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

2-6 EFFECTIVENESS AND IMPACT OF TAX INCENTIVES IN THE SADC REGION
and the size of the local market. With so many factors at work, how important are the tax
considerations? To answer this question, it is helpful to identify the principal determinants of
investment by reviewing the economic theory of investment behavior.
TAXES IN THE THEORY OF INVESTMENT BEHAVIOR
A simple theory of investment postulates that the desired stock of capital for any firm is
proportional to the target level of output. Hence, the desired change in the capital stock each
year—that is, net investment 13 —is proportional to the expected change in output. It follows
that the ratio of net investment to GDP depends on the expected rate of GDP growth. 14 This is
called the “accelerator” model because it shows that investment rises when output growth
accelerates and falls when output growth decelerates (even if the growth rate is still positive).
In other words, an economy on a rapid growth path attracts a high rate of investment, while a
stagnant or shrinking economy offers no inducement for net investment aimed at the
domestic market. Of course, capital investment is itself a determinant of growth. Hence, we
have an interactive system that can create either a virtuous circle of high growth and high
investment, or a vicious circle of low growth and low investment.
A more realistic version of the model, called the “flexible accelerator,” recognizes that the
desired capital stock depends not only on output, but also on the user cost of capital (UCC), 15
defined below. In this model investment takes place as long as the value of the added output
from an investment exceeds the UCC—in other words, when the benefits exceed the cost.
From this basic condition one can readily incorporate tax considerations into the analysis. In
particular, tax elements heavily influence the UCC, which is the cost per year of deploying
capital in an investment project. Neglecting taxes for a moment, the UCC consists of three
elements:
•
•
The financial cost of funds tied up in capital goods. This cost depends on the price of the
capital good relative to output prices (PK), and the real (inflation-adjusted) cost of funds.
The cost of depreciation or wear-and-tear of the capital asset. This cost depends on PK and the
economic rate of depreciation.
13 Net investment (In) = total investment (It) – replacement investment (Ir), where Ir is the investment needed to
maintain the existing capital stock as it depreciates through wear-and-tear. In is therefore the net addition to
the capital stock. For simplicity, we focus on net investment in fixed business capital, and neglect replacement
investment as well as investment in inventory stocks and residential housing.
14 Let α represent the ratio of capital to output for the whole economy. Then:
K* = α Q*
In = ∆K* = α ∆Q*, where In is net investment
In/Q = α ∆Q*/Q = α x gQ, where Q is real GDP.
15 This presentation draws on Chirinko (1993), Mankiw (2002), Shome (1995) and OECD (2001a).