January 2010 investment climate IN PRACTICE Investment PolIcy and PromotIon 54017 no. 7 Providing Incentives for Investment Advice for policymakers in developing countries Are tax incentives effective at attracting investment? Or are they a sebastian James waste of resources? The answer depends on the policies used and Dr. Sebastian James the sectors where investment is sought. This note consolidates the (sjames2@ifc.org) is Senior Investment Policy Officer in the policy implications of the latest research by the World Bank Group's World Bank Group's Invest- Investment Climate Advisory Services on the efficacy of investment ment Climate Advisory Services incentives. The research finds that such incentives are ineffective where and is a taxation expert. He advises countries on the design investment climates are weak, and they cannot compensate for such of their tax policies and admin- deficiencies. Moreover, even where incentives are effective in attracting istrations, with an emphasis on improving their investment investment, they have significant costs. When incentives are clearly climates for economic growth. ineffective, political considerations often drive their continued use. This This note benefited from note identifies best practices for incentive policy and administration and contributions from Joseph provides a framework for analyzing the likely effectiveness of investment Battat, Nathalie McGregor, incentives under different conditions and in different types of countries. William Mut, and Stefan Van Parys of the Investment Climate Advisory Services of the World Bank Group. Many governments offer tax incentives to Incentives and the This note was developed by attract investment, yet policies often fail to investment climate the Investment Policy and fully assess their likely costs and potential Promotion team of the World benefits. Incentive policy should balance the Investment incentives have a mixed record. They higher revenues and social benefits--jobs, have been associated with growth in some Bank Group's Investment positive externalities, signaling effects--from countries (Ireland, Mauritius, Singapore, parts Climate Advisory Services. The (possibly) increased investment with the of the Caribbean) but had limited impact in team advises governments on indirect costs of incentives (such as others (francophone Africa). The World Bank attracting and retaining invest- administrative and leakage costs) and the Group's Investment Climate Advisory Services ment to create jobs and foster revenue losses from incentives given to recently conducted research to show the economic growth. investments that would have been made even econometric evidence behind this dichotomy without them. (see James 2009 for more details). In countries with weak investment climates--say, Such investments can have positive, often long-term with extensive red tape on accessing land, starting spillover effects on the economy or environmental a business, or exporting and importing--lowering protection, making it easier to justify spending on the effective tax rate has limited impact on foreign investment incentives. direct investment (FDI). The average response is far more pronounced in countries with good Public goods investment climates. For example, lowering the To the extent possible, cash-strapped governments effective tax rate from 40 percent to 20 percent can use incentives to encourage the private sector raises average FDI by 1 percent of GDP for to fund public goods or goods with a strong public countries ranked in the bottom half in terms of good character (such as infrastructure). By the investment climate--while the same change same token, incentives should be limited for raises FDI by 8 percent of GDP for countries in activities unlikely to generate social benefits. the top half. When a country's level of public goods is very low, Thus tax incentives are far less effective in weaker the marginal benefit from an additional amount of investment climates than in stronger ones. public good is more than the marginal cost. Moreover, tax incentives should not be used in an Accordingly, providing investment incentives to effort to compensate for a weak investment investors who provide public goods more than climate. Doing so causes revenue losses because covers their revenue cost. For example, investment incentives do not foster additional investments in incentives may be provided to businesses creating such an environment, so the benefits go to assets that can also be used by the public, such as a investments that would have been made anyway. road to a plant or factory that is also available for Improving the investment climate is a better public use, a school for children of workers that is strategy for attracting investments. also open to other students, or a captive power plant that provides surplus energy to the local power grid. Potential rationales for incentives The goal is to compare the opportunity costs of public funds with the returns on funds used for Governments should consider using investment investment incentives. And when incentives are incentives in three areas. eliminated or not used, the resources saved should be used for spending that the private sector is Positive externalities unwilling to cover. Government may use investment incentives to encourage investments that generate positive International tax competition externalities (that is, when an investment creates To be competitive, governments often offer tax multiplier effects and benefits far beyond the incentives similar to those offered by neighboring investor). Examples include: countries. The danger is that tax competition creates a race to the bottom, with countries Investments in technology--such as research competing to provide more generous incentives. and development or high-tech industries-- Countries that attract such investments may suffer that upgrade worker skills. from the "winner's curse"--having given up too Infrastructure projects--such as power and much in exchange for investment. Governments roads--that encourage business growth. should work with their neighbors to curb harmful Investments that create jobs in areas with tax competition. high unemployment. Investments in environmentally friendly In addition, many investors bargain with multiple technology. governments to secure the best incentive package, Anchor investments--those that provide and governments generally acquiesce. Hence multiplier effects through signaling (showing governments should not get carried away when that the country is open and attractive for competing with neighboring countries. In the investment) and by creating linkages to the short term, governments may be at a disadvantage local economy. if they do not provide tax rates as competitive as In PractIce INvEsTmENT PolICy and PromotIon 2 those extended by their neighbors. But in the long Indirect costs of incentives should be mitigated term it is much better to follow an alternative Effective incentive policy requires reducing the approach to attracting investment--one that takes indirect costs of providing incentives. Such costs advantage of each country's unique strengths and can include: does not involve providing competing incentives. Distortions created by encouraging new investments that are not economically viable Best practices in or that are detrimental to existing ones. administering incentives Time and money spent by businesses lobbying for tax incentives. Incentives require governments to administer them Time and money spent by businesses and curb their misuse. They can impose additional qualifying for and obtaining tax incentives. costs on businesses and create opportunities for rent Revenue lost to illegal activity, such as seeking. Hence policies are required to mitigate such from businesses that do not qualify for tax problems. The following principles can help guide exemptions but falsify information to do so, policymakers in such efforts. or indirect revenue lost to businesses that do not qualify for tax incentives but use tax- Incentives should be granted automatically exempt entities to source goods. Eligibility for incentives provided by law should be Additional costs to authorities responsible for based on clear criteria, not granted through special administering tax incentives. permission or certification by investment promotion agencies, ministries of trade, or other Though these nonrevenue costs are difficult to government agencies. This approach ensures quantify, they may greatly exceed the financial prompt decisionmaking and quick turnaround costs of incentives. Thus they should be kept in times for investors--essential to attracting and mind when formulating incentive policy. retaining investment. Tax incentives should be part of the tax code reforming tax incentive Tax-related investment incentives should be placed policy and administration in the relevant tax code so that tax authorities can administer them. Some countries provide tax This section advises policymakers on best practices incentives through different statutes, and in for providing tax incentives, including needed extreme cases through individual agreements with policies and reforms. investors. These separate laws often contradict each other, confusing investors. If tax incentives are The best policy option for tax incentives outside tax laws, it is unclear whether the tax A good tax system ensures predictable revenue for administration has the authority to administer the government, presents a reasonable tax burden to incentives. If relevant tax clauses cannot be moved investors, is stable, and minimizes distortions in to tax laws, they should at least be mirrored or investment decisions. There is broad consensus copied there. Doing so unambiguously allows the that a reasonable, uniform tax rate on a broad base tax administration to administer tax incentives and of taxpayers is sound policy. By definition, this limit their abuse. approach rules out tax incentives. Incentives require adequate Imposing taxes on a broad base can be justified by monitoring and control the establishment of a broader, more stable revenue The tax administration should ensure that investors base. With a broader base and for a given revenue receiving tax incentives satisfy the requirements for requirement, tax rates can usually be lower than them. To enable them to do so, it should be with a narrow tax base. The lower tax rate reduces compulsory for tax returns, declarations, and relevant economic distortions. With little exclusion from forms to be filed regularly for investors to receive tax the tax base, tax evasion or avoidance (by claiming benefits. Tax incentives should not be used as an to belong to an excluded category) becomes harder. excuse to avoid tax administration, information, As a result, lower taxes reduce incentives not to audits, and any other compliance requirements. comply--further widening the base. In PractIce INvEsTmENT PolICy and PromotIon 3 Last but not least, special tax provisions increase that they are working to increase investment and the time and cost required for the tax administration generate jobs. Reform policies can give immediate to verify claims made by taxpayers, with the relief to investors without providing overly generous additional disadvantage of the tax administration tax incentives. Such policies include: becoming a potential source of corruption. Fostering investments in plants and For all these reasons, governments in developing machinery by lowering taxes on capital economies should aim for a reasonable low tax rate investments. on a broad tax base--with limited exemptions. Making incentives available automatically, signaling to investors that government is The reform path for best practice incentive policy making the investment process friendlier. Policymakers seeking to move toward the best If offering new incentives, then doing approach for tax incentive policy may wish to so with time limits, to send a signal to consider the reform path suggested in Figure 1, potential investors that there is a limited along two distinct dimensions: tax policy and tax window for benefits. administration. Most countries fall somewhere in the Publicly announcing investors who benefit middle of these paths, so more detailed guidance on from incentives--increasing transparency and reform is given below. providing political backup. Pursuing a time-bound plan to reduce other Provide immediate relief to investors. In the short barriers to investment. term and for various reasons--including political-- governments face pressure to act quickly to show Move away from tax holidays. Tax holidays partly or completely exempt income from taxation for a Figure 1: reform Path for tax Incentive Policy specified number of years. This is a popular but and administration ineffective incentive for several reasons: It is a blanket benefit unrelated to the amount of capital invested, its growth, or its Tax policy Tax administration contributions to the economy during the tax holiday. Firms have an incentive to close and sell their Discretionary or businesses at the end of the tax holiday--only Generous tax holidays nontransparent tax to reopen as a "new" investment, thus gaining incentives an indefinite tax holiday. If FDI operates under double taxation Tax incentives based on agreements without tax sparing (that is, Partial tax holidays individual agreements the home country respecting the incentives offered by the host country), tax holidays Investment-linked tax Increased transparency simply transfer tax revenues from the country incentives (investment (publish list of investors receiving the investments to the country they credits and the like) benefiting from incentives) originate from. Tax holidays enable firms to funnel profits, Tax incentives only using transfer pricing, from an existing Tax incentives for (limited) anchor investments included in tax laws profitable company through the company receiving the tax holiday, and so avoid paying taxes on either. Only indirect tax incentives Tax expenditure budget Most capital-intensive investments do for capital inputs for incentives not yield a profit until several years after operations start. Accordingly, tax holidays for Uniform low tax rate a "startup" period of five years are ineffective. No tax incentives covering a broad base Thus tax holidays are a blunt investment incen- tive. To limit their damage, tax holidays should In PractIce INvEsTmENT PolICy and PromotIon 4 have clear end dates after which no such benefits Would the investment have occurred anyway-- are available. Moreover, alternatives to tax holidays obviating the need for incentives? Would incentives can benefit taxpayers while encouraging invest- for anchor investments put existing investments at ment. Such incentives are known as investment- a disadvantage? Do such incentives cause leakages linked or performance-based incentives. There are of tax revenue? And do they undermine the three main types of investment-linked incentives: investment environment by encouraging other investors to press for similar incentives? Investment tax credits allow a fixed percentage of an investment to be deducted The reform path for best practice from taxes owed. Rules differ about credits incentive administration in excess of tax liability--they may be lost, Several bad practices involving the administration carried forward, or refunded. of tax incentives should be avoided. Some countries Investment allowances allow a fixed award incentives on a case by case basis or give percentage of an investment to be deducted investment certificates to "approved" investors, from taxable profit (in addition to allowing them to claim incentives. These discretionary, depreciation). The value of this allowance nontransparent practices--hidden from the public-- is the product of the allowance and the tax are prone to abuse and may not lead to the rate. So, unlike a tax credit, its value will vary government's desired outcomes. In addition, some across firms unless there is a single tax rate. countries provide investment incentives by The value is also affected by changes to the executive decree and not by tax code. Even when tax rate, with a tax cut reducing it. such decrees are given by the highest authority, Accelerated depreciation allows depreciation such as the president, this approach lacks proper at a faster schedule than is available for the checks and balances. rest of the economy. This can be done in many ways, including through higher first- But even tax incentives awarded based on the law year depreciation allowances or increased run the risk of proliferation if they are delivered by depreciation rates. In nominal terms tax sector ministries. These ministries are not responsible payments are unaffected, but their net present for collecting taxes, so they do not bear the costs of value falls and the liquidity of firms increases. the incentives they award. The best approach is to The tax benefits of tax holidays can be converted to grant incentives based on tax laws that offer as little an equivalent investment-linked incentive or a flat discretion as possible. Because tax incentives are corporate tax rate. By properly calibrating the rates, essentially forgone revenues, to improve transparency such a conversion retains incentives for investors their revenue costs should be calculated as part of while eliminating the disadvantages of tax holidays. the budget process. This approach enables broader Though lowering tax rates provides a strong discussion on the costs and benefits of incentive policy. incentive for investment, lowering them too far is quite costly for revenue. As a result, any reform path Finally, when incentives are provided it is essential that moves a country toward the best option should that they be based on rules and not be open-ended balance the competing objectives of attracting (with strict time limits), that those benefiting investment and protecting the revenue base. from incentives file tax returns and face audits, that governments produce tax expenditure Develop policies for anchor investments. Anchor statements so that the cost of incentives is investments generate multiplier effects, have transparent, and that incentives are occasionally significant linkages to local economies, and are often reviewed for their efficacy. made by highly reputable firms that jumpstart investment in several areas. Accordingly, governments Gauging the cost-effectiveness of often woo such investors with incentive packages. investment incentive policies But first, some basic questions should be answered. A popular metric for measuring the cost-effectiveness of investment incentive policies is to calculate the Will the investment eventually generate additional dollar cost of the jobs they create, based on total tax tax revenue? Does the anchor investment provide spending. Though this approach is not very precise, positive externalities (such as signaling future it provides a ballpark figure that helps policymakers investors and creating linkages to the economy)? decide if the incentive was worthwhile. In PractIce INvEsTmENT PolICy and PromotIon 5 Figure 2: Framework for Finalizing Incentive For example, a recent study found that the Yemeni Policy government spent about $6,000 for each of 8,000 jobs that investment incentives helped create-- more than six times the country's per capita income (FIAS 2008). Similarly, investment incentives in Thailand cost the government 16 Investment responds Social benefits from times the average annual wage of an industrial strongly to the incentive and revenue + increased investment due to the incentive worker (FIAS 1999). rises as a result recommendations for incentive policy > The framework in Figure 2 provides a general guide for policymakers finalizing an incentive policy, based on country conditions and goals. For overall benefit Lost revenue from Indirect costs of to the country, any incentive provided should pass investments that would the test in the figure. have been made anyway + incentives-- administrative, evasion, but receive the and distortion costs Using this framework and the principles outlined incentive in this note, Table 1 summarizes desirable short- and long-term incentive policies for various types of countries. table 1: recommended Investment Incentive Policies under Various Country Scenarios Scenario Short-term policy Long-term policy Countries with weak Investment incentives are ineffective Such countries should reduce barriers to investment climates and therefore a waste of tax revenues. investment by, for example, simplifying Such revenues should instead be used investment procedures. to provide public goods. Reforms should also be introduced to clean up the tax system. Countries facing tax Incentives can be used in the short- Such countries should work on regional competition term to ensure that countries are not pacts to stop tax competition and at a disadvantage relative to their promote their substantive differences neighbors. (labor skills, infrastructure, and so on). Countries seeking to Such countries can use incentives Broader industrial policy strategies have diversify their linked to investment growth to be followed, including a focus on economies (investment allowances, accelerated sector targeting and promotion to attract depreciation), but for a limited period investments. based on clear prioritization of sectors in line with FDI competitiveness. Countries with unique General investment incentives to Barriers should be lowered for advantages (natural attract investments that exploit such investments designed to exploit natural beauty, natural advantages waste revenue unless they resources, improve access to land, and so on. resources) kick-start investment. In PractIce INvEsTmENT PolICy and PromotIon 6 Lessons references In PraCtICE Whatever investment incentives a government FIAS (Foreign Investment Advisory Service). 1999. The Investment Climate IN decides to offer and however it structures them, it "Kingdom of Thailand: A Review of Investment PRACTICE note series is published should make every effort to ensure that they are: Incentives." World Bank Group, Washington, D.C. by the Investment Climate Affordable--forgone income should not ------. 2008. "Report of Rationalization of Tax Advisory Services of the World severely undermine government revenue Incentives and Consolidation of Sub-National Taxes, Bank Group. It discusses practical streams. Fees and Charges in Yemen (Yemen Tax Simplification considerations and approaches Based on evidence--targets for incentives Project)." World Bank Group, Washington, D.C. for implementing reforms that should be based on research that confirms James, Sebastian. 2009. "Incentives and Investments-- aim to improve the business they will benefit the country in ways that would not have been possible if there were no Evidence and Policy Implications." World Bank environment. The findings, incentives. Group, Investment Climate Department, Washington, interpretations, and conclusions Simple--incentive administration should D.C. http://www.ifc.org/ifcext/fias.nsf/Attachments included in this note are those of permit easy accessibility and eligibility ByTitle/PublicationMT_IncentivesandInvestments/ the author and do not necessarily determination. $FILE/IncentivesandInvestments.pdf. reflect the views of the Executive Reviewed periodically--investment Directors of the World Bank or the incentives should be reviewed regularly to determine their relevance and economic governments they represent. benefits relative to their budgetary and other costs, including long-term impacts on about the Investment resource allocation. Climate advisory Services Conclusion Providing incentives can create risks for the The Investment Climate Advisory investment climate and fiscal compliance. It also Services of the World Bank Group encourages lobbying and rent seeking. Over the long helps governments implement run, making the costs and benefits of tax incentives reforms to improve their business more transparent helps frame future policy. Many environments, and encourage and countries have found that the best investment incentive is providing a level playing field to all retain investment, thus fostering businesses through a broadly based, low, uniform tax competitive markets, growth, and rate and a good investment climate. job creation. Funding is provided by the World Bank Group (IFC, The global financial crisis has once again shed light MIGA, and the World Bank) and on the need for effective fiscal policy to raise over 15 donor partners working revenues for public goods while not compromising a country's attractiveness as a destination for through the multidonor FIAS investment or job creation. The principles outlined platform. in this note suggest that governments take an approach that balances investment attractiveness with fiscal responsibility. In PractIce INvEsTmENT PolICy and PromotIon 7 International Finance Corporation World Bank Group www.wBgInVEStmEntCLImatE.org