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

ECONOMIC TOOLKIT 4-3
is also zero. With a well designed program the same incentive could be obtained without
foregoing all of the company tax revenue.
If we modify the example to include debt financing and deductibility of nominal interest
expenses along with 100 percent expensing of the capital outlay, then the METR becomes
negative. This is because the tax system reduces the real interest rate through interest
deductions, effectively subsidizing debt financing, and the project as a whole.
The tax wedge appears at two levels—one arising from taxes on the company, and a second
stemming from taxes on the remittance of earnings or capital gains to the owners. Thus, the
METR can be computed in terms of the returns seen by the company undertaking the
investment, or the owners of the company. The second approach gives a better indicator of
the impact of the tax system on investment decisions. But the METR computation becomes
more complicated, particularly if the investor is a foreign entity because the analysis must
then take into account a variety of interactions between host- and home-country tax laws. 47
Most empirical studies estimating the METR from microeconomic data rely on the familiar
proposition that profit-maximizing firms increase investment to the point where the after-tax
rate of return on capital equals the user cost of capital: RORat = UCC. By calculating the UCC
with and without tax adjustments (as defined in chapter 2) one obtains an indirect estimate of
the before- and after-tax rates of return on capital.
A striking result of such studies is that the METR can differ greatly from sector to sector, even
if all investors face the same tax regime, with no special tax preferences. The METR
differences reflect inherent biases in the basic tax code, as a function of the capital structure
(machinery, plant, vehicles, land) and financial structure (debt versus equity), among other
things. For example, the World Bank (1988, 92) reports on a study in Malawi which showed
that the METR in 1984 varied from 47 percent to 67 percent despite a uniform statutory tax
rate of 50 percent. The variations depended on whether an investment was in manufacturing
or not, and whether the capital assets were short- or long-lived. Similarly, Chua (1995) cites a
Canadian study which found that the METR for investment in machinery in the mid-1980s
ranged from 0.4 percent in agriculture and 7.6 percent in manufacturing to 31.6 percent in
utilities. A study by Broadway et al. (1995) found that METRs in Malaysia in 1993 varied by
more than ten percentage points depending on the sector of activity and whether the projects
were financed by bonds or retained earnings. These figures show that tax policy imposes a
strong bias on investment patterns even in the absence of selective tax breaks.
47 There are many variations to take into account, including home country provisions for tax paid in overseas
operations, the presence of double tax agreements and tax sparing agreements, company options for
deferring repatriation of earnings, and whether the company has an excess or deficit of foreign tax credits on
a worldwide basis. These complications go beyond the scope of the present study. See OECD (2001) and
Slemrod (1995) for more details.