Evaluating the Costs and Benefits of Corporate Tax Incentives IN FOCUS Methodological Approaches FINANCE, COMPETITIVENESS & and Policy Considerations INNOVATION Hania Kronfol and Victor Steenbergen INVESTMENT CLIMATE © 2020, The World Bank Group 1818 H Street NW Washington, DC 20433 Telephone: 202-473-1000 Internet: www.worldbank.org All rights reserved. This volume is a product of the staff of the World Bank Group. The World Bank Group refers to the member institutions of the World Bank Group: The World Bank (International Bank for Reconstruction and Development); International Finance Corporation (IFC); and Multilateral Investment Guarantee Agency (MIGA), which are separate and distinct legal entities each organized under its respective Articles of Agreement. We encourage use for educational and non- commercial purposes. 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Hania Kronfol (hkronfol@worldbank.org) is a Private Sector Specialist and serves as the workstream lead for investment incentives in the World Bank Group’s Investment Climate Unit. Victor Steenbergen (vsteenbergen@worldbank.org) is an Economist in the same unit with expertise in investment, tax, trade and public finance policy. The authors are grateful for peer review comments received by Luisa Dressler, Sebastian S. James, Peter Kusek, Tuan Minh Le, Richard Record, and Erik von Uexkull. Photo Credit: Shutterstock.com D eveloping countries are increasingly offering tax breaks to attract investors and pursue various policy objectives such as encouraging investments in research and development (R&D) and increasing exports. Such incentives, however, can be very costly to governments. Too often, developing countries—already struggling with revenue mobilization—adopt investment incentives in an ad hoc manner, without analyzing the value for money of these instruments. Cost-benefit analysis can help policy makers demonstrate the direct cost (tax revenue foregone) incurred by governments against the economic benefits being pursued. Global evidence on investment location decisions suggests that while tax incentives can help attract investment, other factors, such as the wider investment climate and market opportunities, matter most. Tax incentives should therefore be conceived as part of a country’s broader investment policy framework and governments should be realistic about the potential impact any measure may have. In this light, cost-benefit analysis can serve as a powerful tool to inform incentives policy reform and offer important inputs into a country’s investment policy strategy. I. Context: Why Governments Need The Growing Prominence of Tax Incentives to Evaluate the Costs and Benefits and Their Fiscal Implications of Investment Incentives Developing countries are increasingly relying on investment incentives to attract investors “Striking the right balance between an and influence their activities. As of 2015, out of attractive tax regime for domestic and foreign 107 developing countries, more than half were investment using tax incentives, and securing granting tax holidays or preferential corporate tax the necessary revenues for public spending, is rates across sectors at the national level. Between a key policy dilemma.” 2009 and 2015, 46 percent of them adopted new tax incentives or made existing incentives more –– IMF, OECD, UN, and World Bank 2011 generous (Andersen, Kett, and von Uexkull 2017) (see figure 1).1 The values cover corporate income tax reductions/holidays at the national level only. Other tax incentives are often offered at 1 the subnational level (such as concessions on municipal taxes), suggesting that overall usage is likely even more widespread. EVALUATING THE COSTS AND BENEFITS OF CORPORATE TAX INCENTIVES | 1 Figure 1. Nearly Half of Developing Countries Introduced New Tax Incentives or Increased the Generosity of Existing Ones from 2009-15 Share of Countries with Changes In Use Of Corporate Tax Incentives, 2009–15 (Percent) East Asia and Pacific 36 14 Europe and Central Asia 39 22 Latin America and the Caribbean 35 22 Middle East and North Africa 50 50 South Asia 17 50 Sub-Saharan African 65 21 Low Income 44 22 Lower-Middle-Income 43 16 Upper-Middle-Income 31 Developing Countries Average 46 24 0 10 20 30 40 50 60 70 Share of countries that made incentives more generous in at least one sector Share of countries that made incentives less generous in at least one sector Source: Andersen, Kett, and von Uexkull 2018. The growing popularity of corporate tax incentives economic evidence. In fact, at the global level, derives partly from increased competition to attract there is a strong, negative relationship between the foreign direct investment (FDI). Policy makers are generosity of countries’ corporate tax incentives and driven to match, or even surpass, their regional their corporate tax revenue as a share of GDP. Figure neighbors by offering more generous concessions, 2 shows that for each 10-percentage point increase which can motivate unhealthy competition between in corporate tax incentives, corporate tax revenue states, referred to as a “race-to-the-bottom.” goes down by around 0.35 percent of GDP. A likely From the governments’ perspective, foregone tax reason for this finding is that incentives do not only revenue from the reduction in firms’ tax liability go to new, foreign firms, but also commonly reduce can impose significant fiscal losses if incentives the tax liability of existing firms in the country, thus are not strategically conceived and applied. The eroding the overall corporate tax base. costs of incentives are most burdensome for lower- income countries, which are already struggling with The Tenuous Impact of Tax Incentives revenue mobilization, and where tax incentives tend on Investment to be less influential in attracting investment (IMF, OECD, UN and World Bank 2015a). International The role of tax incentives in influencing companies’ cooperation among countries on tax incentives policy investment decisions is generally quite limited, can play a key role in curtailing some of the risks, although they have demonstrated some results in but such frameworks are notoriously challenging to specific contexts. In countries like the Republic implement and require a longer-term time horizon. of Korea, Taiwan, China, and Singapore, tax incentives have been shown to be part of a broader Policy makers who advocate for the use of incentives strategy that helped attract investors and encourage often justify their costs by suggesting that they are industrialization between the 1960s and 1990s compensated for by the new investment, jobs and (Wade 1990; Tanzi and Shome 1992). However, spillovers created by the firms benefiting from these surveys of investors around the world find that concessions. But such assertions are rarely based firms often do not rank incentives among their top on proper evaluation methods and the underlying reasons for investing but rather are often trumped 2 | EVALUATING THE COSTS AND BENEFITS OF CORPORATE TAX INCENTIVES Figure 2. More Generous Tax Incentives are Associated with Lower Corporate Tax Revenue Effect on Corporate Tax Revenue (% of GDP) 0.5 0 -5 -1 -1.5 0 10 20 30 Corporate Tax Incentives (% Discount in CIT Rate) 95% CI Fitted values Zero Line Source: Authors’ calculations based on the World Bank Group’s Global Tax Incentives Database (Andersen, Kett, and von Uexkull 2018) and World Development Indicators (WDI), covering 109 countries: 72 developing countries and 37 high-income countries, for 2009−15. Note: Corporate tax incentives are measured as percent-point difference between the standard corporate income tax (CIT) rate and tax incentive CIT rate. See annex table A.1 for details. CI = confidence interval. by other variables, which typically include market that are more internationally mobile (such as globally opportunities and the broader investment climate oriented manufacturing and financial services firms) (Kusek and Silva 2018; James 2014). have also been found to be more responsive to tax incentives (Zolt 2013). Other country-level factors As a result, at the aggregate level, tax incentives such as political stability, regulatory quality, and often result in little or no new investment (Allen et market opportunities are more critical to investors’ al. 2001; IMF, OECD, UN and World Bank 2015a; initial location considerations compared to tax rates Klemm and Van Parys 2012; Van Parys 2012). At and incentives (World Bank 2017; UNIDO 2011). In the same time, they can pose a risk to government general, a low tax burden cannot compensate for a finances. For example, an assessment of the Eastern weak or unattractive FDI environment (Göndör and Caribbean Currency Union from 1990 to 2003 found Nistor 2012). Yet, for suitable locations, incentives that tax incentives had limited effect on FDI, though can play a role in the final stage of the site selection they significantly aggravated fiscal deficits and debt process when investors are deciding on shortlisted overhangs (Chai and Goyal 2006; James and Van locations and wavering between similar options Parys 2010). (Freund and Moran 2017). The success of incentives in attracting FDI depends In this context, different approaches and strategies for strongly on country-level characteristics. Tax incentives reform may be warranted across countries. incentives are more effective in countries with For example, in countries with poor performance better infrastructure, reasonable transport costs, and along dimensions reflecting their investment climate, a policy framework favoring investment (Bellak, it may be best to streamline tax incentives to protect Leibrecht, and Damijan 2009; Kinda 2014). In fact, these countries’ tax base. Tax revenues can instead tax incentives have been shown to be eight times be directed to help reduce firms’ cost of doing more effective in attracting FDI in countries with business (such as through public investment in good investment climates (James 2014). Investors infrastructure and utilities). In countries with better EVALUATING THE COSTS AND BENEFITS OF CORPORATE TAX INCENTIVES | 3 investment climates, tax incentives may be targeted • They represent an exception and a departure from toward higher-potential investors who are likely to regional tax conventions and benchmarks (for be influenced by these instruments and contribute example, they include tax holidays—which no to economic development objectives. Deciding on country regards as standard—but do not include an the appropriate approach to take requires a better investor’s ability to deduct investment expenses, understanding of the costs and benefits of the which is conventional in almost all countries). existing incentives framework, which can inform policy reforms to improve the targeting, design, Estimating the Costs transparency, and administration of tax incentives. Tax incentives bear a range of different costs, including the direct cost (such as tax revenue II. Methodology: How Can Governments foregone), government administrative costs, and Undertake Cost-Benefit Analysis various indirect costs like market distortions from weakened domestic competition and increased Defining and Mapping Corporate risks of rent-seeking. Most analytical cost-benefit Tax Incentives techniques focus on measuring the direct costs Tax expenditures can be defined as “all tax measures incurred by governments through tax revenue that deviate from an established benchmark tax that is not collected. This cost often has the system” (Baar and Chandler 2017). Therefore, the most profound effect on public finances, and is type of tax expenditures included depends critically methodologically easier and less subjective to on how the benchmark tax system is defined, which estimate than indirect costs. varies across countries. While some countries There are various ways to calculate the direct use a narrowly defined set of tax measures to be cost of tax incentives (see box 1). The different departures from a “benchmark” tax system (such approaches to measuring these tax expenditures as tax subsidies), others cover many tax measures can result in significantly different estimates of (such as “all available tax reductions, discounts and their value. Most countries rely on the revenue exemptions”) (ICAS 2009). foregone approach, which is an estimation of the Corporate tax incentives constitute a subset of tax static revenue loss incurred by governments from expenditure that are departures from the benchmark the introduction of a tax incentive compared to the system that are granted only to those investors or standard or benchmark rate2 (IMF, OECD, UN and investments that satisfy the prescribed conditions World Bank 2015b). (Easson and Zolt 2002). To identify which measures can be considered tax incentives, three main criteria may be used (IFC 2014): Example calculation using revenue foregone approach: A firm in country A has a total taxable • They apply only to a subset of taxpayers that profit of US$90 million. It benefits from a 15% qualify according to a targeted set of criteria (such reduced corporate income tax rate, rather than as companies located in export-processing zones). the conventional 30% rate. The tax expenditure • They are designed to induce a change in firms’ associated with this incentive equals: (Taxable economic activity (such as to encourage a firm to Profits × Benchmark Rate) − (Taxable Profits locate in a particular location, or to invest more in × Discount Rate) = (US$90 million × 0.30) − R&D). (US$90 million × 0.15) = US$13.5 million. While the benchmark rate is obvious at times (such as corporate tax rates applied to most firms), in other cases it is less 2 clear, especially for taxes that vary considerably, such as customs duties. Because countries differ in how they define their benchmark tax system, cross-country comparisons of tax expenditures (such as tax expenditure as a share of GDP) can be misleading and should be interpreted with caution. 4 | EVALUATING THE COSTS AND BENEFITS OF CORPORATE TAX INCENTIVES Box 1. Approaches to Estimating the Direct Cost of Tax Incentives There are three main ways to estimate tax expenditures related to incentives: • The revenue foregone method is a calculation of the static revenue loss incurred by introducing a tax incentive, assuming everything else remains unchanged. This is an ex post calculation of the difference between the revenue raised by the benchmark and the case in which the tax incentive is introduced into the tax system. This method does not consider interactions with other tax incentives or behavioral effects on taxpayers. • The revenue gain method is defined as the amount by which tax revenue increases by eliminating a tax incentive, considering the change in taxpayer behavior and the effects on revenues from other taxes because of a shift in tax incentives. Since this approach depends on expected changes in taxpayer behavior and interactions with other taxes, the estimates are sensitive to the behavioral parameters (such as elasticities) used in the calculations. • The outlay equivalence approach estimates the equivalent amount of direct incentives that would be required, in pre-tax dollars, to achieve the same after-tax dollar benefit if a tax incentive were replaced by a corresponding direct incentive program, with which the tax incentive is associated. Direct cost estimates should consider not only consider locating in in a specific country or corporate income tax incentives, but should also region if their general return on investment extend to the wider combination of tax concessions is above a minimum return to investment offered to firms, including customs duties, capital benchmark, also known as the “hurdle rate,” gains tax, pay-as-you-earn, and value added tax. and their profitability is competitive to other Ultimately, it is the aggregate of all these incentives locations and other types of investments that constitutes the total amount of government (World Bank 2016; Forstater 2017). The aim of support. Different tax types often differ in their locational tax incentives then is to raise a firm’s amount and targeting of support for firms.3 expected level of profitability and are considered successful if they help switch a firm’s decision Defining Success from “do not invest” to “invest,” or motivate the firm to invest in one location over another.5 A key conceptual step for undertaking a cost- benefit analysis of incentives is to identify the • Behavioral incentives aim to stimulate firms’use policy objectives (benefits) pursued through such of specific inputs/factors of production (such instruments. Two broad types of objectives can as employment) or raise types of outputs (such be identified.4 The ways of defining their overall as exports) by lowering their user costs (such as “success” or “failure” differ (figure 3). by reducing payroll taxes or reimbursing export expenses). Behavioral incentives are considered • Locational incentives seek to attract new successful if they motivate firms to change their investors into a country or region by reducing operational activities, for instance, by employing their (tax) costs and thus raising their expected more staff or investing in more R&D than they profit margins. Conceptually, firms would only would have otherwise. 3 Each incentive will have a different effect on firms’ tax liability, requiring separate micro-simulations and analysis that consider the interactions among all incentives to estimate the cost of the comprehensive set of incentives combined. 4 These two broad types of investment incentives are not mutually exclusive and typically intersect in practice. The categorization is helpful in defining key parameters to develop a measure for the benefits. See box 3 for an example where both locational and behavioral metrics were examined for a more holistic cost-benefit estimate. 5 To minimize the risk of market distortions by “picking winners,” governments should generally avoid targeting individual firms through their incentive schemes. Instead, targeting can be based on type and characteristics of investors (such as their sector, size, and activities). EVALUATING THE COSTS AND BENEFITS OF CORPORATE TAX INCENTIVES | 5 Figure 3. Locational and Behavioral Incentives Have Different Aims and Expected Benefits Attract New Grow Create Promote R&D Promote Objectives Investment Strategic Sectors Jobs & innovation Exports Locational Objectives Behavioral Objectives Objective Type (Attracting New Firms) (Shifting Firm Behavior) Raise firms’ expected level of profitability Lower user cost of specific behavior Incentive Aim • Effect on profit • Effect on input cost • Transparency/clarity • Effect on output cost New firms establish in the country/region Firms use inputs more/produce Incentive Success due to incentives more output due to incentives Firms receiving incentives Firms receiving incentives would have used Incentive Failure would have located there anyway the same inputs/same outputs anyway Note: R&D = research and development. Measuring the Benefits the most rigorous, compared to the other two approaches described below, but is also the most There are different approaches to quantifying the data-intensive and time-consuming. benefits of incentives. To consider attribution, the focus is on identifying “marginal changes”—that • Sectoral regression analysis considers the is, whether and to what extent the incentives are relationship between incentives and the total necessary for the investment or changed behavior number of firms in a sector.6 This approach to take place. Different tools may be used to assess commonly considers how taxes affect tax effectiveness of locational and behavioral incentives. liability of a “sample” firm in that sector by imputing the average effective tax rate (AETR).7 Locational Incentives If sectors with more generous incentives observe When considering the effectiveness of locational a greater increase in number of firms, incentives incentives, there is an underlying methodological may have helped attract those investors. This limitation stemming from the inability to observe approach is faster, but also less robust than the performance of firms that chose not to settle ROI analysis. Because governments may in a specific location. Without a “control” group, simultaneously adopt other policies that affect there is no direct way to estimate a counterfactual. firm numbers across sectors, it can be difficult to Three different approaches are often leveraged in isolate the effect of incentives alone on changes this regard, each with different data requirements, in the number of firms in each sector. strengths, and weaknesses (figure 4): • Investor motivation surveys can provide • Return on investment (ROI) analysis uses qualitative data on the role of incentives by firm-level data to conduct a micro-simulation of directly asking investors if they would or would the effect of all incentives on profitability. ROI not have invested in the country in the absence is defined as post-tax profits divided by total of these concessions. Such surveys commonly capital stock. A comparison of the estimated focus on firms already established in the country ROI of firms with and without incentives that are receiving incentives. It can also include helps determine the role of incentives in firms’ other multinationals exploring whether to invest location decisions (see box 2). This approach is 6 For an example of this approach applied to Hungary, Latvia, and Poland, see Clark and Skrok (2019). 7 AETR is calculated by dividing each firm’s overall tax liability by its overall net taxable income. 6 | EVALUATING THE COSTS AND BENEFITS OF CORPORATE TAX INCENTIVES Figure 4. Approaches for Evaluating Locational Incentives Have Different Data Requirements, Strengths, and Weaknesses More Data-Intensive Less Data-Intensive Type of Analysis ROI Analysis (Micro-Simulation) Sectoral Regression Analysis Investor Motivation Surveys Investor survey data (sampled Firm-level data (corporate tax Sector-level data (number of firms, Data Requirements from firms receiving, or eligible declaration, capital stock). incentives eligible). for, incentives). No previous data required. Can Fastest approach. Requires little Strengths Most rigorous and detailed results. assess awareness of incentives. data. “First-cut” option. Helps in ranking of incentives. Heavy data requirement. More Not always representative. Weaknesses Not as rigorous/accurate. Firms’ response and actual difficult and time-consuming. behavior may differ. in the country. However, this approach may tariff reform on domestic output and tax revenue lack representativeness and suffer from biased using price-demand elasticities. An adapted responses if investors inflate the importance of TRIST can similarly assess the effect of customs incentives. More broadly, firms’ survey responses duty exemptions (versus full tariff prices) on and actual behavior may differ.8 firms’ input costs, output, employment, and profits (benefits), as well as foregone tax revenue (costs). Behavioral Incentives When considering behavioral outcomes, standard • Conventional regression analysis is commonly impact evaluation approaches such as difference- used for all other behavioral incentives (such as in-differences, propensity score matching, and R&D grants and employee training deductions). regression discontinuity design may be leveraged Such analysis is based on a comparison of a to assess different performance indicators. Three “treatment” group (firms receiving incentives) main approaches stand out: and a “control” group (comparable firms that are not receiving incentives but are otherwise similar • User Cost of Capital (UCC) approach8 assesses to the “treatment” group in terms of sector, size, the effect of corporate tax incentives (such as tax capital intensity, etc.). The difference in behavior holidays) on a firm’s total amount of investment. between the two groups then helps identify the The approach combines information about tax effect of incentives. rates, tax incentives, and depreciation to estimate the cost of investment after taxes. These data points are then used in a regression with investment rates Comparing Costs With Benefits as a determinant to derive the long-term elasticity Once both the costs and benefits of incentives have of investment to the user cost of capital, which is been estimated, different metrics can be used to used to predict how incentives affects firms’ level compare them and to gauge the “value for money” of of investment. incentives. For benefits, the focus is on contributions to the objectives of the incentive programs (such as • Tariff Reform Impact Simulation Tool (TRIST) job creation, export growth, or new investment). For is a World Bank Group tool to assess the impact of 8 Investor motivation surveys may also be used to gain insight into the role of behavioral incentives by asking investors whether, and to what extent, they would have engaged in the incentivized activity (like investing in more R&D) without the concession. The approach has the same advantages and challenges as in the locational context. Investor motivation surveys can often serve as a valuable complement to other more rigorous evaluation approaches. 9 For more details, see James (2014); and World Bank (2016). EVALUATING THE COSTS AND BENEFITS OF CORPORATE TAX INCENTIVES | 7 Box 2. A Closer Look at the Return on Investment (ROI) Approach The ROI approach relies on the premise that tax incentives are considered effective if they allow a company to become profitable when they would be otherwise unprofitable without tax incentives. Profitability is defined as exceeding a minimum return to investment benchmark or the “hurdle rate”a related to the investment. Tax incentives are considered redundant, meaning that the incentive was not ultimately influential in the investor’s marginal decision, if a firm is sufficiently profitable in absence of the tax incentives. Firms whose returns remain below the identified hurdle rate even with incentives, or above it even without incentives, are also less likely to be affected in their investment decision by incentives. Based on these considerations, three types of firms can be identified (figure B2.1): • Already viable (project A): Firms that would be highly profitable even without tax incentives. Tax incentives are likely to be redundant for this type of firm. • Marginal (project B): Firms that shift from being insufficiently profitable to profitable with the tax incentives. Tax incentives are likely to be cost-effective in attracting this type of firm. • Unviable (project C): Firms that are unprofitable, even with incentives, so the firm is likely to be unresponsive to incentives. Tax incentives are likely to be redundant for this type of firm. Figure B2.1. Firm Profitability and Investors’ Location Decisions Project A: Already Viable Return on Investment (ROI) Project B: Marginal Project C: Unviable Hurdle Rate ROI with tax incentives ROI without tax incentives Note: The ROI approach to cost-benefit analysis is explained in more detail in James (2014). a. The “hurdle rate” is the minimum rate of return a company expects to earn when investing in a project. Also known as the required rate of return or target rate, it is the rate that is needed for a project to proceed. Defining an appropriate investment hurdle rate is required for this type of evaluation and two approaches may be considered: (1) The user cost of capital can be estimated by summing the cost of borrowing (lending rate) and the opportunity cost of time (inflation rate). This sets an absolute minimum ROI that capital must meet to break even. (2) The expected ROI can also be obtained based on investors’ self-reporting from investor motivation surveys. It should be noted that estimating an average hurdle rate across the economy or sectors will invariably have limitations since different types of firm characteristics (e.g. financing structure, capital allocations, etc.) influence the actual value. 8 | EVALUATING THE COSTS AND BENEFITS OF CORPORATE TAX INCENTIVES the costs, the key variable of interest is the net effect • Advising policy targeting and design of on tax revenue. By dividing specific benefits by the incentives: Benefits from incentives may differ costs, several useful ratios can be estimated, such by sector and type of firm. Cost-benefit analysis as the cost-per-job-created, the cost-to-export ratio, can help target the types of investors whose and/or the the cost-to-investment ratio. decisions to invest are most likely swayed by incentives. If incentives are used, the findings Cost-benefit ratios can be an important input to from the analysis can inform government inform policy reforms to a country’s incentives decisions on how to reform incentive programs regime. It can be helpful to consider differences to maximize their value for money. in cost-benefit ratios across types of tax incentives (such as tax holidays versus customs duty The different approaches for examining the role of exemptions) or across different priority sectors incentives on investors’ locational and behavioral (see box 3). decisions can be used ex ante to forecast the outcomes of incentives or weigh different policy III. Conclusions: How Can options, as well as ex post—integrated as part of a broader monitoring and evaluation framework. Cost-Benefit Analysis Inform Such analysis may suggest reforms to scale up or Incentives Policy down certain incentives (such as by incentive type Developing countries are faced with a policy or beneficiary sectors); change incentive targeting tension. On the one hand, they feel they need to by revising the eligibility criteria; improve offer more tax breaks to keep pace with growing incentive administration (such as by addressing global competition for investment. On the other compliance issues or rent-seeking behavior); or hand, they need to increase domestic tax revenue adjust the parameters of the underlying corporate to ensure fiscal sustainability. Cost-benefit tax structure. analysis can improve and inform important policy However, undertaking an isolated cost-benefit dimensions, including: evaluation of incentives covers only part of the • Fostering greater transparency of public story around the success and challenges of these finances: Systematically estimating the revenue instruments. Variations across the cost-benefit ratios foregone from incentives can result in greater may be attributed to many different factors that go transparency of public finances. Especially since beyond the characteristics of the tax incentives. The the costs associated with tax incentives can face effect of incentives is fundamentally entrenched less scrutiny than direct government spending, in broader aspects of a country’s investment, estimating and incorporating such analysis as part trade, competition, and tax policies, as well as the of the budgetary process can lead to more informed related administration and governance. Any reform budgetary and fiscal policy decision-making. option needs to be considered within the broader enabling environment, tailored to country-specific • Gauging the impact of incentives and their variables, and integrated with complementary opportunity cost: Comparing the costs of qualitative assessments (especially in countries incentives to benefits (such as levels of investment, with limited data). and jobs created) helps inform whether and to what extent incentives are achieving their aims The key objective is for governments to consider and at what expense. A comparison also sheds cost-benefit analysis in their arsenal of diagnostic light on whether these instruments are the most tools. And the larger premise of the exercise is cost-effective means to achieve policy objectives for governments to shift away from an incentives or whether government funds are better allocated system that is often based on vested interests or by focusing on other measures (such as public anecdotal observations to one that is rooted in investments in infrastructure). economic evidence. EVALUATING THE COSTS AND BENEFITS OF CORPORATE TAX INCENTIVES | 9 Box 3. Cost-Benefit Analysis of Corporate Tax Incentives in the Philippines In 2018, the Government of the Philippines approached the World Bank Group for assistance in its efforts to reform the country’s incentives regime. As part of its policy planning, the Government wanted to better understand the overall revenue impact and developmental benefits brought about by corporate tax incentives (including reviewing different tax policy proposals). To address this request, the World Bank Group supported a cost-benefit evaluation of incentives, considering the potential benefits across a range of objectives (locational and behavioral), combining various empirical methods. As illustrated in figure B3.1, the approach brought together four components: • Direct costs (revenue foregone) estimated through a micro-simulation; • Direct locational benefits (attracting new firms) analyzed using the ROI approach; • Direct behavioral benefits (such as raising employment for existing firms) identified through matching-based regression analysis; and • Indirect benefits (such as jobs created via supplier linkages) identified by considering sectoral input links (via industry Input-Output tables), combined with estimated employment-to-sales elasticities. Combining these components, all the costs and benefits were compared across sectors via aggregate cost-benefit ratios. The output reflected a wide range of cost-per-job ratios. Policy makers were then able to leverage this analysis to inform recommendations on streamlining the country’s incentives regime by focusing resources on those sectors and incentive instruments for which the cost-benefit ratios were more favorable. Figure B3.1. Combining Locational and Behavioral Outcomes to Undertake a Cost- Benefit Analysis of Corporate Tax Incentives Gross Cost From Tax Incentives Direct Costs (revenue foregone) Micro-Simulation Direct Benefits Locational Benefits Behavioral Benefits ROI Analysis Regression (Matching) Demand-Effects Demand-Effects Indirect Benefits (new firms’ operations) (existing firms’ extended operations) Regression + IO Tables Regression + IO Tables Cost-Effectiveness (E.g. cost-per-job created) = DIRECT COSTS ÷ DIRECT BENEFITS + INDIRECT BENEFITS Note: IO = input-output; ROI = return on investment. 10 | EVALUATING THE COSTS AND BENEFITS OF CORPORATE TAX INCENTIVES Annex Regression Analysis: The Relationship Between the Generosity of Tax Incentives and Corporate Tax Revenue (see Figure 2) Table A.1. Regression of Generosity of Tax Incentives and Effect on Corporate Tax Revenue Variable Corporate Tax Rrevenue (Percent of GDP) CIT Rate 0.195*** (0.0247) Tax Incentives Rate -0.0602*** (0.0140) Region X Year Fixed Effects Yes Observations 682 R-squared 0.1871 Source: Authors’ calculations based on the World Bank Group’s Global Tax Incentives Database and World Development Indicators (WDI) for 2009-15, jointly covering 109 countries: 72 developing countries and 37 high-income countries. See Andersen, Kett, and von Uexkull (2018) for details about the World Bank Group’s Global Tax Incentives Database. Although only developing countries are covered in the publication, the full dataset includes high-income countries as well. Note: Corporate tax incentives are measured as percent-point difference between standard corporate income tax (CIT) rate and tax incentive CIT rate. Robust standard errors in parentheses, *** p<0.01, ** p<0.05, * p<0.1. 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