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

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3-12 EFFECTIVENESS AND IMPACT OF TAX INCENTIVES IN THE SADC REGION Exhibit 3-3 Import Duties, Effective Rate of Protection, and Economic Efficiency The effective rate of protection (ERP) is a measure of the extent to which import duties affect the ability of domestic producers to compete against import competition. Consider a domestic firm that produces cooking oil worth P* per unit in the world market. If the import duty on cooking oil is to, then the firm can charge up Pd = P* (1 + to) and still compete against imports in the domestic market. Suppose the firm uses imported inputs that cost C* in the world market, bearing an average duty rate of ti . The cost of the inputs in the domestic market is then Cd = C* (1 + ti). This firm can meet or beat import competition as long as the margin between the output price and the cost of imported inputs does not exceed Pd – Cd = P* (1 + to) – C* (1 + ti). This is the domestic value added, or VAd. In the world market, competitive producers convert the same inputs into cooking oil at a value added margin of VAw = P* – C*. The ERP is defined as the difference between VAd and VAw, expressed as a fraction of VAw (the international standard): ERP = ( VAd – Vaw) / VAw = [P* (1 + to) – C* (1 + ti)] / [P*– C*] This ratio is called the effective rate of protection because it shows the extent to which domestic producers are protected, in the sense that they can operate less efficiently than international rivals and still compete in the domestic market. The level of the ERP depends on the duty rates on imported inputs and outputs, as well as the domestic content of the activity. Some representative calculations show how powerful the protection effect of tariffs can be: Domestic content Case 1 Case 2 (P*-C*)/P* to = 30%; ti = 10% to = 20%, ti = 5% 20% 110% 80% 40% 60% 43% 60% 43% 30% 80% 35% 24% 100% 30% 20% There are some remarkable lessons here. First, even moderate tariff differentials can shelter highly inefficient investments. Second, a large amount of protection can be delivered without reducing the import duty on inputs to zero. Third, protective tariffs selectively favor investment projects that have low domestic content; this distortion actually discourages the development of backward linkages The problem is not just that tax incentives may foster investments with low productivity, but that they tilt the playing field and draw resources away from other projects with higher productivity. Exhibit 3-4 provides an instructive example from a classic paper on tax policy in developing countries by Leechor (1986). The example shows how a plausible set of tax incentives can lead to an undesirable result, namely that the least productive projects have the highest after-tax rate of return, while the most productive projects become less attractive to investors.
ECONOMICS OF TAX INCENTIVES 3-13 Exhibit 3-4 Impact of Tax Differentials on the Allocation of Capital In an early paper on tax policy in developing countries, Leechor (1986) gave a simple numerical example to illustrate how tax differentials can distort the allocation of capital and reduce economic efficiency. The example involves projects in three sectors—A, B, and C. Each has an initial cost of 100 in year 0, financed entirely by equity, and a ten-year economic life with straight-line depreciation. The before-tax rates of return are • 20 percent for A, • 15 percent for B, and • 10 percent for C. In this example the company tax rate is a flat 50 percent on income net of depreciation. If all three investments faced uniform tax treatment, then the after-tax rates of return would preserve the order of profitability as indicated above. Sector A would be most attractive to investors. But sector B happens to benefit from a special 10 percent tax rate. And sector C has successfully lobbied for a 20 percent protective tariff on competing imports, which boosts the market price of the output and increases profit margins. These tax differentials invert the incentives facing investors. The after-tax rates of return are, respectively, • 11.0 percent for A, • 13.8 percent for B • 20.1 percent for C. Project A is the most productive use of capital resources, but the least attractive sector for investment due to the tax differentials. The tax system pulls capital to sector C, reducing overall productivity in the economy. Of course, this apparent “distortion” in the allocation of capital might be justified if sectors B and C generate large positive externalities or dynamic benefits to the economy. Is this so in the real world? Of course, this example begs the question of why a particular sector or activity is granted tax preferences. Recall that tax incentives can be used to enhance efficiency and growth by compensating for market failures such as positive spillover effects or underdeveloped capital markets. The fundamental issue is whether governments can and should use tax incentives as a tool for selective “industrial policy,” in the sense of subsidizing investments that may not be profitable in the short run but are expected to generate large dynamic benefits for the economy. Can governments “pick winners”? Does it make sense to shelter “infant industries”? This is not the place to discuss industrial policy in detail. Suffice it to say that even for countries such as Japan, Korea, and Taiwan, the efficacy of selective industrial policy is endlessly debated. Even experts who believe that government interventions have worked well in the Asian context generally concede that the outcome is due to special circumstances such as high-quality bureaucracy, a well educated labor force, and the linking of benefits to competitive success in export markets. 33 Most experts are reluctant 33 See Pack (2000); Pack and Noland (2003); Rodrik (1995); Roemer (1994); World Bank (1993); Porter (1998, pp. 656-675). A recent paper by Hausmann and Rodrik (2003) makes an interesting case for “spurring investment in non-traditional activities” where success can easily be copied. If the market can quickly replicate a successful product or technology, then the benefits of entrepreneurship are heavily diluted and the incentive
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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
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Page 25 and 26: 1. Introduction Why should schemes
Page 27 and 28: INTRODUCTION 1-3 well administered.
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Page 31 and 32: 2. Taxation, Investment, and Growth
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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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