Page 5 - Working Paper (Tax Incentives: An Alternative to Revenue Enhancement)

DDTC Working Paper 1115
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tax rates and other favorable provisions to reduce circumstances . Reducing import tariffs as part
the tax burden on foreign companies. Developing of an overall program of trade liberalization is
countries are competing against each other to a major policy challenge currently facing many
provide better tax and economic situations for developing countries. Tariff reduction should not
foreign investors, but without a well-established lead to unintended changes in the relative rates of
tax structure they bring negative effects to their effective protection across sectors. One simple way
own economies and to international commerce of ensuring that unintended consequences do not
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as well . Developing countries often establish occur would be to reduce all nominal tariff rates by
tax incentives without having the proper policy the same proportion whenever such rates need to
planning, so the design and implementation of the be changed.
tax measure is not well structured – but the need
to collect more revenue from foreign investment is While granting tax incentives to promote
helping to create jobs and build infrastructure, this investment is common in countries around the
may lead one of the conclusion that the incentive world, evidence suggests that their effectiveness
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are working . Moreover, by granting preferences in attracting incremental investments—above
and incentives, emerging economies give up a and beyond the level that would have been
substantial portion of their tax base. IMF studies reached had no incentives been granted—is often
have documented that widespread tax exemptions questionable. As tax incentives can be abused by
have led to low tax ratios, which are major fiscal existing enterprises disguised as new ones through
factors in contributing to fiscal crises in emerging nominal reorganization, their revenue costs can
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market economies . be high. Moreover, foreign investors, the primary
target of most tax incentives, base their decision to
As shown in Table 1 above, neighboring enter a country on a whole host of factors of which
countries utilized a mix of tax incentives to tax incentives are frequently far from being the
channel investment to specific regions, sectors most important one. Tax incentives could also be
and to enhance corporate performance as well as of questionable value to a foreign investor because
to transfer of technology. Similar to Batam Special the true beneficiary of the incentives may not be
Zone in Indonesia, Malaysia also establishes special the investor, but rather the treasury of his home
economic zone in Labuan Offshore Financial Center. country.
The majority of tax incentives granted by these
This can come about when any income spared
countries relate to investment in manufacture,
from taxation in the host country is taxed by the
oil and other mineral resources extraction, and
investor’s home country. Evidence from emerging
tourism. Malaysia, Singapore, and Philippines
economies suggests that tax incentives have a more
also employ additional incentives to attract
apparent effect on the composition of FD than on
headquarters of companies through reduced
its level. Indeed, most government uses tax policies
corporate tax rates. Foreign companies engaged in
to attract particular types of investment rather
agriculture, forestry, or animal husbandry located
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than to increase the overall level of investment .
in a remote undeveloped area will receive a 15 – 30
A recent study found that large foreign companies,
percent reduction of income tax rate for a further
such as those in the automobile sector, are generally
10 years after the expiration of the initial tax
in a better position to negotiate special tax regimes
exemption and reduction period.
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and thus to extract rents from host governments .
3. Types of Tax Incentives Of all the forms of tax incentives, tax holidays
(exemptions from paying tax for a certain period
Tax incenTives can be jusTified if of time) are the most popular among developing
They address some form of markeT countries. According to the United Nations
failure, mosT noTably Those Conference on Trade and Development, as many
involving exTernaliTies. as 67 countries offered tax holidays. Tax holidays
provide benefits as soon as the companies generate
income. In practice, tax holiday offers larger benefit
Tax incentives are part of the tax system of
for short-term (i.e. footloose industries) investment
developing countries and are usually established
that might move easily from one jurisdiction to
by the Government to grant foreign investors more
another. Therefore, tax holiday usually prefers the
attractive conditions to invest in their country. This
establishment of new multinationals companies
incentive must be created under stable political
12. Pisani, Op.Cit., page 300
13. Morriset, Jacques, Op.Cit., page 3
9. Pisani, Op.Cit., 302
14. Oman, C,”Policy Competition for FDI: A Study of Competition among
10. Ibid. Governments to Attract FDI”, Development Center Studies, OECD, Paris,
11. Baker, Op.Cit., at 8 2000.