Causes, Benefits, and Risks of Business Tax Incentives

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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

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Todays presentation
Views are my own and do not necessarily
represent those of the IMF

• An overview of tax incentives
• Empirical evidence on tax incentives

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An Overview of Tax Incentives
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Introduction

• 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

• 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
• Tax cuts / generally available depreciation
  schemes not considered tax incentives.

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Typical incentives

• Tax holidays
• Special zones
• Investment tax credits / allowances
• Accelerated depreciation
• Reduced tax rates
• Exemptions from various taxes
• Financing incentives

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Reasons for tax incentives

• Address externalities
• Regional development
• Political economy
• Doing something
• Fragmented policy making
• Tax competition
• Incentives allow differentiation between more and
  less mobile capital

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Tax competition

• 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
• Capital imperfectly mobile
• Tax system complicated (bases, rates, incentives)
• Economic rents location- or company-specific

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Economic rents

• Location-specific, e.g., natural resources.
• 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.
• Regional, e.g., scenery.
• Regional cooperation, however, could allow
  taxation without capital leaving the regions.
• Firm-specific, e.g., patents.
• 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.

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Complexity of tax system

• Tax incentives permit countries to discriminate
  between more and less mobile capital
• This may even be beneficial (Keen 2002, Janeba
  and Smart 2003)
• Other reforms may also achieve this
• Base-broadening rate-cutting

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Intermediate conclusions

• 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
• Need to consider details of the costs and
  benefits of tax the different incentives

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Evaluation of tax incentives

• Costs
• Revenue forgone
• Nil if only apply to new activity and no crowding
  out
• Full, if no new net activity
• Administrative/compliance costs
• Rent-seeking behavior/corruption
• Distortions (unless desired)
• ? Very hard to assess

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Evaluation of tax incentives

• Benefits
• Additional investment/growth (but what is
  counterfactual?)
• Better quality of investment
• Externalities reduced
• ? Even harder to assess

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Cost-benefit analysis

• 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
• As usual (infrastructure limits, labor market,
  etc.)
• Additionally Because of higher taxes needed on
  other industry
• Cannot always be calculated, but needs to be
  mentioned

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Principles for choosing tax incentives

• General principles for good tax policy
• Transparency / simplicity
• Include in tax laws
• Predictability
• Rules rather than discretion
• Enforceability / robustness to evasion
• Economic efficiency?
• Equity?

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Tax holidays

• Very popular
• Particularly harmful
• Most attractive to short-term, footloose, rapidly
  profitable investment
• Unknown cost
• Encourage rent-seeking behavior (renewals)
• Possible, but difficult, to make theoretical case

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Investment allowances

• Same effect as investment tax credits (algebra)
• Directly contingent on investment
• Distort choice of capital goods
• 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

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Accelerated depreciation

• Similar impact as allowances/tax credits
• But more limited
• Timing advantage only
• Time-value of money
• Help for cash-constrained, but profitable business

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Reduced tax rates

• If limited in time, similar to tax holiday
• If applied to well-defined sectors, can play a
  useful role
• Attract profitable investment

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Special zones

• 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)
• Especially if zones not geographically
  concentrated

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Financing incentives

• 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
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Comparison of main incentives
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Revenue loss on existing capital

• 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.

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Conclusions from theoretical considerations

• 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
• Need to be effective (attractive to profitable,
  mobile capital)
• Costs and benefits need to be weighed, including
  general equilibrium/indirect effects.

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Best choices of tax incentives
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Empirical Evidence on Tax Incentives
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Motivation

• Little evidence in literature
• Case studies
• Calculation of effective tax rates
• Econometric evidence
• General tax competition
• Effect of taxes on investment
• But not on the role of tax incentives
• Some specific incentives (RD tax credits)
• Need evidence on typical incentives used by
  developing countries

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New econometric evidence

• Set up a panel database of tax incentives in
  developing countries
• Investigate two questions
• Do countries use tax incentives for tax
  competition?
• Are tax incentives effective in attracting
  investment or boosting growth?

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Data Source

• 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

• 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

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Results
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Results interpretation

• 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

• Dynamic panel data model
• 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
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Results interpretation
FDI Pr. investment Real growth
CIT rate - (-) -
Holiday 0 0
Inv. allowance 0 0 0

• Why is FDI affected, but not investment and
  growth?
• 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
• gt investment spillovers apparently not
  important
• Why are tax holidays effective, but not
  investment allowances?
• Holiday more interesting for highly profitable
  investment
• gt especially high profit investment is attracted

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Conclusions from empirical evidence

• 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
• 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 !

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Conclusion from econometrics

• New empirical evidence confirms that some tax
  incentives
• are important tax competition tools
• do affect investment (but not growth)
• Can explain why
• countries prefer some incentives over others
• keep using incentives.
• But
• cannot prove that benefits outweigh costs
• reasons to be skeptical remain

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Overall Conclusions

• Economists have been skeptical of incentives
• Reason for skepticism remains valid, but
• Forces that push countries into adopting
  incentives are strong
• Understandable that few countries replaced tax
  holidays by accelerated depreciation / investment
  allowances
• Even if first-best of worldwide removal of
  incentives is not achieved
• Can at least change structure of incentives
  towards types that are less harmful and to
  situations where they are most likely to work

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Thank you