Page 7 - Working Paper (Tax Incentives: An Alternative to Revenue Enhancement)

DDTC Working Paper 1115
7

Table 3 - Proponent and Opponent to is applied to all foreign investors . The investments
17
Tax Incentives that benefit from tax incentives are additional
to what would take place in the absence of the
Proponent Opponent
incentives. An investment is financially feasible
Revenue loss due to and viable in the host country but could earn a
Higher profits to the firms
redundancy higher risk-adjusted rate of return in another new
Positive externalities - Revenue loss due to partial location, and the profit differential is high enough
spillover effects from the redundancy that tax incentives will compensate the location
accumulation of knowledge change. Additionally, tax incentive gives positive
Signal a country’s effect if an investment is not viable under the
commitment to facilitating Revenue loss due to reverse current tax set up, but becomes so due to the tax
foreign aid
investment
break. As stated in Table 3 above, tax incentives
Indirect Revenue cost do cause some negative results. Some selective
– this occurs if the tax-
favored activities undercut incentives do no or only change little the attitude of
Tax competition
the profitability of other foreign investors. These categorized as superfluous
producers who do pay taxes and partial redundancy tax incentives. An example
due to harsh competition. is a resource-based investment such as Mahakam
Capital mobility – attracting Revenue leakage through project block in East Kalimantan operated by
inward flows of foreign avoidance and evasion TOTAL E&P Indonesia. As long as the project is still
investment
financial and economically viable, TOTAL cannot
Revenue leakage through simply pull up their operations elsewhere.
Compensating for other avoidance and evasion
deficiencies in the – company churning:
investment climate establishing new company to
get the facility 4. Economic Analysis of Tax Incentives
Transfer pricing practice on
Revenue gains John Maynard Keynes’s General Theory
purchases and sales
set investment as a central variable in the
Revenue leakage due to false
Political cover determination of the aggregate level of output. The
export declaration
level of investment is a function of the marginal
Practicality that contributes
to other policy objectives Increasing the tax burden on efficiency of capital weighed against the market
such as investment other activities and persons. interest rate (see Figure 1). The market interest
promotion and job creation. rate itself is considered as the cost of capital
Experience shows that for investors. As interest rate or cost of capital
incentives can work decreases (from r to r*), investment will increase
Effectiveness and Economic Impact of Tax Incentives in the SADC Region, 2004 (from Io to I*). The application of tax incentives
reduces cost of capital, assume all other variables
difficult to administer. Conversely, the authority constant, will improve investment. However, there
may see a discretionary triggering mechanism as are few elements that the central government
preferable to an automatic one because it provides needs to identify.
them with more flexibility.
First, the government should be able to measure
This advantage is likely to be outweighed, loss of revenue due to tax incentives and match it
however, by a variety of problems associated with with the benefit originating from future investment.
discretion, most notably a lack of transparency in There is no doubt that tax incentives are costly. The
the decision-making process, which could in turn first and most direct associated costs are those
encourage corruption and rent-seeking activities. associated with the potential loss of revenue for the
If the concern about having an automatic triggering authorities. Second, possibility of creating adverse
mechanism is the loss of discretion in handling selection problems because most of the incentives
exceptional cases, the preferred safeguard would for intended specific sectors and regions and not on
be to formulate the qualifying criteria in as the performance of each entities. Third, conducive
narrow and specific a fashion as possible, so that central and local regulatory frameworks. These
incentives are granted only to investments meeting regulations are mostly pertaining to industrial and
the highest objective and quantifiable standard of trade. From Figure 1 below, dark blue rectangle
merit. On balance, it is advisable to minimize the measures the amount of tax revenue forgone (or
discretionary element in the incentive-granting tax expenditure) by imposing tax incentives and
process. the light blue triangle is the dead-weight loss of
creating such policies. Measuring the dead-weight
General tax incentives may reduce the risk of
loss is not easy as it looks. Tax incentives may have
corruption in developing countries since the policy
17. Pisani, Op.Cit., 301