Tax Incentives under Scrutiny

Tax Incentives under Scrutiny

Mon 13 Jul 2015

On 9 July 2015, the OECD released a discussion draft on options for low income countries’ effective and efficient use of tax incentives for investment.

This Discussion Draft is a result of the G20’s Development Working Group (DWG) who has invited four International Organisations i.e. International Monetary Fund (IMF), Organization for Economic Co-operation and Development (OECD), the World Bank and the United Nations (UN), to write a report on options for low income countries’ effective and efficient use of tax incentives for investment.

The underlying concern of the DWG is that low income countries (LIC) often face acute pressures to attract investment by offering tax incentives, which then erode the countries’ tax bases with little demonstrable benefit in terms of increased investment. The International Organisations are asked to use their shared expertise—based on many years of country interactions and analysis—to assist low income countries in making better use of tax incentives.

In order for us to look at the discussion draft in more detail, it is important to point out that ‘tax incentives’ mean special tax provisions granted to qualified investment projects or firms providing favorable deviation from the general tax code. They can take several forms, such as tax holidays (complete exemption from tax for a limited duration), preferential tax rates in certain regions, sectors or asset types, or targeted allowances for certain investment expenditures.

  1. Experience shows that there is ample room for more effective and efficient use of investment tax incentives in low-income countries
  2. Effective and efficient use of tax incentives requires that they be carefully designed
  3. Good governance of incentives is critical for their effectiveness and efficiency
  4. Regional coordination can help mitigate spillovers from tax competition
  5. More systematic evaluations are needed to facilitate informed decision-making.

Drawing on recent country experiences and an extensive range of academic and other studies, the report aims to take a fresh look at tax incentive policies in low income countries. The aim is to develop principles for the design and governance of tax incentives and to provide guidance on good practices in these areas. Since much of the pressure to offer incentives stems from an awareness of those offered by other countries, the report also discusses options for international coordination to address the risk of mutually damaging spillovers from such tax competition. Finally, a separate background document reviews practical tools and models that can help assess the costs and benefits of tax incentives, which is essential to enhance transparency and support informed decision making. The ultimate goal is thus to assist low-income countries (LICs) in reforming their tax incentives, so as to better align them with their developmental objectives.

Introduction and Warming-up

A good revenue system adopts taxes that are simple, fair and efficient. Tax incentives risk compromising these principles to the extent that they complicate the tax system, create horizontal inequities, and distort production efficiency; and they may forgo revenue that could have been spent more productively or needs to be replaced in other and more damaging ways. At the same time, tax policy may be able to play a purposive role in improving on market outcomes that are inefficient or unfair. The economic rationale for tax incentives must thus be evaluated in terms of their ability to achieve clear goals in ways that are both effective and efficient, relative to other policies, both tax and non-tax. 

This report draws on the ample experiences and insights that IOs have gained from interactions with countries. IOs and many other observershave often found tax incentives to be ineffective, inefficient and associated with abuse and corruption. As a result, they have frequently advised countries to remove them or to improve their design, transparency and administration. Yet, this advice has had limited effect and many governments continue to choose tax incentives that many observers regard as poorly-designed over other types of government action to achieve their goals. Reluctance to reform may reflect vested interests, political inertia, and tax competition with other countries. It might also be that observers have underestimated the benefits incentives have generated. Drawing on recent insights from interactions with countries and an extensive range of academic and other studies, this paper aims to take a fresh look at incentive policies in LICs in order to develop practical advice for improvement, supported by simple tools for making progress.

The analysis in this paper is necessarily selective. In particular, focus is on:

  • Tax incentives, as defined above- thus ignoring non-tax incentives, such as grants, in-kind benefits or loan guarantees: such other measures can in principle mimic the effects of tax incentives, but are usually designed differently and subject to different governance procedures.
  •  …for investment—excluding tax incentives aimed at other objectives, such as to charitable giving, owner occupation or pollution reduction. The focus, moreover, is on incentives in the tax treatment of business income; governments may also seek to attract investment by special treatment in relation to VAT or tariffs, for instance, but these are touched on only briefly—both for reasons of space and because income taxation and the associated policy concerns have been more prominent in the debate on tax incentives.
  •  ..that are implemented at the national level—those implemented at the sub-national level raise other, broader fiscal federalism issues, which go beyond the scope of this paper.

This paper relates to other global initiatives, aimed at strengthening domestic revenue mobilization in LICs. For instance, there are several initiatives to strengthen tax design and improve capacity in tax administration in LICs to enhance their ability to mobilize domestic resources, including through long-standing technical assistance by the IOs. Moreover, the G20/OECD work on base erosion and profit shifting (BEPS) aims to support the implementation of BEPS outcomes to LICs, as suited to their circumstances, by providing toolkits. During consultations with developing countries on BEPS, a common concern expressed by LICs was the extent to which tax incentives erode their tax bases. This, however, reflects an important dilemma, which was also emphasized earlier by the IOs in their joint report for the DWG in 2011, stating that:The underlying report explores this dilemma in greater detail.

Why Is It Important?

Tax incentives:

  • have been used to achieve a variety of objectives. The primary motivation is usually to stimulate investment and—especially in LICs—attract foreign direct investment.
  • are commonplace around the world.  Countries differ with respect to the type of incentives used, with high-income countries relying more on investment tax credits and favorable tax treatment of research and development (R&D), low-income countries relatively more often offering tax holidays and reduced tax rates, and middle-income countries most often having preferential tax zones (in which income can be tax exempt and other favorable treatments may apply).
  • have become more widespread in LICs.
  • serve a useful social purpose if the social benefits it generates exceed any associated social costs.

Did you know?

China is often quoted as an example of (tax) incentive policies that have been effective. During its transition period between the mid 1980s and mid 2000s, it experimented with a wide range of industrial policy instruments, including tax incentives for special economic zones, reduced tax rates for FDI, and tax holidays for strategic industries. FDI inflows accelerated during this period and the country became a top destination for many multinationals. Evidence suggests, for instance, that the number of special economic zones (which also enjoy various non-tax benefits) in Chinese regions systematically increased FDI inflows (Cheng and Kwan, 2000).

Evidence for 40 Latin American, Caribbean and African countries between 1985 and 2004 suggests that the length of tax holidays systematically increased FDI inflows. At the same time, these FDI inflows did not increase total investment, nor did they increase economic growth. This suggests full displacement of domestic by foreign capital (Klemm and Van Parys, 2012).

In 2000, the government of India removed incentives for exporters, except those located in export processing zones or qualified as export-oriented units. Investment behavior hardly changed due to this reform. Indeed, firms that lost their incentives maintained the same level of investment as before, despite higher tax rates, similar to the control group that kept their incentives. However, reported profits did respond aggressively to the loss of incentives. In particular, reported pre-tax profits dropped by half on average in firms that lost their incentives, despite little change in sales. In contrast, pre-tax profits in firms that kept their incentives showed an increase. Hence, companies seem to have diverted profits from affiliates facing higher taxes to those exempt from tax due to the incentives (James, 2007).

Next Step

Comments and feedback have been invited on the draft Options Paper by 5 August. The OECD team will review all submitted comments and share them with the other International Organisations collaborating. The final paper will be submitted to the G20 for its Leader Summit in November 2015 and made public through posting on the websites of the International Organisations involved. The report will then be used as a reference point and as guidance in supporting developing countries on effective and efficient use of tax incentives for investment.

Source: OECD website

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