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

3-6 EFFECTIVENESS AND IMPACT OF TAX INCENTIVES IN THE SADC REGION
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example of redundancy is a resource-based investment such as diamond mining projects in
Botswana or titanium mining projects in Mozambique. As long as the projects are
fundamentally viable, tax incentives are redundant. The investors cannot simply pull up
stakes and shift their operations to Costa Rica or Bangladesh.
Partial redundancy: In some cases tax incentives may be essential to attract a particular
investment, but the benefit package is more generous than necessary. The incentive is then
partially redundant, and a portion of the tax break is a genuine revenue loss to the treasury. 27
For example, consider a project with a hurdle rate of 25 percent and a prospective rate of
return before tax of 34 percent. If the tax rate is 35 percent, then the after-tax rate of return is
just 22 percent. Under the normal tax system, the project will not be implemented.
However, if the investor were offered a 10-year tax holiday that boosts the net return to,
say, 30 percent, then the project would go ahead. But this tax holiday actually pushes the
return well above the hurdle rate of 25 percent. The project would be viable with a tax
break less than half this large. So more than half of the benefit is redundant.
In real-world situations, governments do not have inside information about the investor’s
hurdle rate or expectation of profitability. So it is very difficult to judge whether a given
incentive is essential, redundant, or partially redundant. An interesting example arose in
Mozambique in 1997−1998 when the government was negotiating fiscal benefits for the $1.3
billion Mozal aluminum smelter project. There is widespread agreement that large tax
incentives were essential for landing this huge strategic project. Yet there has also been
much debate about whether the deal was too generous. Mozambique did not offer a zero
tax rate. Rather, Mozal was subject to a 1 percent tax on gross export revenue. 28 If a zero
rate was not needed for Mozal, then it is not needed for most other investments. As a rule, a
zero tax rate entails an unnecessary loss of revenue.
“Reverse foreign aid”: This case arises when the investor originates from a country such as
the United States, Japan, or the United Kingdom, which taxes worldwide income upon
repatriation, subject to a tax credit for the imputed tax obligation to the host country. Under
these conditions a tax break in the host country—or a tax rate below that in the investor’s
home country—is simply offset by additional tax payable in the source country. The tax
incentive may have no effect on the investment decision. This situation is called “reverse
foreign aid” because the host-country treasury is effectively giving money away to the
source-country treasury.
27 The impact of a tax incentive offered by the host country also depends on whether its basic company tax rate
exceeds that of the source country, the technical specification of the tax incentive, whether the company has
excess foreign tax credits on its worldwide income, and source country provisions for Controlled Foreign
Corporation treatment of earnings retained offshore. See Slemrod (1995) for a careful explanation of the hosthome
country tax linkage.
28 This device not recommended for general application because the effective tax rate varies unpredictably
from year to year and from company to company depending on the profit margin. If profits are 20 percent of
sales, a 1 percent turnover tax is equivalent to a 5 percent tax on profit. If profits are higher the effective tax
rate is lower, and vice versa. This is not a sensible system.