The link between taxation and corporate investment activity has attracted huge attention in the public finance literature and there is consensus among empirical studies that corporate taxes deteriorate investment activity. 

In contrast to the industrialised world, many developing countries make use of business tax incentives extensively, like tax holidays and special investment allowances granted to particular sectors, regions or firms. Recent years have seen mounting attention to the importance of these incentive regimes. While such regimes are, in principle, designed to lead to expanded investment, most observers, led by the IMF, increasingly view them as problematic.

Firstly, incentives, especially if granted arbitrarily, are associated with substantial revenue costs. In many African countries, revenue authorities grant tax exemptions worth around 5% of GDP, which corresponds to up to one-third of total tax revenues. They moreover amount to a beggar-thy-neighbor policy that is likely to enhance tax competition, and drive down tax rates on mobile capital (the latter supported by evidence that countries respond to incentives granted by their neighbors. In practice they are widely felt to increase administrative costs, introduce distortions to the economy as a result of preferential treatment of investment qualifying for incentives and be subject to significant corruption and abuse.

If elites and large firms systematically avoid using of incentives, inequality may increase and the broader tax morale and the culture of tax compliance might be undermined.  While not directly tested by existing research, there is extensive broader research indicating that tax compliance tends to decline where neighbours are believed to be avoiding payment.5

Detailed empirical research on the issue is relatively rare.  A small body of recent research has generally found that while some types of incentives induce increased levels of foreign investment, they have generally not led to aggregate increases in total investment; that is, they have suggested that incentives, by introducing differential tax rates for different firms or activities, have induced primarily substitution rather than aggregate gains.

Anecdotal evidence further pointed to the frequent abuse of tax incentives or tax holidays, for example through round tripping or regular sham sales and re-incorporation of firms in order to exploit time limited incentives and exemptions. On top, even if time limited incentives cannot be gamed, it is highly unclear whether they are instrumental in attracting long-term investment which stays after their expiry. The implication is that any such research needs to pay close attention to the aggregate impact of incentives on real levels of investment.  Finally, as with the case of tax havens, theoretical models have suggested the possibility that under certain circumstances tax exemption regimes could, counter-intuitively, reduce overall levels of tax competition, by allowing tax competition to be restricted to highly mobile capital, but again empirical evidence is needed to substantiate such a possibility.7

Research of this kind has been constrained by the unavailability of data, as government have had poor record keeping or unwilling to share relevant data.  This, however, is beginning to change, with many countries, particularly in Latin America, introducing systematic tax expenditure monitoring.  At a minimum this opens the door to a clearer understanding of the content and revenue costs of these regimes, as well as to cross country comparisons, while more challenging research aimed at estimating broader impacts on investment is also needed.

Notes and References

  1. See Devereux, M.P. and G. Maffini (2007), The Impact of Taxation on the Location of Capital, Firms and Profit: A Survey of Empirical Evidence’, Oxford University CBT Working Paper CBT WP07/02 and De Mooij, R.A. and S. Ederveen (2003), Taxation and Foreign Direct Investment: A Synthesis of Empirical Research, International Tax and Public Finance 10(6), 673–93.

  2. International Development Committee, House of Commons (2012), Fourth Report: Tax in Developing Countries: Increasing Resources for Development, London, United Kingdom.

  3. Klemm, A. and S. Van Parys (2009), Empirical Evidence on the Effects of Tax Incentives, IMF Working Paper WP/09/136.

  4. Klemm, A. (2010), Causes, Benefits, and Risks of Business Tax Incentives, International Tax and Public Finance 17(3), 315-336.

  5. Fjeldstad, O.-H. and C. Schulz-Herzenberg (forthcoming). "Peoples' Views of Taxation in Africa:  Theories, Evidence and an Agenda for Future Research." ICTD Working Paper - forthcoming and Fjeldstad, O.-H. (2004). "What's Trust Got To Do With It? Non-Payment of Service Charges in Local Authorities in South Africa." Journal of Modern African Studies 42(4): 539-562

  6. Klemm, A. and S. Van Parys (2009), Empirical Evidence on the Effects of Tax Incentives, IMF Working Paper WP/09/136 and Van Parys, S. and S. James (2010). "The Effectiveness of Tax Inventives in Attracting Investment: Panel Data Evidence from the CFA Franc Zone." International Tax and Public Finance 17: 400-429

  7. Keen, M. and K. Konrad (2012). "International Tax Competition and Coordination." Max Planck Institute for Tax Law and Public Finance Working Paper 2012-06.

  8. Azémar, C. and A. Delios (2008), Tax Competition and FDI: The Special Case of Developing Countries, Journal of Japanese International Economies 22, 85–108.

  9. Mutti, J. and H. Grubert (2004), Empirical Asymmetries in Foreign Direct Investment and Taxation, Journal of International Economics 62 (2004) 337– 358