## 1. Possible Justifications for Tax Incentives ## Source details **Canonical URL:** [1. Possible Justifications for Tax Incentives](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2009/_wp0921.pdf) ## Other formats - [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2009/_wp0921.pdf.md) - [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2009/_wp0921.pdf.json) --- ### Introduction - "Tax incentives are common around the world and are constantly evolving." - Few public finance laws are passed without reference to special rules regarding a specific activity or circumstance. - Paper adopts a narrower definition to allow a more thorough study and focuses on incentives that aim to encourage economic activity, particularly investment. ### Definition and scope - For this paper: tax incentives = measures that provide for a more favorable tax treatment of certain activities or sectors compared to what is granted to general industry. - Under this definition: - A general cut in the tax rate or a generous depreciation scheme applicable to all firms would not be considered tax incentives. - Incentives need not be part of a special code; they can be an integrated part of the tax law. - Footnote note: Alternative definitions (e.g., any provision that lowers after-tax cost of capital below pre-tax cost) have conceptual and practical problems and would classify much of corporate tax systems as incentives. ### Rationale for granting incentives - Granting a tax incentive implies that the capital stock—either of some type or in aggregate—is considered too low and that either the tax system is the obstacle or other obstacles exist that can be compensated by the tax system. - Other objectives of incentives: - Attracting reported profits (tax-motivated relocations). - Improving social outcomes (e.g., encouraging education or pension saving). - Discouraging activity (e.g., reducing overproduction in agriculture). ### Economists' view and purpose of the paper - Economists often favor broad tax bases and low rates; skeptical about special incentives. - Paper explains continued popularity of incentives despite such advice, arguing strong political and competitive forces drive countries to adopt incentives. - Provides guidance on proper design for countries determined to maintain incentives, noting relative costs and benefits differ enormously. ### Role of tax competition - Paper emphasizes tax competition as a particularly important force behind many tax incentives. - System with tax incentives is not obviously the worst possible response to competitive pressures. - Paper outlines competitive forces and possible responses (see Section II in source). --- ### Box 1. Typical Tax Incentives H3 Types of tax incentives (definitions) - Tax holidays: Temporary exemption of a new firm or investment from certain specified taxes, typically at least corporate income tax. Partial tax holidays offer reduced obligations rather than full exemption. - Special zones: Geographically limited areas in which qualified firms can locate and thus benefit from exemption of varying scope of taxes and/or administrative requirements. - Investment tax credit: Deduction of a certain fraction of an investment from the tax liability; rules differ regarding excess credits (lost, carried forward or refunded). - Investment allowance: Deduction of a certain fraction of an investment from taxable profits (in addition to depreciation); value equals allowance × tax rate. - Accelerated depreciation: Faster depreciation schedule than available for the rest of the economy; reduces net present value of tax payments and improves liquidity. - Reduced tax rates: Reduction in a tax rate, typically the corporate income tax rate. - Exemptions from various taxes: Exemption from tariffs, excises and VAT on imported inputs. - Financing incentives: Reductions in tax rates applying to providers of funds (e.g., reduced withholding taxes on dividends). H3 Costs and benefits (key findings) - Costs extend beyond immediate revenue loss to include: - Distortions from preferential treatment of qualifying investment. - Administrative costs to run and prevent fraud. - Social costs of rent-seeking behavior, including possible increases in corruption. - Direct revenue cost extremes: - If incentives apply only to investment that would not have taken place otherwise, direct revenue forgone could be nil. - If incentives are purely redundant, the entire tax revenue waived is the direct revenue cost. - Indirect effects: - Incentives may crowd out other, more highly taxable investment. - Aggregate investment may not increase if incentives simply reallocate investment between sectors or jurisdictions. - Benefits are difficult to assess because: - Medium-term development objectives are affected by many factors. - Hard to determine counterfactual growth without incentives or under alternative tax reforms. - Attribution uncertain for incentives addressing externalities (e.g., R&D). H3 Principles for choosing tax incentives (design considerations) - Transparency and predictability are essential for investor understanding and to reduce corruption. - Incentives should ideally be part of tax laws (not only investment laws, decrees, or private contracts). - Automatic eligibility based on clear criteria is generally preferable to discretionary grants. - Provisions should be robust to tax evasion; if incentives open new evasion routes, costs could rise enormously. - Economic efficiency: temporary incentives should be limited to investments that remain viable after expiration to limit long-term distortions. - Equity effects are rarely considered; most likely beneficiaries are wealthier individuals and often non-residents. H3 Assessment of typical incentives (comparative analysis) - Tax holidays: - Particularly harmful and attractive to short-term, footloose, rapidly profitable investments. - Revenue costs often intransparent because beneficiaries may be exempt from filing or underreporting. - Encourage rent-seeking and requests for extensions; often offered continuously. - Narrow justification: signal commitment to broader reforms, but rarely used this way in practice. - Investment allowances and tax credits: - Transparent and automatic; contingent on new investment. - Distort choice of capital toward short-lived goods and physical rather than financial or human capital. - If non-refundable, advantage established firms over startups. - Accelerated depreciation: - Brings deductions forward; reduces EMTR but not to zero unless full expensing allowed. - Less valuable for initially unprofitable investments. - Reduced tax rates: - Merit depends on scope and permanence. Limited-time reduced rates face same concerns as tax holidays. - Split-rate systems targeted at more mobile activities can be justified but may face legal or political constraints. - Exemptions from border taxes: - Often second-best; may mask deeper tax or administrative problems that should be fixed directly. - Special zones: - Vary widely; deep tax exemptions can generate substantial revenue loss and profit shifting. - Financing incentives: - Often have limited impact when: (1) investors are in residence-based tax countries, (2) investors avoid withholding via tax-exempt structures, or (3) marginal finance source is retained earnings or debt. H3 Effective tax rates and illustrative comparisons (methodology & numerical assumptions) - Effective measures: - EMTR: effective marginal tax rate for marginal investment (post-tax return equals cost of capital). - EATR: effective average tax rate for rent-earning investment. - Comparative findings: - Cash-flow tax (full depreciation in year of acquisition) reduces EMTR to nil; it is neutral for investment. - Investment allowance or tax credit can lead to a negative EMTR (under assumptions of refundable or offsettable credits). - Accelerated depreciation reduces EMTR but not to zero unless full expensing is allowed. - Tax holidays provide large benefits for very profitable (rent-earning) investments (substantially reduce EATR during holiday) but are comparatively ineffective for marginal investments (EMTR benefit limited and can be negative in some holiday years because of lost depreciation allowances). - Reduced tax rate permanently benefits repeat investments more than a time-limited holiday. - Numerical example assumptions used in staff calculations (Figure 1): - Statutory tax rate: 30 percent. - Tax holiday: 8 years (assumed taxes paid after the eight-year holiday). - Asset: plant and machinery. - Source of finance: equity. - Inflation: 3 percent. - Real rate of interest: 5 percent. - Economic depreciation: 12.25 percent. - Depreciation allowance: 25 percent, declining balance. - Net profit rate (EATR): 30 percent. - Personal taxes excluded. - Illustrative quantitative insights: - Tax holidays reduce EATR sharply for investments undertaken at the start of the holiday but the EATR on additional investment rises quickly as the holiday nears expiration. - Generous depreciation or full expensing is most valuable for low-profit projects; for highly profitable (rent-earning) investments, tax holidays or reduced tax rates yield much larger benefits. H3 Responses to tax competition (policy options and trade-offs) - Possible policy responses: - Broad bases and low tax rates (base-broadening rate-cutting reforms): attractive for economies with few natural resources and high multinational activity; less appropriate for resource-rich economies or those dominated by small entrepreneurs. - Neutral corporate income taxes (tax rents only), e.g., cash-flow taxes or allowance for corporate equity: tax base smaller, implying higher rates for same revenue; less distortionary for closed economy but may discourage mobile, firm-specific rent investments in open economies. - Abolition of corporate income tax: theoretically optimal under perfect capital mobility but fraught with enforcement and political issues. - High tax rates, narrow bases, lax profit-shifting rules: raises revenue from immobile firms but invites massive avoidance and costly firm restructuring. - System with targeted tax incentives: can attract mobile capital while preserving taxation of immobile firms but raises complexity, distortions, administrative costs, and potential legal impediments. - Strategic trade-offs: - Incentives can be used as a competitive tool under revenue constraints, but risks include leakage, profit shifting, and crowding out of other investments. - Political constraints may lead countries to adopt inferior incentive-based solutions when fundamental reforms are politically infeasible. H3 Scope for coordination (regional/global considerations) - Regional cooperation rationale: incentives that merely shift investment across jurisdictions without creating net regional investment are revenue-wasting at regional level. - Coordination challenges: - Heterogeneous gains across countries make agreements difficult; small generous-tax countries stand to lose most. - Broader participation increases incentive for outsiders to remain low-tax. - Forms and effects of coordination: - Minimum tax rate without base harmonization can have limited impact and may yield unintended EMTR/EATR changes. - Prohibiting special regimes for foreign investors can lead to lower uniform rates (example cited in source). - Information exchange initiatives and regional codes (e.g., EU Code of Conduct) aim to limit preferential tax treatment. - Where coordination can succeed: - Region-specific rents (duty-free access, common scenery) that are location-linked can be taxed regionally without inducing relocation within the region. H3 Empirical evidence (summary of literature findings) - General FDI-tax sensitivity literature: - Consensus: taxes affect FDI volume and location. - Meta-analysis (De Mooij and Ederveen, 2003): median semi-elasticity of FDI to the tax rate is -3.3, reported standard deviation of semi-elasticities is 9.0; majority within range -5 to 0; over 80 percent negative. - R&D tax credits: - Panel evidence (Bloom et al., 2002) for nine OECD countries: a $1 tax expenditure leads to $1 increase in R&D in the long run, with much smaller short-run impact. - Caveat: studies typically omit administrative costs, relabeling, and crowding out. - Economic zones and incentives: - U.S. panel studies comparing zones with neighboring regions find very small beneficial effects on employment and investment. - Developing country evidence: - Little econometric work; mostly descriptive or case studies. - Example: Bond (1981) finds tax holidays lead to short-lived and small firms in Puerto Rico. - Overall empirical message: - Incentives sometimes attract FDI under certain pre-conditions and correct design, but net benefits remain doubtful once costs, crowding out, and relabeling are considered. --- ### V. CONCLUSION H3 Effectiveness of tax incentives - Tax incentives are often ineffectual because: - Offered incentives may not be valuable to firms. - Important pre-conditions may be unmet (stable macroeconomic environment, satisfactory public infrastructure). - Studies tend to conclude that investment incentives are more effective than tax holidays. - Most empirical studies estimate effects on cost of capital or METR, but not on ultimate policy goals (typically investment). H3 New econometric evidence - Klemm and van Parys (forthcoming) use a panel of African, Caribbean and Latin American countries to test for tax competition and explore effects on FDI and total investment. - Key findings: - Countries react to other countries’ tax incentives, similar to reactions to tax rates. - FDI increases if tax incentives, particularly tax holidays, are offered, although this is partially counteracted by the negative effect of the resulting higher corporate tax rate. - There is no robust effect on total gross fixed capital formation or economic growth, suggesting FDI crowds out other investment or attracts change-of-ownership rather than new investment. H3 Interpretation and limitations - Skepticism about incentives often appears warranted; advice against rampant use is appropriate. - In principle, incentives could combine competitive taxation for mobile activities with higher taxes elsewhere, but in practice this is difficult due to incentive disadvantages and administrative difficulties. - Cost-benefit analysis must go beyond obvious revenue loss and administrative costs to avoid being misleading. - Previous work often examines incentives at the margin rather than discrete rent-earning investment decisions by multinationals. H3 Guidance on choice of incentives - If aim is to attract investors expecting economic rents (e.g., multinationals owning patents or special knowledge): - Accelerated depreciation seems inappropriate; a permanently reduced tax rate may be more promising. - If a country can offer only the possibility of a rent (e.g., uncertain natural resources): - Accelerated depreciation may reduce risks in case of higher capital costs. - Optimal incentive depends on industry nature and international competition. - Advice to avoid tax holidays remains generally valid; they attract short-lived one-off investment. H3 Practical policy considerations and risks - A coherent and simple tax system has advantages; once exemptions are created for one sector or region, pressure for further ones increases, risking a less efficient tax system. - Even if an incentive can be useful in principle, a country may be well advised to refrain from introducing one. H3 Table1. Possible Justifications for Tax Incentives (summary) - I Strong - a. Internationally particularly mobile activity - If perfectly competitive industry: investment allowances; if firm-specific rents: permanently reduced tax rate - b. Positive externalities - Ideally subsidy/tax credit based on activity (e.g., R&D). Otherwise as Ia. - II Ambiguous - a. Regional rents - Regional tax coordination. Failing that: Ia. - b. Unattractive location - Address weakness directly (improve governance, infrastructure...). Failing that: Ia. - c. Tax cut could spark reactions in other jurisdictions - May be best to wait; if eventual tax cuts inevitable, possible benefit from being first mover. - III Weak - a. Location-specific rents - Instead of incentive, additional neutral rent tax could be charged. - b. None of the above - Instead cut overall tax rate or remove other overall disincentive to invest. *Source: _wp0921 — 1. Possible Justifications for Tax Incentives; Box 1. Typical Tax Incentives; V. Conclusion — https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2009/_wp0921.pdf* ### 1. Possible Justifications for Tax Incentives........................................................................... ### 1. Possible Justifications for Tax Incentives ### Introduction - "Tax incentives are common around the world and are constantly evolving." - "Few public finance laws are passed without reference to special rules regarding a specific activity or circumstance." - "Instead of trying to analyze all of their possible manifestations, it is useful to adopt a narrower definition to allow a more thorough study." ### Definition and scope - "For the purposes of this paper, tax incentives are defined as all measures that provide for a more favorable tax treatment of certain activities or sectors compared to what is granted to general industry." - "Under this definition, a general cut in the tax rate or a generous depreciation scheme applicable to all firms would not be considered tax incentives." - "Incentives need not be part of a special code, they can be an integrated part of the tax law." - "The focus of this paper will be on those incentives which aim to encourage economic activity, particularly investment." - Footnote text: "2 Other definitions have been suggested, for example labeling any provision that lowers the after-tax cost of capital below the pre-tax cost as an incentive. Such a definition has a number of conceptual and practical problems, though. It would mean that most countries’ corporate tax system would be considered a tax incentive, because the combination of interest deductibility and depreciation allowances often yields negative tax rates at the margin. Moreover, under this definition any measure that reduced the tax burden of an activity would not be recognized as an incentive as long as some tax is levied at the margin, irrespective of how other activities are taxed." ### Rationale for granting incentives - Granting a tax incentive "implies that the capital stock—either of some type or in aggregate—is considered too low and that either the tax system is the obstacle or other obstacles exist that can be compensated by the tax system." - "Other incentives exist, such as those which are not aimed at the real economy but at attracting reported profits or those aimed at improving social outcomes, for example, by encouraging education or saving for a pension." - "Moreover, incentives can be used to discourage activity, for example in case of overproduction, especially in the agricultural sector." ### Economists' view and purpose of the paper - "Economists have often been skeptical about tax incentives and instead supported broad tax bases to enable low rates." - "This paper attempts to provide an explanation for the continued popularity of incentives despite such advice." - "It argues that, even though the rationale for the advice remains valid, there are strong forces that drive countries to adopt tax incentives." - "Moreover, irrespective of whether one finds the arguments for tax incentives compelling, it would be useful to give advice on the proper design of incentives to those countries which are determined to maintain them, as their relative costs and benefits differ enormously." ### Role of tax competition - "Tax incentives are granted for a wide variety of reasons, but this paper argues that tax competition is a particularly important force behind many of them." - "This paper thus begins by a brief description of the competitive forces countries are facing and the possible responses to them (Section II)." - "It argues that a system with tax incentives is not obviously the worst possible response to such pressures." *Source: _wp0921 - 1. Possible Justifications for Tax Incentives — https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2009/_wp0921.pdf* ### Box 1. Typical Tax Incentives ### Box 1. Typical Tax Incentives ### Types of tax incentives (definitions) - Tax holidays: Temporary exemption of a new firm or investment from certain specified taxes, typically at least corporate income tax. Sometimes administrative requirements are also waived, notably the need to file tax returns. Partial tax holidays offer reduced obligations rather than full exemption. - Special zones: Geographically limited areas in which qualified firms can locate and thus benefit from exemption of varying scope of taxes and/or administrative requirements. Zones are often aimed at exporters and located close to a port. In some countries, however, qualifying companies can be declared “zones” irrespective of their location. - Investment tax credit: Deduction of a certain fraction of an investment from the tax liability. Rules differ regarding excess credits (credits in excess of tax liability) and include the possibility that they may be lost, carried forward or refunded. - Investment allowance: Deduction of a certain fraction of an investment from taxable profits (in addition to depreciation). The value of an allowance is the product of the allowance and the tax rate. Unlike a tax credit, its value will thus vary across firms unless there is a single tax rate. Moreover, the value is affected by changes to the tax rate, with a tax cut reducing it. - Accelerated depreciation: Depreciation at a faster schedule than available for the rest of the economy. This can be implemented in many different ways, including a higher first year depreciation allowances, or increased depreciation rates. Tax payments in nominal terms are unaffected, but their net present value is reduced and the liquidity of firms is improved. - Reduced tax rates: Reduction in a tax rate, typically the corporate income tax rate. - Exemptions from various taxes: Exemption from certain taxes, often those collected at the border such as tariffs, excises and VAT on imported inputs. - Financing incentives: Reductions in tax rates applying to providers of funds, e.g., reduced withholding taxes on dividends. ### Costs and benefits (key findings) - Costs of incentives extend beyond immediate revenue loss to include: - Distortions from preferential treatment of qualifying investment. - Administrative costs to run and prevent fraud in incentive schemes. - Social costs of rent-seeking behavior, including possible increases in corruption. - Direct revenue cost extremes: - If incentives apply only to investment that would not have taken place otherwise, direct revenue forgone could be nil. - If incentives are purely redundant, the entire tax revenue waived is the direct revenue cost. - Indirect effects matter: - Incentives may crowd out other, more highly taxable investment. - Aggregate investment may not increase if incentives simply reallocate investment between sectors or jurisdictions. - Benefits are difficult to assess because: - Medium-term development objectives are affected by many factors. - It is hard to determine counterfactual growth without incentives or under alternative tax reforms. - For incentives addressing externalities (e.g., R&D), attribution of outcomes to the incentive is uncertain. ### Principles for choosing tax incentives (design considerations) - Transparency and predictability are essential for investor understanding and to reduce corruption. - Incentives should ideally be part of tax laws (not only investment laws, decrees, or private contracts). - Automatic eligibility based on clear criteria is generally preferable to discretionary grants, given risks of corruption and government inability to "pick winners." - Provisions should be robust to tax evasion; if incentives open new evasion routes, costs could rise enormously. - Economic efficiency: incentives inherently distort allocation; temporary incentives should be limited to investments that remain viable after expiration to limit long-term distortions. - Equity effects are rarely considered; most likely beneficiaries are wealthier individuals and often non-residents. ### Assessment of typical incentives (comparative analysis) - Tax holidays: - Particularly harmful and attractive to short-term, footloose, rapidly profitable investments. - Revenue costs often intransparent because beneficiaries may be exempt from filing or underreporting. - Encourage rent-seeking and requests for extensions; often offered continuously rather than briefly. - Possible narrow justification: signal commitment to broader reforms, but rarely used that way in practice. - Investment allowances and tax credits: - Transparent and automatic; directly contingent on new investment. - Distort choice of capital toward short-lived goods and physical rather than financial or human capital. - If non-refundable, advantage established firms over startups (only established firms have profits to offset). - Accelerated depreciation: - Similar implications to allowances/credits but more limited: brings deductions forward, reducing net present value advantage only through time value of money. - Less valuable for initially unprofitable investments. - Reduced tax rates: - Merit depends on scope and permanence. Limited-time reduced rates face same concerns as tax holidays. - Split-rate systems targeted at more mobile activities can be economically justified but may face legal or political constraints. - Exemptions from border taxes (tariffs, excises, VAT on imports): - Often second-best; may mask deeper tax or administrative problems that should be fixed directly (e.g., VAT refund systems). - Special zones: - Vary widely; some simply reduce administrative hassle for re-exports, others provide deep tax exemptions that can generate substantial revenue loss and profit shifting. - Financing incentives (e.g., reduced withholding on dividends): - Often have limited impact when: (1) investors are in residence-based tax countries, (2) investors avoid withholding via tax-exempt structures, or (3) marginal finance source is retained earnings or debt. ### Effective tax rates and illustrative comparisons (methodology & numerical assumptions) - Effective measures: - EMTR: effective marginal tax rate for marginal investment (post-tax return equals cost of capital). - EATR: effective average tax rate for rent-earning investment. - Comparative findings: - Cash-flow tax (full depreciation in year of acquisition) reduces EMTR to nil; it is neutral for investment. - Investment allowance or tax credit can lead to a negative EMTR (under assumptions of refundable or offsettable credits). - Accelerated depreciation reduces EMTR but not to zero unless full expensing is allowed. - Tax holidays provide large benefits for very profitable (rent-earning) investments (substantially reduce EATR during holiday) but are comparatively ineffective for marginal investments (EMTR benefit limited and can be negative in some holiday years because of lost depreciation allowances). - Reduced tax rate permanently benefits repeat investments more than a time-limited holiday. - Numerical example assumptions used in staff calculations (Figure 1): - Statutory tax rate: 30 percent. - Tax holiday: 8 years (assumed taxes paid after the eight-year holiday). - Asset: plant and machinery. - Source of finance: equity. - Inflation: 3 percent. - Real rate of interest: 5 percent. - Economic depreciation: 12.25 percent. - Depreciation allowance: 25 percent, declining balance. - Net profit rate (EATR): 30 percent. - Personal taxes excluded. - Illustrative quantitative insights: - Tax holidays reduce EATR sharply for investments undertaken at the start of the holiday but the EATR on additional investment rises quickly as the holiday nears expiration. - Generous depreciation or full expensing is most valuable for low-profit projects; for highly profitable (rent-earning) investments, tax holidays or reduced tax rates yield much larger benefits. ### Responses to tax competition (policy options and trade-offs) - Possible policy responses: - Broad bases and low tax rates (base-broadening rate-cutting reforms): attractive for economies with few natural resources and high multinational activity; may be less appropriate for resource-rich economies or those dominated by small entrepreneurs. - Neutral corporate income taxes (tax rents only): e.g., cash-flow taxes or allowance for corporate equity; tax base smaller, implying higher rates for same revenue; less distortionary for closed economy but may discourage mobile, firm-specific rent investments in open economies. - Abolition of corporate income tax: theoretically optimal under perfect capital mobility but fraught with enforcement and political issues. - High tax rates, narrow bases, lax profit-shifting rules: raises revenue from immobile firms but invites massive avoidance and could be costly if firms restructure to avoid taxes. - System with targeted tax incentives: can attract mobile capital while preserving taxation of immobile firms but raises complexity, distortions, administrative costs, and potential legal impediments (e.g., EU constraints). - Strategic trade-offs: - Tax incentives can be used as a competitive tool under revenue constraints, but risks include leakage, profit shifting, and crowding out of other investments. - Political constraints may lead countries to adopt inferior incentive-based solutions when fundamental reforms (e.g., tax administration improvements) are politically infeasible. ### Scope for coordination (regional/global considerations) - Regional cooperation rationale: incentives that merely shift investment across jurisdictions without creating net regional investment are revenue-wasting at regional level. - Coordination challenges: - Heterogeneous gains across countries make agreements difficult; small generous-tax countries stand to lose most. - Broader participation increases incentive for outsiders to remain low-tax. - Forms and effects of coordination: - Minimum tax rate without base harmonization can have limited impact and may yield unintended EMTR/EATR changes. - Prohibiting special regimes for foreign investors can lead to lower uniform rates (example cited: Ireland moved from a split system to a single low rate). - Information exchange initiatives aim to limit tax evasion; regional codes (e.g., EU Code of Conduct) prohibit preferential tax treatment to subsets of firms. - Where coordination can succeed: - Region-specific rents (duty-free access, common scenery) that are location-linked can be taxed regionally without inducing relocation within the region. ### Empirical evidence (summary of literature findings) - General FDI-tax sensitivity literature: - Consensus: taxes affect FDI volume and location. - Meta-analysis (De Mooij and Ederveen, 2003): median semi-elasticity of FDI to the tax rate is -3.3 (implying a 1 percentage point increase in the tax rate reduces FDI by 3.3 percent). Reported standard deviation of semi-elasticities is 9.0. Majority of elasticities within range -5 to 0; over 80 percent have a negative sign. - R&D tax credits: - Panel evidence (Bloom et al., 2002) for nine OECD countries: a $1 tax expenditure leads to $1 increase in R&D in the long run, with much smaller short-run impact. - Caveats: studies typically do not account for costs beyond revenue forgone (administrative costs, relabeling of existing investment, crowding out), and a one-to-one relationship questions whether direct government spending on R&D would be equally effective. - Economic zones and incentives: - U.S. evidence: panel studies comparing zones with neighboring regions find very small beneficial effects on employment and investment. - Developing country evidence: - Little econometric work; most analyses are descriptive or case studies due to data limitations. - Example: Bond (1981) finds tax holidays lead to short-lived and small firms in Puerto Rico. - Overall empirical message: - Incentives sometimes attract FDI under certain pre-conditions and correct design, but net benefits remain doubtful once costs, crowding out, and relabeling are considered. *Source: IMF staff summary of "Box 1. Typical Tax Incentives" in the provided PDF content.* ### conclusion from them is that tax incentives are often ineffectual, either because the particular ### V. CONCLUSION ### Effectiveness of tax incentives - Tax incentives are often ineffectual, either because the particular incentives offered are not very valuable to firms or because important pre-conditions are not met, such as a relatively stable macroeconomic environment and satisfactory public infrastructure. - Studies tend to conclude that investment incentives are more effective than tax holidays. - Many studies focus on one country only, making it difficult to control for factors other than tax incentives. - Most studies present just estimates of the effect of incentives on the cost of capital or the METR, but not on the ultimate goal of the policy, i.e., typically investment. ### New econometric evidence - Klemm and van Parys (forthcoming) use a panel of African, Caribbean and Latin American countries to test for tax competition in tax incentives and to explore the effects of tax incentives on FDI and total investment. - Key empirical findings reported: - Countries react to other countries’ tax incentives, just as they do to their tax rates. - FDI increases if tax incentives, particularly tax holidays, are offered, although this is partially counteracted by the negative effect of the resulting higher corporate tax rate. - There is no robust effect on total gross fixed capital formation or economic growth, suggesting that FDI crowds out other investment or that especially the part of FDI that covers change of ownership rather than new investment is attracted. ### Interpretation and limitations - Previous skepticism about tax incentives often seems warranted; advice against their rampant use appears appropriate. - In principle, tax incentives could combine a competitive tax system for mobile activities with higher taxes elsewhere, but in practice this outcome is difficult to achieve because of disadvantages of existing tax incentives and administrative difficulties. - Given the difficulty in assessing both the costs and benefits of tax incentives, cost-benefit analysis must go beyond obvious costs in terms of revenue loss and administrative costs, otherwise it will be very misleading. - Previous work has generally considered investment incentives at the margin only, rather than discrete rent-earning investment decisions often taken by multinationals. ### Guidance on choice of incentives - If the aim is to attract investors who expect to earn economic rents (e.g., multinationals owning patents or special knowledge): - Accelerated deprecation seems an inappropriate choice and a permanently reduced tax rate may be more promising. - If a country can only offer the possibility of a rent (e.g., natural resources suspected but amount and extraction costs unknown): - Accelerated deprecation may have merits because it would reduce risks in the case of higher capital costs. - The optimal incentive depends on the exact nature of the industry and of the international competition. - The advice to avoid tax holidays remains generally valid, as they are particularly attractive to short-lived one-off investment. ### Practical policy considerations and risks - A coherent and simple tax system has advantages; it cannot take account of all issues, especially since they may be changing over time. - Once a system has created the precedence of an exemption for one particular sector or region, pressure for further ones will increase, potentially resulting in a less efficient tax system even if some incentives have sound economic rationale and are cost-effective. - Even if a tax incentive can be useful in principle, a country may be well advised to refrain from introducing one. ### Table1. Possible Justifications for Tax Incentives (summary of cases and best choice of incentive) - I Strong - a. Internationally particularly mobile activity - If perfectly competitive industry: investment allowances; if firm-specific rents: permanently reduced tax rate - b. Positive externalities - Ideally subsidy/tax credit based on activity (e.g., R&D). Otherwise as Ia. - II Ambiguous - a. Regional rents - Regional tax coordination. Failing that: Ia. - b. Unattractive location - Address weakness directly (improve governance, infrastructure...). Failing that: Ia - 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. - III Weak - a. Location-specific rents - Instead of incentive, additional neutral rent tax could be charged. - b. None of the above - Instead cut overall tax rate or remove other overall disincentive to invest. *Source: V. Conclusion and Table1 from the provided IMF Working Paper content.* --- _Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2009/_wp0921.pdf_