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

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6-4 EFFECTIVENESS AND IMPACT OF TAX INCENTIVES IN THE SADC REGION Community is prepared to pursue full tax harmonization, Member States cannot be expected to “avoid” all such “prejudice.” Is there a more operational way to deal with the real problem of inefficient investment diversions due to tax competition in the region? This question can best be answered after examining some pertinent theoretical concepts. 6.2 Theory of Tax Competition 82 A starting point for examining the theory of tax competition is a pioneering model of inter- jurisdictional tax differentials known as the Tiebout hypothesis. For a decentralized fiscal system, Tiebout postulated that tax competition promotes efficiency by allowing states or localities to cater to different tastes of citizens for taxation and the provision of public goods. Some jurisdictions will choose low taxes and limited public services, while others choose high taxes and more extensive public services. Within a union, individuals can then “vote with their feet” by moving to a jurisdiction that suits their preferences. In the Tiebout model, tax differentials are fundamentally benign. In the international context, individuals cannot so easily move to a compatible fiscal regime. Yet the model aptly describes the fact that some governments choose to restrain the tax burden while others adopt high-tax, high-expenditure outcomes to suit the preferences of their constituents. Equally, jurisdictions differ legitimately in their preference regarding the structure of the tax system. Some countries depend more heavily on consumption-based taxes, while others place more weight on income taxes. Moreover, inter-jurisdictional competition can be a positive force for encouraging tax reform and improving efficiency in the administration of public services. Although it is useful to recognize the healthy side of tax competition, this view obviously omits considerations that lie at the heart of the debate about harmful tax practices. The decision by one state to pursue a low-tax strategy creates fiscal externalities for other jurisdictions. These include 83 • Factor movements to the low-tax state (LTS), which erode the tax base in the high-tax state (HTS). Even if HTS offers better public services overall, the additional expenditure may fall in areas (such as social services) that appeal to voters but not to potential investors. If so, the service differentials will not compensate companies for the higher tax rate. Thus, investment, jobs, and taxable income will shift to LTS. 82 This section draws on the survey by Lemgruber (1999). 83 This is only a partial list. Gordon (1983) identifies six inter-jurisdictional tax interactions in a non-cooperative equilibrium, including the first two above plus equity effects, congestion effects, effects from changes in consumption patterns, changes in the cost of public goods, and changes in the terms of trade (relative prices) between jurisdictions.
ECONOMICS OF HARMFUL TAX COMPETITION 6-5 • The fiscal regime in LTS can constrain HTS to reduce its own tax rates in order to stem the loss of capital. Even if the tax base is fixed, revenues will be lower than in the unconstrained political equilibrium and the supply of public services will be suboptimal. Alternatively, HTS could maintain the level of public services by increasing other taxes, but this approach creates adverse effects in terms of equity and efficiency. • Companies that operate in both states can arbitrage the tax differential by using intracompany transactions and charges to shift income into LTS, at the expense of HTS. Thus, competition from the LTS causes a loss of fiscal resources for the HTS and for the regional fiscal system as a whole. The problem becomes more acute when one takes into account strategic behavior. Here, the classic model is the “prisoner’s dilemma” game, where two players make rational strategic choices which lead to an outcome that is sub-optimal for both in the absence of co-operation. Table 6-1 shows how the logic of the prisoner’s dilemma can affect the decision on tax incentive. Table 6-1 Prisoner’s Dilemma and Tax Incentives State B, Standard Tax Policy Notes State B, Tax Concessions State A, Standard Tax Policy State A, Tax Concessions Cell 1 Outcome A B . AETR 35% 35% Tax base 100 100 Tax revenue 35 35 Cell 3 Outcome A B . AETR 35% 25% Tax base 50 150 Tax revenue 17.5 37.5 Cell 2 Outcome A B . AETR 25% 35% Tax base 150 50 Tax revenue 37.5 17.5 Cell 4 Outcome A B . AETR 25% 25% Tax base 100 100 Tax revenue 25 25 AETR = Average effective tax rate = tax collected per unit of tax base, taking into account incentives. In this example, each player has a myopic incentive to choose the tax concession policy, regardless of which policy option it expects the other player to select. This myopic incentive lands them in cell 4 (tax concessions), which is a worse outcome for both of them than cell 1 (standard tax policy). In this simplified example, each state faces a choice of structuring its tax system so that the average effective tax rate is either 35 percent (standard tax policy) or 25 percent (tax concessions). When both states set the same rate, they share equally in investment, and each has a tax base of 100. If just one state sets AETR at 25 percent, then it gets most of the
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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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TAXATION, INVESTMENT, AND GROWTH 2-
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3-2 EFFECTIVENESS AND IMPACT OF TAX
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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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