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

2-8 EFFECTIVENESS AND IMPACT OF TAX INCENTIVES IN THE SADC REGION
actual impact. (Still, policy changes that worsen profitability may provoke an immediate
cessation of planned investments.)
Second, recent models that highlight the effect of uncertainty show that investors may defer
projects even if they are fundamentally viable. Faced with substantial uncertainty about
economic stability or the sustainability of pro-investment policies, along with irreversible
start-up costs, investors may choose to wait and see how events unfold before committing
funds. Implicitly, they demand a higher hurdle rate consisting of the standard UCC plus the
value of the “option to wait.” 17 The result may be a very sluggish investment response. The
antidote is to reduce uncertainty by establishing a track record of dependable policy
management and political stability.
Third, liquidity constraints and imperfections in the financial markets can enhance the
effectiveness of tax cuts. The neoclassical model assumes that investors have access to debt
and equity financing at a market-determined cost of funds (adjusted for risk). This is a
reasonable assumption for large multinational companies. But for many companies the main
source of funds for investment is retained earnings. In this case, tax cuts can foster investment
by augmenting the company’s net cash flow, providing the means to take advantage of viable
investment opportunities that otherwise would be missed for lack of finance.
ROLE OF INDIRECT TAXES
How do indirect taxes such as import duties and VAT enter the theoretical analysis of the
investment decision? The usual premise is that a uniform tax on production or sales does not
substantially affect investment incentives because it is largely passed along to final consumers
in the form of higher product prices. However, investment behavior can be strongly
influenced by differential indirect taxes which fall on some activities more than others. For
example, the common policy of imposing lower import duty on inputs than on outputs
enhances the profitability of import-substitution activities, stimulating investment that would
otherwise not be profitable or sustainable. (Chapter 3 discusses the economic efficiency cost of
this investment promotion policy.)
Another important indirect tax issue is the imposition of import duty or tax on the purchase
of machinery and equipment. If this tax (tK) were fully passed along to consumers, then it
would not significantly affect the profit maximization decision of investors. But it might not
be passed through fully if the duty on competing imports of final products remains
unchanged, or if competing producers use more labor-intensive production processes and
therefore pay less of this tax. In these cases, competition constrains the output price, so the
producer would bear the cost of the indirect tax. The price of capital goods in the model rises
from PK to (1 + tK) PK. By increasing the price of capital goods, the indirect tax on machinery
17 See Hubbard (1994) for an excellent review of these “real option” models.