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

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5-6 EFFECTIVENESS AND IMPACT OF TAX INCENTIVES IN THE SADC REGION Capital Recovery Incentives--Accelerated Depreciation and Initial Capital Allowances Accelerated depreciation front-loads the capital allowance for tax purposes, relative to the economic rate of capital consumption. The true pattern and rate of depreciation is not generally known, so any designated depreciation schedule is somewhat arbitrary. The most common form is straight-line (SL) depreciation over a plausible number of years for each class of assets. Hussey and Lubick (1996) propose the declining balance method (DBM) as the standard in their model tax code, at annual rates ranging from 5−25 percent. 67 A write-off faster than the DBM can be regarded as an incentive, albeit a moderate one because it affects only the timing of cost-recovery, not the amount. Initial capital allowances (ICAs) are special capital write-offs that enhance cost-recovery at the start of a project. The ICA is a percentage of the asset cost that can be written off in the first year (or the first few years). Sometimes the initial write-off involves a corresponding reduction in the basis for depreciation. In other systems the ICA is an extra or additional allowance, over and above full depreciation of the capital asset. This case is equivalent to a subsidy on the purchase price of the capital. The value of an incentive in the form of a capital allowance depends how the exact specification of the tax provision, other aspects of the tax law, and characteristics of each investment. For example, this type of benefit has little value to an investment that would show large tax losses anyway in the early years, unless the losses can be used to offset income from other related sources. Capital allowances therefore favor projects undertaken by existing businesses. Nonetheless, generous investment allowances can strongly reduce the METR on new investments. In particular, an initial allowance of 100 percent—full expensing—can reduce the METR to zero for an equity-financed investment, and less than zero for a debt- financed project, if interest payments are deductible. 68 For most capital-recovery incentives the revenue cost is fairly moderate. Under full expensing, the revenue loss is the tax rate times the difference between the allowable capital cost and the present discounted value of normal depreciation allowances. For large projects this can represent a significant amount of tax money, but it is nonetheless a limited amount of exposure for the Treasury. Capital recovery incentives are relatively simple to administer. However, serious problems can arise if companies abuse the incentives through sham sale and re-purchase of assets, or channeling asset purchases through qualifying companies on behalf of non-qualifying 67 Specifically, they propose annual capital consumption allowances of 5 percent for buildings and structures; 25 percent for automobiles and light trucks, office equipment and computer systems; and 15 percent for all other tangible property. 68 A negative METR means that the after-tax return is higher than the before-tax return. In the case cited here, full expensing reduces the METR to zero and the interest deduction provides a further advantage by lowering the cost of borrowed funds.
DESIGN OF INVESTMENT TAX INCENTIVES 5-7 partners. On this point, Exhibit 5-1 presents an interesting cautionary tale based on experience in India. Exhibit 5-1 A Cautionary Tale from India The tax code in India has included initial capital allowances since 1945. Since 1955, the investment allowance also included a “development rebate” for strategic industries, giving a total write-off of 125 percent of capital expenditure. These provisions were introduced to offset the disincentive effect on investment stemming from high income tax rates and the distortion created by lack of an inflation adjustment in computing the basis for depreciation. The investment allowances were modified many times over the years until 1990, when they was discontinued altogether in favor of a reduction in the basic company tax rate from 52.5 percent to 43.2 percent. At the same time depreciation rates were reduced. Underpinning this decision was a detailed empirical study using microeconomic tax data, showing that the capital allowance increased investment by less than 2 percent, while reducing corporate tax revenue by approximately 13 percent. Most benefits went to major corporations that did not require tax breaks to finance investment. Furthermore, litigation and political pressure had widened the scope of the incentive program far beyond the strategic sectors originally intended. SOURCE: Modi (2003) Worse, tax audits uncovered many allowance claims “which were patently untenable.” Nearly 25 percent of the investigated claims were at least partially disallowed.* In the years after 1990, private corporate investment in plant and equipment more than doubled as a percentage of GDP. The Government of India concluded that the “investment allowance was an inefficient method of achieving the objective of enabling internal accrual of resources for replacement and modernization.” In 2002 a government task force on direct taxes considered and rejected appeals by industry for re-introduction of investment allowance, favoring instead a further reduction in the basic company tax rate to 30 percent. * The government introduced a special 100 percent depreciation deduction for windmills in 1996, as part of a new energy policy. One result (perhaps the main one) was to stimulate thousands of false claims for the windmill deduction, which demanded considerable administrative resources to challenge. Source: Personal communication with Sebastian James, Department of Revenue, Government of India. Turning to the impact on economic efficiency, the main problem with special investment allowances is that their value is a function of the amount of capital goods being purchased. Consequently, these incentives bias investment decisions in favor of capital-intensive rather than labor-intensive products and processes—which is antithetical to the usual goal of job creation. The incentives also favor short-lived investments and early scrapping of existing capital assets. If the magnitude of the tax break is moderate, then the biases will not be very large. Also, accelerated depreciation can be used to correct (crudely) for a tax bias in the opposite direction caused by inflation, in systems where depreciation is based on historical
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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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XIV EFFECTIVENESS AND IMPACT OF TAX
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XVI EFFECTIVENESS AND IMPACT OF TAX
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XVIII EFFECTIVENESS AND IMPACT OF T
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1. Introduction Why should schemes
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INTRODUCTION 1-3 well administered.
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INTRODUCTION 1-5 from selective to
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2. Taxation, Investment, and Growth
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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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Effectiveness and Economic Impact of Tax Incentives in the SADC ...

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