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

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4-4 EFFECTIVENESS AND IMPACT OF TAX INCENTIVES IN THE SADC REGION The reason empirical studies often measure the METR by estimating the UCC is that the data requirements are less formidable for this approach than for the alternative of computing rates of return directly. Even so, estimation of the UCC is no simple exercise. It requires, for a “typical” investment in each sector or category, obtaining data or estimates of the respective cost of borrowing, the required return on equity, the capital composition, and the financing structure, as well as estimates of the difference between economic and tax depreciation rates. 48 Policy studies (as distinct from empirical research) typically simplify the data problems by constructing representative examples of investment projects, rather than delving into microeconomic data sets. With this approach one can isolate the impact of various tax provisions by holding constant other factors that affect the METR. Using this approach, it is easy to calculate the METR because the examples are constructed to provide the information needed to compute rates of return before and after taxes. This is a very useful method for analyzing tax policies and comparing tax systems across countries. Exhibit 4-1 gives an example using a representative project to compare how the METR varies under different tax instruments. Starting with a statutory marginal tax rate of 35 percent, the example shows that the METR can vary from 11.1 percent to 45.6 percent depending on what tax incentives are in place. Of the options that were examined, the 20 percent investment credit has by far the largest effect, reducing the METR to less than one-third the statutory rate. Tax holidays have far less effect on the METR. Table 4-1 presents an international comparison of METRs using tax parameters for 1985. This analysis dramatically illustrates the difference between statutory and effective tax rates, as well as the large METR differences between debt and equity financing. For an investment financed entirely with equity (assuming 5 percent inflation), Portugal had a statutory rate of 40 percent and an METR of 45.5 percent. Guatemala had a higher statutory rate of 42 percent, but the METR was just 10.7 percent. With 50 percent debt financing the METR in Guatemala drops to 2.1 percent, compared to 28.7 percent in Portugal. 49 48 Data of this sort for all SADC countries were not available for the present study. 49 Inflation also has a big effect on the METRs (not shown in table). High inflation reduces the METR through the deductibility of nominal interest rates, but increases it through use of historical cost for depreciation, firstin-first-out inventory valuations, and lack of indexing of capital gains.
ECONOMIC TOOLKIT 4-5 Exhibit 4-1 How Different Tax Incentives Affect the Marginal Effective Tax Rate In an influential study for the World Bank, Pellechio, Sicat and Dunn (1987) calculated how different tax incentives affect the marginal effective tax rate (METR) for an illustrative investment project. The project consists of an equity-financed mix of machinery and equipment (40 percent), buildings (40 percent), vehicles and land (10 percent each). The marginal tax rate for company income is 35 percent, and a 10 percent duty is applied to imported capital goods, which account for 20 percent of the building cost and 75 percent of the cost of machinery, equipment, and vehicles. Each asset class is depreciated at a designated rate, and tax losses are carried forward. (Here, we examine only the case of straight-line depreciation.) If standard tax rates apply to the investment, then the METR is 45.6 percent. This means that the tax system reduces the rate of return on capital by nearly half. Here are some of the other results: Tax provisions METR 1. Standard case, with 35% tax rate 45.6 2. Five-year tax holiday 29.3 3. Eight-year tax holiday 23.2 4. 20% initial investment deduction 33.1 5. 20% investment tax credit (not refundable) 11.1 6. Exemption from 10% import duty on capital goods 37.0 The up-front investment tax credit has by far the most powerful effect in reducing the METR and therefore improving the incentive to invest. Tax holidays are much less effective. The exemption from import duty on capital goods has a surprisingly weak effect on the METR. This is because the example assumes that the duty rate is low, that nearly half the capital assets are not imported, and that the import duty is a deductible expense. With multiple tax incentives, the combined effects are not simply additive. For example, combining the 20 percent investment tax credit with the five-year tax holiday gives a METR of 9.4 percent, which is hardly different from the ITC effect itself. But interacting the five-year tax holiday with the import duty exemption provides much more relief than either instrument by itself; in this case the METR is 19.9 percent. A more complete analysis would show how inflation, debt financing, and other complications, including alternative specifications of the sample project, affect METR differentials. SOURCE: Pellechio, Sicat and Dunn (1987), in Bird and Oldman (1990).
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TECHNICAL REPORT Effectiveness and
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Contents Executive Summary xi 1. In
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Contents (continued) ILLUSTRATIONS
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Glossary ACT additional company tax
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Preface The Scope of Work (SOW) for
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PREFACE IX Export Development & Inv
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XII EFFECTIVENESS AND IMPACT OF TAX
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Page 25 and 26: 1. Introduction Why should schemes
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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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