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

2-10 EFFECTIVENESS AND IMPACT OF TAX INCENTIVES IN THE SADC REGION
A major review of the literature on investment behavior a decade ago, by Chirinko (1993),
reported that variables reflecting the UCC, which includes tax effects, had only a small effect
on investment. In contrast, output variables had a large effect, in line with the accelerator
model discussed above. But Chirinko also concluded that investment models in general
produced weak results. Most of the studies examined in this survey used macroeconomic data
for estimating investment functions. Perhaps the most important lesson from this early work
is that one does not get strong and consistent results about investment behavior from
macroeconomic models.
To overcome this problem many researchers have begun to use microeconomic data, which
produces a far larger sample size and more discerning statistical tests. These papers generally
find that variables reflecting the UCC, including tax effects, are statistically significant and
quantitatively important as determinants of investment. Zee et al. (2002) cite several estimates
of the elasticity of investment with respect to the UCC in the range of -0.5 to -1.0. This means
that a 10 per cent reduction in the UCC, due to lower financing costs or tax benefits, tends to
increase investment by 5-10 per cent. This is a large impact. 20 Looking more specifically at
evidence for developing countries, however, the same paper reaches the following conclusion:
The main messages of this research are that tax incentives can stimulate investment,
but that a country’s overall economic characteristics may be more important for the
success or the failure of industries than any tax incentives package; and even if tax
incentives stimulate investment, they are not generally cost effective. 21
Here the statement that incentives are not “cost effective” means that the amount of
additional investment is less than the estimated revenue loss. In this sense, cost-effectiveness
appears to vary widely by the type of investment and by the tax instrument used (Shah 1995).
General tax reductions appear to be less cost-effective than incentives tied directly to new
investment because a large part of the revenue loss in the former case benefits existing capital.
Also, R&D investment appears to be more sensitive to tax incentives than other types of
investment.
Numerous studies focus on the determinants of FDI, in particular, using firm-level data or
international cross-section and time-series data. Much of this research finds significant effects
of both host-country and home-country tax parameters. Also, FDI seems to be getting more
tax-sensitive over time as capital has become more mobile and production more global.
Bear in mind, though, that the data and the results are dominated by FDI flows between
industrial countries. As OECD countries have become more homogenous in infrastructure,
returns from investment, or high trade taxes that distort the trade regime, or simply the presence of a large
and intrusive government sector.
20 In a widely cited study of FDI determinants, which focuses on corruption, Wei (2000) finds highly significant
effects of both the statutory tax rate and the average effective tax rate. His famous conclusion: “An increase in
corruption from the Singapore level to the Mexico level would have the same negative effect on inward FDI
as raising the corporate income tax rate by eighteen percentage points.”
21 Zee et al., 2002, p.1508