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

DESIGN OF INVESTMENT TAX INCENTIVES 5-11
zero duty rate is offered as a general incentive, or only to qualified investors. In the first case
the revenue loss can be very high, especially in developing countries where most capital
goods are imported.
Cutting the duty on capital goods (relative to other imports) creates significant economic
distortions. Most important, it biases resource allocation by favoring capital-intensive
investments over those that use labor more intensively. This incentive also hinders the
development of a domestic capital goods industry because the benefit is tied to the use of
imported capital goods. Domestic machine tool producers often face negative effective protection
as a result of this policy because they pay duty on some of their inputs while trying to
compete against duty-free imports.
Differences in import duty rates create administrative problems as well. Importers have
strong incentives to misclassify shipments as capital goods. Besides, many capital goods have
dual use as consumer goods; without adequate controls, investors can import the goods duty
free and flood the consumer market with products that have escaped tax. 75 In cases where the
low or zero duty rate applies selectively, the beneficiary may be limited to a pre-approved list
of imported capital goods. This approach limits abuse, but at the expense of adding red tape
and administrative controls.
Some countries also reduce the import duty on raw materials and intermediate goods as an
additional investment incentive. If all producers in an industry rely on imported inputs to a
similar extent, then the cost reduction from this measure generally accrues to consumers in
the form of lower product prices. There is no ultimate improvement in the rate of return for
investors. 76 The measure could make a difference if some producers use imported inputs to
compete against others who use domestic supplies. But in this case the impact is perverse: the
tariff reduction creates a disadvantage for the producers who use domestic supplies—which
is probably not what the policymakers had in mind.
Protective Tariffs
As shown in Exhibits 3-3 and 3-4, protective tariffs can be highly effective in drawing
resources into import-competing production activities. In years past, steep tariff barriers were
a common feature of the policy landscape in most developing countries. However, this
strategy usually ended up breeding highly inefficient investments, at a high cost to domestic
consumers. With few exceptions, highly protective tariffs have proved to be a losing strategy
75 For example, an agricultural investor in Mozambique who was entitled to duty-free capital goods imports
tried in 2001 to bring in hundreds of refrigerators and washing machines, claiming that they were needed for
the farm workers. Their claim was denied by customs authorities, but not without public controversy.
76 One often hears that this measure assists liquidity-constrained enterprises by improving their cash flow.
There is much less to this argument than meets the eye. Suppose that (a) the tax rate on imported raw
materials and intermediate goods is 15 percent; (b) these inputs represent 60 percent of total costs; (c) the
nominal interest rate is 30 percent; and (d) the average turnover period is 6 weeks. Then even a total
remission of the import duty will reduce costs by just 0.3 percent, relative to the ex-factory product price.