirical evidence confirms that
some tax incentives
are important tax competition tools
 do affect investment (but not growth)
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Can explain why
countries prefer some incentives over others
 keep using incentives.
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But…
cannot prove that benefits outweigh costs
 reasons to be skeptical remain
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Overall Conclusions
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Economists have been skeptical of
incentives
Reason for skepticism remains valid, but:
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Even if first-best of worldwide removal of
incentives is not achieved
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Forces that push countries into adopting incentives
are strong
Understandable that few countries replaced tax
holidays by accelerated depreciation / investment
allowances
Can at least change structure of incentives towards
types that are less harmful and to situations where
they are most likely to work
Thank you
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