Causes, Benefits, and Risks of Causes, Benefits, and Risks of Business Tax IncentivesBusiness Tax Incentives

IMF Tax Policy Seminar for Asian and IMF Tax Policy Seminar for Asian and Pacific Countries on Tax IncentivesPacific Countries on Tax Incentives

Tokyo, June 9-11, 2009 Financed by JSA Tokyo, June 9-11, 2009 Financed by JSA

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Today’s presentationToday’s presentation

An overview of tax incentivesAn overview of tax incentives Empirical evidence on tax incentivesEmpirical evidence on tax incentives

“Views are my own and do not necessarily represent those of the IMF”

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An Overview of Tax IncentivesAn Overview of Tax Incentives

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IntroductionIntroduction

Tax incentives are controversial: Tax incentives are controversial: Economists generally skepticalEconomists generally skeptical But remain popular, especially in developing But remain popular, especially in developing

countriescountries Is there a need to reconsider/reinforce Is there a need to reconsider/reinforce

advice?advice? At least more research needed!At least more research needed!

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DefinitionDefinition

““Any measure that provides for a more Any measure that provides for a more favorable tax treatment of certain favorable tax treatment of certain activities or sectors compared to what activities or sectors compared to what is available to general industry.”is available to general industry.”

Alternative definitions exist, but not Alternative definitions exist, but not practicablepracticable

Implication:Implication: Tax cuts / generally available depreciation Tax cuts / generally available depreciation

schemes not considered tax incentives.schemes not considered tax incentives.

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Typical incentivesTypical incentives

Tax holidaysTax holidays Special zonesSpecial zones Investment tax credits / allowancesInvestment tax credits / allowances Accelerated depreciationAccelerated depreciation Reduced tax ratesReduced tax rates Exemptions from various taxesExemptions from various taxes Financing incentivesFinancing incentives ……

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Reasons for tax incentivesReasons for tax incentives

Address externalitiesAddress externalities Regional developmentRegional development Political economyPolitical economy

Doing somethingDoing something Fragmented policy making Fragmented policy making

Tax competitionTax competition Incentives allow differentiation between more and less Incentives allow differentiation between more and less

mobile capitalmobile capital ……

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Tax competitionTax competition

Countries attempt to attract capital or taxable Countries attempt to attract capital or taxable profits, by reducing taxes on capitalprofits, by reducing taxes on capital

Theoretical result: small open economies Theoretical result: small open economies should not levy source-based capital income should not levy source-based capital income taxestaxes

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

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Economic rentsEconomic rents Location-specific, e.g., natural resources. Location-specific, e.g., natural resources.

Such rents can be taxed and there should be no interaction with Such rents can be taxed and there should be no interaction with other governments. other governments.

a positive rent (present discounted value (PDV) net of tax) a positive rent (present discounted value (PDV) net of tax) should be enough for an investment to be worthwhile.should be enough for an investment to be worthwhile.

Regional, e.g., scenery. Regional, e.g., scenery. Regional cooperation, however, could allow taxation without Regional cooperation, however, could allow taxation without

capital leaving the regions. capital leaving the regions. Firm-specific, e.g., patents. Firm-specific, e.g., patents.

Such rents are subject to full tax competition.Such rents are subject to full tax competition. Even if a project's PDV for a discrete investment project remains Even if a project's PDV for a discrete investment project remains

positive after taxation, investment will not take place, if after-tax positive after taxation, investment will not take place, if after-tax PDV higher in another country.PDV higher in another country.

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Complexity of tax systemComplexity of tax system

Tax incentives permit countries to Tax incentives permit countries to discriminate between more and less discriminate between more and less mobile capitalmobile capital This may even be beneficial (Keen 2002, This may even be beneficial (Keen 2002,

Janeba and Smart 2003)Janeba and Smart 2003) Other reforms may also achieve thisOther reforms may also achieve this

Base-broadening rate-cutting Base-broadening rate-cutting

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Intermediate conclusionsIntermediate conclusions

Tax incentives appear rational Tax incentives appear rational response to tax competitionresponse to tax competition Does not mean they are best responseDoes not mean they are best response Even incentives with domestic intent, can lead Even incentives with domestic intent, can lead

to tax competitionto tax competition Need to consider details of the costs Need to consider details of the costs

and benefits of tax the different and benefits of tax the different incentivesincentives

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Evaluation of tax incentivesEvaluation of tax incentives

CostsCosts Revenue forgoneRevenue forgone

Nil if only apply to new activity and no crowding outNil if only apply to new activity and no crowding out Full, if no new net activityFull, if no new net activity

Administrative/compliance costsAdministrative/compliance costs Rent-seeking behavior/corruptionRent-seeking behavior/corruption Distortions (unless desired)Distortions (unless desired)

→ → Very hard to assessVery hard to assess

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Evaluation of tax incentivesEvaluation of tax incentives

BenefitsBenefits Additional investment/growth (but what is Additional investment/growth (but what is

counterfactual?)counterfactual?) Better quality of investmentBetter quality of investment Externalities reducedExternalities reduced

→ → Even harder to assessEven harder to assess

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Cost-benefit analysisCost-benefit analysis

Partial equilibrium approach can be Partial equilibrium approach can be very misleading:very misleading: A study of an incentive reveals that x new A study of an incentive reveals that x new

plants were set up, which would not have plants were set up, which would not have occurred otherwiseoccurred otherwise

But other investment possibly crowded outBut other investment possibly crowded out As usual (infrastructure limits, labor market, etc.)As usual (infrastructure limits, labor market, etc.) Additionally: Because of higher taxes needed on Additionally: Because of higher taxes needed on

other industryother industry Cannot always be calculated, but needs to be Cannot always be calculated, but needs to be

mentionedmentioned

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Principles for choosing tax incentivesPrinciples for choosing tax incentives

General principles for good tax policyGeneral principles for good tax policy Transparency / simplicityTransparency / simplicity

Include in tax lawsInclude in tax laws PredictabilityPredictability

Rules rather than discretionRules rather than discretion Enforceability / robustness to evasionEnforceability / robustness to evasion Economic efficiency?Economic efficiency? Equity?Equity?

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Tax holidaysTax holidays

Very popularVery popular Particularly harmfulParticularly harmful

Most attractive to short-term, footloose, Most attractive to short-term, footloose, rapidly profitable investmentrapidly profitable investment

Unknown costUnknown cost Encourage rent-seeking behavior (renewals)Encourage rent-seeking behavior (renewals)

Possible, but difficult, to make Possible, but difficult, to make theoretical casetheoretical case

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Investment allowancesInvestment allowances

Same effect as investment tax credits Same effect as investment tax credits (algebra)(algebra)

Directly contingent on investmentDirectly contingent on investment Distort choice of capital goodsDistort choice of capital goods

Short rather than long-lived capitalShort rather than long-lived capital Physical rather than financial or intangible capitalPhysical rather than financial or intangible capital

Useful only to profitable businesses (unless Useful only to profitable businesses (unless refundable)…refundable)…

… … but not very valuable to most profitable but not very valuable to most profitable onesones

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Accelerated depreciationAccelerated depreciation

Similar impact as allowances/tax Similar impact as allowances/tax creditscredits

But more limited:But more limited: Timing advantage onlyTiming advantage only

Time-value of moneyTime-value of money Help for cash-constrained, but profitable businessHelp for cash-constrained, but profitable business

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Reduced tax ratesReduced tax rates

If limited in time, similar to tax holidayIf limited in time, similar to tax holiday If applied to well-defined sectors, can If applied to well-defined sectors, can

play a useful roleplay a useful role Attract profitable investmentAttract profitable investment

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Special zonesSpecial zones

Characteristics differ, hard to make Characteristics differ, hard to make general assessmentgeneral assessment

Some reduce compliance cost only, Some reduce compliance cost only, e.g., zones for international trading e.g., zones for international trading companiescompanies

Some provide tax exemption. Revenue Some provide tax exemption. Revenue cost can be enormous (profit shifting)cost can be enormous (profit shifting) Especially if zones not geographically Especially if zones not geographically

concentratedconcentrated

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Financing incentivesFinancing incentives

E.g., reduced withholding tax rates on E.g., reduced withholding tax rates on dividends. No impact if:dividends. No impact if: Investor located in residence-based country Investor located in residence-based country

and repatriates all profitsand repatriates all profits Investor able to avoid withholding tax anywayInvestor able to avoid withholding tax anyway Marginal source of finance retained earnings Marginal source of finance retained earnings

or debtor debt

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Comparison of main incentivesComparison of main incentives

EMTR(percent)

Tax holiday

Cash-flow tax

Reduced tax rate

0

5

10

15

20

25

30

8 7 6 5 4 3 2 1 0

Years of tax holiday left at time of investment

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Comparison of main incentivesComparison of main incentivesEATR(percent)

Tax holiday

Cash flow-tax

Reduced tax rate

0

5

10

15

20

25

30

8 7 6 5 4 3 2 1 0

Years of tax holiday left at time of investment

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Revenue loss on existing capitalRevenue loss on existing capital

Some incentives (esp. investment Some incentives (esp. investment allowances, tax holidays) apply only to allowances, tax holidays) apply only to new capital, hence greatest impact for new capital, hence greatest impact for moneymoney

But: this argument always holds. So tax But: this argument always holds. So tax base continuously made more narrow. base continuously made more narrow. End up with inefficient tax system.End up with inefficient tax system.

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Conclusions from theoretical Conclusions from theoretical considerationsconsiderations Most popular incentives have important Most popular incentives have important

drawbacksdrawbacks Alternatives suggested by economists not Alternatives suggested by economists not

attractive enough for competitivenessattractive enough for competitiveness Case for incentives remains weak, but where Case for incentives remains weak, but where

they are employed:they are employed: Need to be effective (attractive to profitable, mobile Need to be effective (attractive to profitable, mobile

capital)capital) Costs and benefits need to be weighed, including Costs and benefits need to be weighed, including

general equilibrium/indirect effects.general equilibrium/indirect effects.

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Best choices of tax incentivesBest choices of tax incentives Case for tax incentives

Characteristic Best choice of incentive

a. Internationally particularly mobile activity

If perfectly competitive industry: investment allowances; if firm-specific rents: permanently reduced tax rate

I Strong

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

II. Ambiguous

c. Tax cut could spark reactions in other jurisdictions

May be best to wait. However, if eventual tax cuts inevitable, possible benefit from being first mover.

a. Location-specific rents

Instead of incentive, additional neutral rent tax could be charged.

III. Weak

b. None of the above Instead cut overall tax rate or remove other overall disincentive to invest.

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Empirical Evidence on Tax IncentivesEmpirical Evidence on Tax Incentives

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MotivationMotivation

Little evidence in literatureLittle evidence in literature Case studiesCase studies Calculation of effective tax ratesCalculation of effective tax rates Econometric evidence:Econometric evidence:

General tax competitionGeneral tax competition Effect of taxes on investmentEffect of taxes on investment

But not on the role of tax incentivesBut not on the role of tax incentives Some specific incentives (R&D tax credits)Some specific incentives (R&D tax credits)

→ Need evidence on typical incentives Need evidence on typical incentives used by developing countriesused by developing countries

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New econometric evidenceNew econometric evidence

Set up a Set up a panel databasepanel database of tax of tax incentives in developing countriesincentives in developing countries

Investigate two questions:Investigate two questions:1.1. Do countries use tax incentives for tax Do countries use tax incentives for tax

competition?competition?

2.2. Are tax incentives Are tax incentives effectiveeffective in attracting in attracting investment or boosting growth?investment or boosting growth?

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Data SourceData Source

Price Waterhouse guides “Corporate Price Waterhouse guides “Corporate taxes, worldwide summaries”taxes, worldwide summaries”

Period: 1985-2004Period: 1985-2004 49 Countries: 49 Countries:

22 African22 African 19 Latin American19 Latin American 8 Caribbean8 Caribbean

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Do countries use tax incentives to Do countries use tax incentives to competecompete for investment? for investment?

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SpecificationSpecification

Need spatial econometric techniques, Need spatial econometric techniques, because of endogeneity of main variable because of endogeneity of main variable

Specifically: use maximum likelihood Specifically: use maximum likelihood estimation on a spatial lag modelestimation on a spatial lag model

Reject alternative specification of spatial Reject alternative specification of spatial error modelerror model

itiititNTit XyWy )(

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ResultsResultsDependent Var y: CIT rate Holiday Inv. allow.

Wy (ρ) 0.277*** 0.363*** 0.110(0.096) (0.100) (0.116)

GDP per capita -1.429* -0.554 -0.002(0.851) (0.526) (0.028)

Population -0.634*** 0.036 0.027***(0.104) (0.064) (0.003)

Openness 0.518 -0.716 -0.070*(1.105) (0.701) (0.037)0.346*** 0.078 0.004(0.080) (0.053) (0.003)

Observations 404 397 404Likelihood -1017.58 -820.131 350.6247

Robust standard errors in parentheses, *** p<0.01, ** p<0.05, * p<0.1.Estimation method: Maximum likelihood on a spatial lag model.

Gov. consumption Expenditure

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Results interpretation:Results interpretation:

We find evidence of strategic We find evidence of strategic interaction on CIT and on tax holidaysinteraction on CIT and on tax holidays

Possible mechanisms:Possible mechanisms: Spillover modelSpillover model: mimicking behavior : mimicking behavior

because of yardstick competitionbecause of yardstick competition Resource flow modelResource flow model: compete for mobile : compete for mobile

tax base, i.e. capital/investmenttax base, i.e. capital/investment Aligned tax policies:Aligned tax policies: (in)formal coordination (in)formal coordination

or common intellectual trendsor common intellectual trends

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Are tax incentives Are tax incentives effectiveeffective in attracting in attracting investment or boosting growth?investment or boosting growth?

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SpecificationSpecification

Dynamic panel data model:Dynamic panel data model:

Panel data bias (lagged dependent variable)Panel data bias (lagged dependent variable)Use system GMM estimatorUse system GMM estimator

Also consider within-groups estimator, as data set Also consider within-groups estimator, as data set relatively long (very similar results)relatively long (very similar results)

itititittiit XTaxInvInv 1,

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Results: system GMMResults: system GMMDependent Variable FDI

Private Investment Growth

Lagged. Dep. Var. 0.488*** 0.634*** 0.244**(0.065) (0.074) (0.095)

CIT -0.045*** 0.014 -0.064*(0.016) (0.032) (0.032)

Holiday 0.102*** 0.083 0.021(0.034) (0.051) (0.038)

Inv. allowance -0.380 -0.699 -0.292(0.404) (0.456) (0.590)

GDP -0.001 0.001 -0.004***(0.001) (0.002) (0.001)

GDP per capita 0.058 0.240 -0.106(0.086) (0.211) (0.078)

Inflation 0.000*** -0.000*** 0.000(0.000) (0.000) (0.000)

Openness 0.215 -0.004 0.666***(0.174) (0.285) (0.233)0.020 -0.060 0.022

(0.034) (0.047) (0.053)Constant 2.583*** 5.232*** 0.244**

(0.754) (1.657) (1.229)

Observations 700 675 716Number of countries 43 42 44Hansen J test 12.70 18.81 13.17P-value 1.000 1.000 1.000Robust standard errors in parentheses, *** p<0.01, ** p<0.05, * p<0.1.

Gov. consumption expenditure

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Results interpretation:Results interpretation:FDIFDI Pr. investmentPr. investment Real growthReal growth

CIT rateCIT rate -- (-)(-) --

HolidayHoliday ++ 00 00

Inv. allowanceInv. allowance 00 00 00

Why is FDI affected, but not investment and growth?Why is FDI affected, but not investment and growth? FDI FDI qualifiesqualifies more for tax incentives than private fixed more for tax incentives than private fixed

investmentinvestment FDI consists of more FDI consists of more mobilemobile capital than total private investment capital than total private investment FinancialFinancial investment more affected than investment more affected than realreal investment investment ForeignForeign investment crowding out investment crowding out domesticdomestic investment investment

=> investment spillovers apparently not important=> investment spillovers apparently not important Why are tax holidays effective, but not investment Why are tax holidays effective, but not investment

allowances?allowances? Holiday more interesting for Holiday more interesting for highly profitablehighly profitable investment investment

=> especially high profit investment is attracted=> especially high profit investment is attracted

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Conclusions from empirical evidenceConclusions from empirical evidence

Strong evidence on strategic policy Strong evidence on strategic policy interaction on CIT rate and holidaysinteraction on CIT rate and holidays

Tax holidays and CIT cuts effective in Tax holidays and CIT cuts effective in attracting FDI, but tax holidays do not boost attracting FDI, but tax holidays do not boost total investment or growthtotal investment or growth Explains reluctance to replace tax holidays by Explains reluctance to replace tax holidays by

investment allowancesinvestment allowances Suggests Suggests resource flow modelresource flow model interpretation of interpretation of

interaction: countries compete on tax instruments that interaction: countries compete on tax instruments that are effective in attracting FDI !are effective in attracting FDI !

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Conclusion from econometricsConclusion from econometrics

New empirical evidence confirms that New empirical evidence confirms that some tax incentivessome tax incentives are important tax competition toolsare important tax competition tools do affect investment (but not growth)do affect investment (but not growth)

Can explain whyCan explain why countries prefer some incentives over others countries prefer some incentives over others keep using incentives.keep using incentives.

But…But… cannot prove that benefits outweigh costs cannot prove that benefits outweigh costs reasons to be skeptical remainreasons to be skeptical remain

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Overall ConclusionsOverall Conclusions Economists have been skeptical of Economists have been skeptical of

incentivesincentives Reason for skepticism remains valid, but:Reason for skepticism remains valid, but:

Forces that push countries into adopting incentives Forces that push countries into adopting incentives are strongare strong

Understandable that few countries replaced tax Understandable that few countries replaced tax holidays by accelerated depreciation / investment holidays by accelerated depreciation / investment allowancesallowances

Even if first-best of worldwide removal of Even if first-best of worldwide removal of incentives is not achievedincentives is not achieved Can at least change structure of incentives towards Can at least change structure of incentives towards

types that are less harmful and to situations where types that are less harmful and to situations where they are most likely to workthey are most likely to work

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Thank youThank you