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

TAXATION, INVESTMENT, AND GROWTH 2-7
• Any change in the relative price of capital goods, due to changing market conditions. This
enters the picture because gains and losses on holding physical assets clearly affect the
returns.
Taxation enters the UCC through three channels:
Company tax rate (u). From the point of view of the investor, the effective return on
capital is diminished to the extent of tax due on company income.
Tax incentives. The cost of paying company tax is offset by any benefit which may accrue to
the investor from tax incentives such as tax holidays, preferential tax rates, investment credits,
or capital allowances in excess of economic depreciation. These benefits arise at different
points in time and vary year to year. To handle this complexity, the standard approach is to
take the present discounted value of the tax benefits, per unit of the investment outlay.
Tax treatment of the cost of funds. Investment can be financed by equity or debt. 16 Hence,
the overall cost of funds depends on both the real interest rate on debt financing and the risk-
adjusted real rate of return required by shareholders who provide equity financing. The real
cost of debt financing (rd) is the nominal interest rate (i) less the rate of inflation (π). Since
nominal interest payments are deductible in most tax systems, the after-tax real cost of debt
financing for the firm is rd = (1 – u ) i – π. Now let re represent the risk-adjusted real rate of
return required by shareholders. If the company and personal tax codes are integrated to
avoid double taxation of dividends, as in Botswana, then re is the effective cost of equity
financing facing the firm. However, if a separate tax is imposed on dividends at the rate td,
then shareholders require a higher tax-inclusive return on equity, namely (1+ td) re. The overall
cost of funds is then a weighted average of these two elements.
In this framework, investment takes place as long as the gross return on additional
investment exceeds the tax-adjusted user cost of capital. In effect, the hurdle value of VMPK
rises with the company tax rate and the tax on dividends, and falls with the value of the tax
incentive package.
A higher user cost of capital reduces the set of viable investment projects. It also provides an
incentive for companies to pursue more labor-intensive projects. Conversely, a lower UCC
expands the set of viable investment projects, and favors capital-intensive projects. Note that
the net impact of tax breaks on job creation is ambiguous, since the changes in investment and
labor intensity work in opposite directions.
The theoretical effect of taxation on investment is mediated by three other considerations.
First, the gestation period for many investments may span several years, particularly for large
projects. So there can be substantial lags before tax policies to stimulate investment have an
16 A third major source of finance, retained earnings, is omitted at this point for simplicity.