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

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3-6 EFFECTIVENESS AND IMPACT OF TAX INCENTIVES IN THE SADC REGION • • 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.
ECONOMICS OF TAX INCENTIVES 3-7 • • As is well known, this problem can be remedied by a “tax sparing” agreement, in which the source-country allows investors to pocket the benefit from host-country tax incentives. The United States is not in the practice of approving tax sparing agreements, and the OECD (1998b) has cautioned members against extending this privilege. 29 The problem of reverse foreign aid is also mitigated to the extent that investors postpone the remittance of income to the home country by one technique or another. In general, the interaction between host- and home-country tax codes is a very important consideration for investors. Hence, the effectiveness and the revenue impact of a tax incentive program may vary depending on the origin of an investment. Indirect revenue costs: Even if investments that benefit from special tax breaks are fully additional and redundancy is zero, significant revenue losses may occur indirectly. This occurs if the tax-favored activities undercut the profitability of other producers who do pay taxes. A classic example is where companies in operating in an export processing zone serve as a conduit for smuggling, which reduces the income of competing domestic producers. 30 Indirect revenue losses also arise where producers with tax preferences bid away customers, skilled labor, or raw materials from other producers who pay full tax. An excellent example arose several years ago at a business-government conference, when the president of one SADC country assured a foreign banker that his company would get a 10-year tax holiday for an investment of $10 million. By law, this tax holiday required that certain procedures be followed. But senior tax officers balked when they were instructed to process the President’s verbal commitment. They pointed out that the tax holiday would give the new bank a huge cost advantage over all of the existing banks, which were among the largest taxpayers in the country. It did not make sense, they argued, to subsidize a new non-taxpayer to siphon business away from existing taxpayers. Ultimately the tax-incentive was not rewarded—and the bank came in anyway with a $10 million investment. 31 2. Revenue Leakage through Avoidance and Evasion. Revenue losses can increase many-fold through an entirely different channel. Tax incentives often create opportunities for businesses and individuals to engage in “aggressive tax planning”—a polite term for tax avoidance. It is instructive to cite a few examples of how tax planning can convert well-intended incentives into a revenue drain. Company “churning.” An existing company (A) can close down all or part of its operations and establish a “new” company (B) that qualifies for a full tax holiday. In the investment 29 The OECD case against tax sparing is that such agreements “provide significant scope for tax planning and avoidance both in the country of the investor and in the country of the investment.” Also, tax sparing agreements favor the remittance of profits over reinvestment in the host country, and encourage short-term investments. 30 A recent New York Times article about customs reform in Mexico cites a government investigation which found that half of all registered maquiladora companies “were fronts for illegal imports” that have been flooding the informal market and strangling domestic producers who pay tax. Source: “Mexico is Making Headway Against Smuggling,” NYT, June 5, 2003, page W1 and W7. 31 Source: Author’s personal observation while working in the country in question.
Page 1: TECHNICAL REPORT Effectiveness and
Page 5 and 6: Contents Executive Summary xi 1. In
Page 7 and 8: Contents (continued) ILLUSTRATIONS
Page 9 and 10: Glossary ACT additional company tax
Page 11 and 12: Preface The Scope of Work (SOW) for
Page 13: PREFACE IX Export Development & Inv
Page 16 and 17: XII EFFECTIVENESS AND IMPACT OF TAX
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Page 25 and 26: 1. Introduction Why should schemes
Page 27 and 28: INTRODUCTION 1-3 well administered.
Page 29 and 30: INTRODUCTION 1-5 from selective to
Page 31 and 32: 2. Taxation, Investment, and Growth
Page 33 and 34: TAXATION, INVESTMENT, AND GROWTH 2-
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ECONOMICS OF HARMFUL TAX COMPETITIO
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7. Tax Systems and Tax Incentives i
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TAX SYSTEMS AND INCENTIVES IN THE S
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Table 7-5 Elements of Tax Structure
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Table 7-5 (continued) Sheet 3 of 4
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Notes a Mozambique information Coun
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8. Conclusions and Recommendations
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CONCLUSIONS AND RECOMMENDATIONS 8-3
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R-2 EFFECTIVENESS AND IMPACT OF TAX
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A-2 APPENDIX The present investment
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A-4 APPENDIX Democratic Republic of
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A-6 APPENDIX Government revenue in
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A-8 APPENDIX income tax payable by
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A-10 APPENDIX (though they are obli
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A-12 APPENDIX • • • Asset All
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A-14 APPENDIX also get zero import
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A-16 APPENDIX EPZ measure was motiv
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