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

DESIGN OF INVESTMENT TAX INCENTIVES 5-5
Preferential tax rates are more distortionary than overall rate reductions because they bias
investment incentives. As shown in Chapter 3, resources are attracted to projects in the
favored sector even when they have a low rate of return. This reduces overall productivity of
the economy, unless the designated beneficiaries, on the whole, yield substantial positive
externalities or dynamic benefits. That is always the wish, but rarely the outcome. At the same
time, a preferential tax rate is less distorting than many other forms of tax incentive because it
does not bias the choice of factor intensity or other technical decisions.
Tax Holidays
A tax holiday is a preferential tax rate with a limited duration (often five years). Tax holidays
are surprisingly popular in developing countries, considering how harshly they are criticized
by tax specialists.
The revenue loss from a tax holiday depends on multiple factors, including the size and scope
of the tax break, the length of the holiday period, and characteristics of each investment
project. A zero rate over a long period obviously entails a maximum revenue loss. As with a
preferential tax rate, the value of a holiday is greatest for projects that are highly profitable—
which are most likely to go ahead even without the tax break. Thus, tax holidays are often
redundant to the investment decision (though happily accepted by the investor).
The administrative impact of a tax holiday is mixed. Many countries do not require the
beneficiary to file returns during the holiday period, which simplifies tax administration. But
there are offsetting considerations. First, the grant of a tax holiday almost always requires
administrative screening, which can be cumbersome. Second, tax holidays are custom-made
for aggressive tax planning to shelter income from other operations of a parent company.
Preventing abusive accounting requires vigilant and highly skilled tax administration. To
reduce the scope for abuse, firms should be required to file returns during the holiday period;
this is also useful for monitoring the respective tax expenditures. Filing during the holiday
period is costly because it absorbs administrative skills without directly generating revenue.
But if returns are not filed, then difficult transitional problems can arise at the end of the
benefit period. Also, many countries have bitter experience with companies that jump in to
take advantage of a tax holiday and then shut down at the end of the holiday period.
In terms of economic efficiency, tax holidays bias the allocation of resources toward the
favored sectors and regions. This can be bad or good depending on the quality of the
screening criteria. In addition, tax holidays systematically favor investments that are fast-
starting, short-lived, and easy to shut down, as well as projects with low capital intensity and
low debt costs, which are more likely to generate taxable income during the years covered by
the holiday. In contrast, tax holidays are of little value to long-term, capital-intensive projects
with long gestation periods, which normally show a tax loss anyway in the early years
because of heavy capital allowances.