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

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