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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.

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Presentation on theme: "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."— Presentation transcript:

1 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

2 2 Today’s presentation An overview of tax incentives An overview of tax incentives Empirical evidence on tax incentives Empirical evidence on tax incentives “Views are my own and do not necessarily represent those of the IMF”

3 3 An Overview of Tax Incentives

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

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

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

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

8 8 Tax competition Countries attempt to attract capital or taxable profits, by reducing taxes on capital 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 Theoretical result: small open economies should not levy source-based capital income taxes But: But: Capital imperfectly mobile Capital 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

9 9 Economic 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 other governments. 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. a positive rent (present discounted value (PDV) net of tax) should be enough for an investment to be worthwhile. Regional, e.g., scenery. Regional, e.g., scenery. Regional cooperation, however, could allow taxation without capital leaving the regions. Regional cooperation, however, could allow taxation without 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 positive after taxation, investment will not take place, if after-tax PDV higher in another country. 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.

10 10 Complexity of tax system Tax incentives permit countries to discriminate between more and less mobile capital Tax incentives permit countries to discriminate between more and less mobile capital This may even be beneficial (Keen 2002, Janeba and Smart 2003) This may even be beneficial (Keen 2002, Janeba and Smart 2003) Other reforms may also achieve this Other reforms may also achieve this Base-broadening rate-cutting Base-broadening rate-cutting

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

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

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

14 14 Cost-benefit analysis Partial equilibrium approach can be very misleading: 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 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 But 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 other industry Additionally: Because of higher taxes needed on other industry Cannot always be calculated, but needs to be mentioned Cannot always be calculated, but needs to be mentioned

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

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

17 17 Investment allowances Same effect as investment tax credits (algebra) Same effect as investment tax credits (algebra) Directly contingent on investment Directly contingent on investment Distort choice of capital goods Distort choice of capital goods Short rather than long-lived capital Short rather than long-lived capital Physical rather than financial or intangible capital Physical rather than financial or intangible capital Useful only to profitable businesses (unless refundable)… Useful only to profitable businesses (unless refundable)… … but not very valuable to most profitable ones … but not very valuable to most profitable ones

18 18 Accelerated depreciation Similar impact as allowances/tax credits Similar impact as allowances/tax credits But more limited: But more limited: Timing advantage only Timing advantage only Time-value of money Time-value of money Help for cash-constrained, but profitable business Help for cash-constrained, but profitable business

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

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

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

22 22 Comparison of main incentives

23 23 Comparison of main incentives

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

25 25 Conclusions from theoretical considerations Most popular incentives have important drawbacks Most popular incentives have important drawbacks Alternatives suggested by economists not attractive enough for competitiveness Alternatives suggested by economists not attractive enough for competitiveness Case for incentives remains weak, but where they are employed: Case for incentives remains weak, but where they are employed: Need to be effective (attractive to profitable, mobile capital) Need to be effective (attractive to profitable, mobile capital) Costs and benefits need to be weighed, including general equilibrium/indirect effects. Costs and benefits need to be weighed, including general equilibrium/indirect effects.

26 26 Best choices of tax incentives

27 27 Empirical Evidence on Tax Incentives

28 28 Motivation Little evidence in literature Little evidence in literature Case studies Case studies Calculation of effective tax rates Calculation of effective tax rates Econometric evidence: Econometric evidence: General tax competition General tax competition Effect of taxes on investment Effect of taxes on investment But 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 used by developing countries

29 29 New econometric evidence Set up a panel database of tax incentives in developing countries Set up a panel database of tax incentives in developing countries Investigate two questions: Investigate two questions: 1. Do countries use tax incentives for tax competition? 2. Are tax incentives effective in attracting investment or boosting growth?

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

31 31 Do countries use tax incentives to compete for investment?

32 32 Specification Need spatial econometric techniques, because of endogeneity of main variable Need spatial econometric techniques, because of endogeneity of main variable Specifically: use maximum likelihood estimation on a spatial lag model Specifically: use maximum likelihood estimation on a spatial lag model Reject alternative specification of spatial error model Reject alternative specification of spatial error model

33 33Results

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

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

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

37 37 Results: system GMM

38 38 Results interpretation: FDI Pr. investment Real growth CIT rate -(-)- Holiday+00 Inv. allowance 000 Why is FDI affected, but not investment and growth? Why is FDI affected, but not investment and growth? FDI qualifies more for tax incentives than private fixed investment FDI qualifies more for tax incentives than private fixed investment FDI consists of more mobile capital than total private investment FDI consists of more mobile capital than total private investment Financial investment more affected than real investment Financial investment more affected than real investment Foreign investment crowding out domestic investment Foreign investment crowding out domestic investment => investment spillovers apparently not important Why are tax holidays effective, but not investment allowances? Why are tax holidays effective, but not investment allowances? Holiday more interesting for highly profitable investment Holiday more interesting for highly profitable investment => especially high profit investment is attracted

39 39 Conclusions from empirical evidence Strong evidence on strategic policy interaction on CIT rate and holidays 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 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 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 ! Suggests resource flow model interpretation of interaction: countries compete on tax instruments that are effective in attracting FDI !

40 40 Conclusion from econometrics New empirical evidence confirms that some tax incentives New empirical evidence confirms that some tax incentives are important tax competition tools are important tax competition tools do affect investment (but not growth) do affect investment (but not growth) Can explain why Can 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 remain reasons to be skeptical remain

41 41 Overall Conclusions Economists have been skeptical of incentives Economists have been skeptical of incentives Reason for skepticism remains valid, but: Reason for skepticism remains valid, but: Forces that push countries into adopting incentives are strong Forces that push countries into adopting incentives are strong Understandable that few countries replaced tax holidays by accelerated depreciation / investment allowances Understandable that few countries replaced tax holidays by accelerated depreciation / investment allowances Even if first-best of worldwide removal of incentives is not achieved 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 Can at least change structure of incentives towards types that are less harmful and to situations where they are most likely to work

42 42 Thank you


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