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

4-8 EFFECTIVENESS AND IMPACT OF TAX INCENTIVES IN THE SADC REGION
Exhibit 4-2
METR Model of Dunn and Pellechio
The marginal effective tax rate (METR) on an
investment project can be quite different from the
statutory tax rate on company income, depending
on many provisions of the tax system, the incentive
regime, and the characteristics of each project. The
METR analysis used in this study is an Excel
spreadsheet model developed by Dunn and
Pellechio (1990). The model allows the user to
investigate how alternative tax policies affect the
real rate of return on investment for a wide variety
of tax parameters and types of investment.
Specifically, the user defines a scenario by
setting parameter values for an array of tax policy
instruments including the corporate and personal
income tax rates; the tax rate on dividends and
capital gains; the capital allowances; the extent and
duration of any tax holidays; the availability of
investment tax credits; the tax on imported capital
goods; as well as provisions for loss carry-forward,
loss offset, and indexing, among other fine points.
In addition, the user specifies the physical
composition of the investment project, the financial
structure, the inflation rate, and the interest rate. A
large side table displays in full detail the various
calculations that determine the Before Tax Cash
Flow and After Tax Cash Flow, for up to 30 years.
Careful appraisal of the cash flow table allows the
user to develop a close understanding of the subtle
interactions between various tax parameters. For
example, one can see exactly how a final
withholding tax on dividends or a heavy tax on
capital gains may offset much of the intended
advantage of granting a tax holiday.
The utility of the model lies in its flexibility and
simplicity in allowing the user to specify and
evaluate a wide variety of alternative situations.
The model, however, should not be used
mechanically. Notwithstanding all of its detail, the
model says nothing about how firms might modify
their behavior in response to changes in the tax
system. The METR model simply enables the user
to get a fairly complete picture of how alternative
tax policies affect the incentive to invest, given any
particular project structure.
The METR analysis is an excellent tool for assessing the tax wedge, but it does not provide
information about how tax breaks will spur investment. If tax reforms or new tax incentives
reduce the METR from 40 percent to 20 percent, will that have a large effect on the volume of
investment, or hardly any? If non-tax elements of the investment climate are in poor shape,
there may be few investments forthcoming even if the METR is very low. And a high METR
may have no impact on investments that have very attractive fundamentals, such as major
petroleum projects. In other circumstances, many investors may be considering projects
where expected returns are close to the hurdle rate; if so, then a high METR will cut them out,
and a low METR will bring them in.
Another caveat is that the METR analysis does not capture slippage in the enforcement of tax
laws. In circumstances where tax administration is arbitrary, ineffective, or corrupt, or where
businesses routinely find ways to misuse investment incentives to shelter other income from
tax, then investors the formal provisions of the tax law may have little meaning. In these
conditions, the METR analysis does not reveal much about the effect of the tax system on
investment incentives.