Effectiveness and Economic Impact of Tax Incentives in the SADC ...

6-6 EFFECTIVENESS AND IMPACT OF TAX INCENTIVES IN THE SADC REGION
investment. The tax base in the low-tax state jumps to 150 at the expense of the high-tax state.
In the absence of cooperation, the dominant strategy for each state is AETR = 25 percent.
Why? Here is the logic from the point of view of state A:
Suppose that B chooses the 35% tax; then we are better off setting our tax at 25%. Now
suppose that B chooses the 25% tax; we are again better off (in the sense of avoiding a
larger loss) by setting the tax at 25%. Either way, 25% is our best choice.
The logic works the same way for state B. Hence, both states are driven to adopt the 25
percent tax rate, leading to the outcome in cell 4. They wind up with the same investments as
in cell 1, but with fewer fiscal resources to finance the provision of public services. Once they
settle into the low-revenue outcome in cell 4, the identical logic applies to further tax cuts. In
the absence of cooperation, each state, acting rationally, has an incentive to reduce the tax to
20 percent. Then to 15 percent. This is the famous “race to the bottom” in tax competition.
This adverse result is not inevitable. One way out is cooperation. If A and B agree to hold
their tax rates at 35 percent, then they mutually benefit by ending up in cell 1 instead of cell 4.
In a dynamic framework there is a chance for implicit cooperation, if forward-looking states
recognize that “beggar thy neighbor” competition is a losing game in the long run.
The logic of the prisoner’s dilemma is not a theoretical anomaly. It explains why common
resources get overused and why cartels break down. More to the point, the model shows that
cooperation to fight HTC can be of mutual benefit to all of the participating states. The problem is
that even if all of the states in a group like SADC agree to cooperate, countries elsewhere are
still pursuing tax practices that divert investment from the region as a whole.
Another consideration is that fiscal competition does not necessarily fall into the prisoner’s
dilemma pattern. If total investment is highly responsive to the tax rate, then competitive tax
cuts can stimulate investment in both countries rather than simply re-shuffling it between the
jurisdictions. In Table 6-1, suppose that cutting tax rates from 35−25 percent causes overall
investment to rise by half. Then cell 4 would leave both countries with a tax base of 150 and
higher revenue due to the tax cuts. In most instances, of course, tax cuts do cause a loss of
revenue and create a need for compensating fiscal adjustments. 84
Another case where the prisoner’s dilemma would not arise is where investment is highly
insensitive to tax differentials. If this is known by both states, then neither has an incentive to
cut its effective tax rate to 25 percent, simply because the tax cut will not be beneficial. If one
state chooses to do so in response to political pressure or poor policy analysis, the other state
would have no incentive to follow suit. For example, Zambia resisted political pressure to
84 Oxfam (2003) attempts to come up with a crude estimate of the revenues foregone by developing countries
due to vying for foreign direct investment through tax relief. Using a 35 percent tax rate as the benchmark,
the study estimates that the overall revenue loss to host countries is $50 billion, roughly equal to total of
foreign aid flows to developing countries.