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

4-2 EFFECTIVENESS AND IMPACT OF TAX INCENTIVES IN THE SADC REGION
18 percent after tax. From the equation: METR = (30-18)/30 = .40, or 40 percent. The METR of
40 percent indicates that the tax system diminishes the real rate of return by 40 percent (in this
case 12 percentage points are lost out of 30).
The METR shows how much the tax system distorts investment incentives by driving a
wedge between the underlying profitability of a project and the after-tax return to the
investor. The METR can be compared across projects, sectors, and countries. The larger the
METR, the bigger the tax wedge. Differences in the METR reveal tax-induced biases in the
incentives that drive the allocation of productive resources. In some cases the biases are
deliberate aims of policy, such as preferences for agriculture or manufacturing. In many cases,
however, the biases are unintended consequences of the tax system.
The tax wedge is normally positive, but it can be zero or negative. An interesting example of a
METR = 0 is the case of full first-year expensing of capital costs that are financed entirely with
equity. To see this, consider the case where the before-tax rate of return on investment is
expressed as follows:
RORbt = Present discounted value of annual net earnings = PDV(E) (4.2)
Capital expenditure K
The company tax at rate u reduces the numerator to (1–u) * PDV(E), but full expensing
reduces the effective cost of the capital expenditure to (1–u) * K. 46 Hence, the after-tax rate of
return is
RORat = (1 – u) PDV(E) = PDV(E) = RORbt (4.3)
(1 – u) K K
which implies that METR = 0 despite the positive tax rate. In this case, the government shares
equally in the capital outlay (by allowing a full deduction for the expense) and the annual
profit (through the tax itself). Consequently, the tax system does not affect the rate of return
for by the investor or distort the incentive to invest. Note that government revenue is positive
in this case as long as the project is profitable—that is, as long as PDV(E) > K. Thus, METR=0
need not mean zero tax revenue. It simply indicates that the revenue is derived in a manner
that does not distort investment incentives.
Several SADC countries have adopted tax incentive programs that achieve METR = 0 simply
by exempting projects from tax. But in this case, the company revenue yield from the projects
46 Technically, this expression requires that tax losses can be claimed in cash or offset against earnings from
other activities in the year they accrue, rather than being carried forward. The simple formula given here also
assumes that: the capital outlay is completed in year 0; there is no tax on dividends; tax depreciation equals
economic depreciation; there is no import duty on capital goods; and there is no tax on capital gains (or no
capital gain to tax).