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

3. Economics of Tax Incentives: Pros
and Cons
Chapter 2 tested the dual premise that tax incentives stimulate investment, and that higher
investment leads to more rapid growth and development. On both points, the conclusion is:
sometimes so, but it depends on the circumstances. Tax incentives can stimulate investment,
particularly for projects that could be viable in several alternative locations where non-tax
conditions are reasonably similar. But non-tax factors determine the viability of most projects
and dominate most investment decisions. Tax considerations are not decisive for most
investments. And if tax breaks cause fiscal problems that worsen other elements of the
investment climate, then the net effect on investment may even be negative. On the second
premise, capital investment is indeed a major source of growth. But the productivity of
investment is at least as important. Incentive policies that encourage investments with low
productivity can backfire and have an adverse impact on growth. In this chapter we address
not only the effectiveness of tax incentives but also their broader economic impact, in the
course of summarizing arguments both for and against incentives.
3.1 Ten Arguments in Favor of Investment Tax Incentives
The following propositions are reasonably familiar and well understood by most stakeholders
in the policy debates. Hence, they do not require elaborate explanation.
1. Higher Profits. Measures that reduce the tax imposed on income from capital leave
investors with a higher net rate of return. This translates directly into greater incentives for
investment, and (hopefully) more investment.
2. Positive Externalities. Modern growth theory highlights the importance of positive
spillover effects from the accumulation of knowledge and innovation. The benefits are often
embodied in new capital investment, investment in research and development, and training
associated with new investment, especially for export projects or investments that help to
develop networks or clusters as centers of excellence. If spillover effects are significant, then