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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. Today’s presentation. An overview of tax incentives Empirical evidence on 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
Today’s presentation • An overview of tax incentives • Empirical evidence on tax incentives “Views are my own and do not necessarily represent those of the IMF”
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!
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.
Typical incentives • Tax holidays • Special zones • Investment tax credits / allowances • Accelerated depreciation • Reduced tax rates • Exemptions from various taxes • Financing incentives • …
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 • …
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
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.
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
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
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
Evaluation of tax incentives • Benefits • Additional investment/growth (but what is counterfactual?) • Better quality of investment • Externalities reduced → Even harder to assess
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
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?
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
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
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
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
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
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
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.
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.
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 (R&D tax credits) • Need evidence on typical incentives used by developing countries
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?
Data Source • Price Waterhouse guides “Corporate taxes, worldwide summaries” • Period: 1985-2004 • 49 Countries: • 22 African • 19 Latin American • 8 Caribbean
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
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
Are tax incentives effective in attracting investment or boosting growth?
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)
Results interpretation: • 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 => investment spillovers apparently not important • Why are tax holidays effective, but not investment allowances? • Holiday more interesting for highly profitable investment => especially high profit investment is attracted
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 !
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
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