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

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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.
ECONOMICS OF HARMFUL TAX COMPETITION 6-7 match a sharp tax cut implemented in Tanzania, because the government’s analysis indicated that the cost would outweigh the benefit (Exhibit 6-1). Exhibit 6-1 Resisting Tax Competition from Next Door, Zambia, 1963 In December, 1991, a Presidential Commission in Tanzania recommended sweeping tax reforms to enhance revenue performance, widen the tax base, and promote economic efficiency. Some reforms were implemented in the 1992/93 budget, including sharp cuts in tax and duty rates. According to the budget program, the revenue loss would be more than offset by improved compliance and tax administration, the elimination of certain exemptions, and higher taxes on petroleum products. But the budget omitted some important revenue enhancement measures that the Commission had recommended as part of the package. Meanwhile, Zambia was pursuing a comprehensive tax reform program based on recommendations of a public-private Tax Policy Task Force. Zambia’s 1993 budget included cuts in income tax and import duty rates comparable to those in Tanzania. One major difference was that Tanzania set a zero rate of customs duty and sales tax on capital goods and raw materials for use by local industries to stimulate production and investment. The corresponding rates in Zambia were 15 percent and 20 percent. Tanzania also implemented much deeper cuts in excise tax rates. Upon hearing about the Tanzanian budget, business leaders in Zambia appealed to the Minister of Finance to match the zero duty and sales tax on capital goods and raw materials. They contended that Tanzania did this to help domestic producers, so Zambia should do the same. Economists in the Budget Office ran the proposal through a revenue estimation model based on import records and found that the measure would cost nearly one-sixth of total revenue. They replied to the Minister saying: Zambia cannot afford these tax cuts without jeopardizing the macroeconomic stabilization program. As it turned out, Tanzania couldn’t afford them either. The 1992/93 tax package led to a fiscal crisis, as revenue dropped to 11.5 percent of GDP, from 21 percent the previous year. Much of the decline was due to falling revenue from sales and excise taxes and import duties. The zero-rated import provisions not only caused revenue losses directly, but also created new avenues for tax evasion. Zambia did well to resist the pressure. SOURCE: Based on Fjeldstad (1995), Ministry of Finance, Zambia (1992) and author’s personal experience in the Ministry of Finance in Zambia, 1993. Another theoretical insight that strengthens the case for cooperation against tax competition is the concept of the “winner’s curse.” In any competitive bidding process there is a systematic tendency for the highest bidder to pay too much. Put simply, the highest bid tends to come from the contender with the most optimistic appraisal of the object of the bidding—whether it is a painting, a license for oil rights, or a footloose investment project. Applying this concept to the case of tax competition for investment, the “true” value of the project to the host economy is inherently uncertain. The most attractive tax breaks are likely to come from a jurisdiction that is overestimating the benefits. As a result, the net gain to the
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TECHNICAL REPORT Effectiveness and
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Contents Executive Summary xi 1. In
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Contents (continued) ILLUSTRATIONS
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Glossary ACT additional company tax
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Preface The Scope of Work (SOW) for
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PREFACE IX Export Development & Inv
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XII EFFECTIVENESS AND IMPACT OF TAX
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XIV EFFECTIVENESS AND IMPACT OF TAX
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XVI EFFECTIVENESS AND IMPACT OF TAX
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XVIII EFFECTIVENESS AND IMPACT OF T
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1. Introduction Why should schemes
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INTRODUCTION 1-3 well administered.
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INTRODUCTION 1-5 from selective to
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2. Taxation, Investment, and Growth
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TAXATION, INVESTMENT, AND GROWTH 2-
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3-2 EFFECTIVENESS AND IMPACT OF TAX
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3-4 EFFECTIVENESS AND IMPACT OF TAX
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R-4 EFFECTIVENESS AND IMPACT OF TAX
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R-6 EFFECTIVENESS AND IMPACT OF TAX
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A-2 APPENDIX The present investment
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A-4 APPENDIX Democratic Republic of
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A-6 APPENDIX Government revenue in
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A-8 APPENDIX income tax payable by
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A-10 APPENDIX (though they are obli
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A-12 APPENDIX • • • Asset All
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A-14 APPENDIX also get zero import
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A-16 APPENDIX EPZ measure was motiv
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Effectiveness and Economic Impact of Tax Incentives in the SADC ...

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