Causes Benefits and Risks of Business Tax Incentives

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” An overview of tax incentives n Empirical evidence on tax incentives n 2

An Overview of Tax Incentives 3

Introduction n Tax incentives are controversial: Economists generally skeptical n But remain popular, especially in developing countries n Is there a need to reconsider/reinforce advice? n At least more research needed! n 4

Definition “Any measure that provides for a more favorable tax treatment of certain activities or sectors compared to what is available to general industry. ” n Alternative definitions exist, but not practicable n Implication: n n 5 Tax cuts / generally available depreciation schemes not considered tax incentives.

Typical incentives Tax holidays n Special zones n Investment tax credits / allowances n Accelerated depreciation n Reduced tax rates n Exemptions from various taxes n Financing incentives n … n 6

Reasons for tax incentives n n n Address externalities Regional development Political economy n n Doing something Fragmented policy making n Tax n n 7 … competition Incentives allow differentiation between more and less mobile capital

Tax competition n 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: n n n 8 Capital imperfectly mobile Tax system complicated (bases, rates, incentives) Economic rents – location- or company-specific

Economic rents n Location-specific, e. g. , natural resources. n n n Regional, e. g. , scenery. n n Regional cooperation, however, could allow taxation without capital leaving the regions. Firm-specific, e. g. , patents. n n 9 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 n Tax incentives permit countries to discriminate between more and less mobile capital n n Other reforms may also achieve this n 10 This may even be beneficial (Keen 2002, Janeba and Smart 2003) Base-broadening rate-cutting

Intermediate conclusions n Tax incentives appear rational response to tax competition Does not mean they are best response n Even incentives with domestic intent, can lead to tax competition n n 11 Need to consider details of the costs and benefits of tax the different incentives

Evaluation of tax incentives n Costs n Revenue forgone n Nil if only apply to new activity and no crowding out n Full, if no new net activity Administrative/compliance costs n Rent-seeking behavior/corruption n Distortions (unless desired) n → Very hard to assess 12

Evaluation of tax incentives n Benefits Additional investment/growth (but what is counterfactual? ) n Better quality of investment n Externalities reduced n → Even harder to assess 13

Cost-benefit analysis n 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 n But other investment possibly crowded out n n As usual (infrastructure limits, labor market, etc. ) n Additionally: Because of higher taxes needed on other industry n 14 Cannot always be calculated, but needs to be mentioned

Principles for choosing tax incentives n General principles for good tax policy n Transparency / simplicity n Include n in tax laws Predictability n Rules rather than discretion Enforceability / robustness to evasion n Economic efficiency? n Equity? n 15

Tax holidays Very popular n Particularly harmful n Most attractive to short-term, footloose, rapidly profitable investment n Unknown cost n Encourage rent-seeking behavior (renewals) n n 16 Possible, but difficult, to make theoretical case

Investment allowances n n n Same effect as investment tax credits (algebra) Directly contingent on investment Distort choice of capital goods n n 17 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 Similar impact as allowances/tax credits n But more limited: n n Timing advantage only n Time-value of money n Help for cash-constrained, but profitable business 18

Reduced tax rates If limited in time, similar to tax holiday n If applied to well-defined sectors, can play a useful role n n 19 Attract profitable investment

Special zones Characteristics differ, hard to make general assessment n Some reduce compliance cost only, e. g. , zones for international trading companies n Some provide tax exemption. Revenue cost can be enormous (profit shifting) n n 20 Especially if zones not geographically concentrated

Financing incentives n E. g. , reduced withholding tax rates on dividends. No impact if: Investor located in residence-based country and repatriates all profits n Investor able to avoid withholding tax anyway n Marginal source of finance retained earnings or debt n 21

Comparison of main incentives 22

Comparison of main incentives 23

Revenue loss on existing capital Some incentives (esp. investment allowances, tax holidays) apply only to new capital, hence greatest impact for money n But: this argument always holds. So tax base continuously made more narrow. End up with inefficient tax system. n 24

Conclusions from theoretical considerations n n n 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: n n 25 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 26

Empirical Evidence on Tax Incentives 27

Motivation n Little evidence in literature Case studies n Calculation of effective tax rates n Econometric evidence: n n General tax competition n Effect of taxes on investment But not on the role of tax incentives n Some → 28 specific incentives (R&D tax credits) Need evidence on typical incentives used by developing countries

New econometric evidence n n Set up a panel database of tax incentives in developing countries Investigate two questions: 1. 29 Do countries use tax incentives for tax competition? Are tax incentives effective in attracting investment or boosting growth?

Data Source Price Waterhouse guides “Corporate taxes, worldwide summaries” n Period: 1985 -2004 n 49 Countries: n 22 African n 19 Latin American n 8 Caribbean n 30

Do countries use tax incentives to compete for investment? 31

Specification n 32 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 33

Results interpretation: We find evidence of strategic interaction on CIT and on tax holidays n Possible mechanisms: n Spillover model: mimicking behavior because of yardstick competition n Resource flow model: compete for mobile tax base, i. e. capital/investment n Aligned tax policies: (in)formal coordination or common intellectual trends n 34

Are tax incentives effective in attracting investment or boosting growth? 35

Specification n Dynamic panel data model: n Panel data bias (lagged dependent variable) Use system GMM estimator Also consider within-groups estimator, as data set relatively long (very similar results) 36

Results: system GMM 37

Results interpretation: FDI Pr. investment Real growth CIT rate - (-) - Holiday + 0 0 Inv. allowance 0 0 0 n Why is FDI affected, but not investment and growth? n n n Why are tax holidays effective, but not investment allowances? n 38 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 n n 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 n n 39 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 n New empirical evidence confirms that some tax incentives are important tax competition tools n do affect investment (but not growth) n n Can explain why countries prefer some incentives over others n keep using incentives. n n But… cannot prove that benefits outweigh costs n reasons to be skeptical remain n 40

Overall Conclusions n n Economists have been skeptical of incentives Reason for skepticism remains valid, but: n n n Even if first-best of worldwide removal of incentives is not achieved n 41 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 42