NOTE NUMBER 253 P U B L I C P O L I C Y F O R T H E privatesector 25521 FEBRUARY 2003 Tax Incentives Jacques Morisset Jacques Morisset Using Tax Incentives to Attract Foreign Direct Investment (jmorisset@ifc.org) is lead economist in the Foreign The increasing mobility of international firms and the gradual Investment Advisory elimination of barriers to global capital flows have stimulated Service--a joint facility of the International Finance competition among governments to attract foreign direct investment, T H E W O R L D B A N K G R O U P PRIVATE SECTOR AND INFRASTRUCTURE NETWORK Corporation and the often through tax incentives. This Note reviews the debate about the World Bank. He has been advising governments on effectiveness of tax incentives, examining two much-contested questions: tax policies and has Can tax incentives attract foreign investment? And what are the costs of written numerous articles on fiscal matters. using them? Previously, he worked for the University of Geneva As more and more governments have tried to But that does not mean that tax incentives and the World Economic attract multinational companies and enhance have no effect on foreign direct investment. It is Forum. the associated technology spillovers, fiscal incen- no coincidence that in 1985­94 foreign direct tives have become a global phenomenon--from investment grew more than fivefold in tax tax holidays and import duty exemptions to havens in the Caribbean and South Pacific. And investment allowances and accelerated depreci- Ireland's tax incentives have been recognized as ation. Although hardly new, this trend appears key in attracting international investors over the to have strengthened since the early 1990s. past two decades. Moreover, in recent years At first glance the impact of tax incentives on there has been growing evidence that tax rates foreign direct investment appears ambiguous. and incentives influence the location decisions Over the past few decades time-series econo- of companies within regional economic group- metric analysis and numerous surveys of inter- ings, such as the European Union, North national investors have shown that tax American Free Trade Area, and Association of incentives are not the most influential factor for Southeast Asian Nations. Similarly, in the multinationals in selecting investment loca- United States incentives can play a decisive role tions. More important are such factors as basic in the final location decisions of foreign com- infrastructure, political stability, and the cost panies once the choices are narrowed down to and availability of labor. Both analysis and sur- a handful of sites with similar characteristics. So, veys have confirmed that tax incentives are a more accurate would be to say that tax incen- poor instrument for compensating for negative tives affect the decisions of some investors some of factors in a country's investment climate. the time. T A X I N C E N T I V E S USING TAX INCENTIVES TO ATTRACT FOREIGN DIRECT INVESTMENT Box The pros and cons of tax holidays tax holidays or temporary rebates for certain types of investment or companies (box 1). 1 Tax holidays are among the most widely used incen- tives, especially in developing countries. In 1995, according to the United Nations Conference on Trade Another targeted approach used in many countries, especially in the industrial world, is to allow fast write-offs of investment expenditures-- and Development (UNCTAD 1995), as many as 67 coun- for all investments or for those that the govern- tries offered this incentive. Tax holidays provide benefits ment wants to promote--through tax allowances as soon as a company begins earning income, while the 1 or credits. Investment tax allowances promote benefits of a lower corporate tax rate accrue more new investment rather than giving windfall gains 2 slowly and over a longer time. But tax holidays benefit primarily short-term investments, typical of "footloose" to owners of old capital, as a reduction in corpo- industries in which companies can move quickly from rate tax rates does. Still, investment tax allowances one jurisdiction to another. They also tend to reward have limitations and drawbacks, especially for the founding of a company rather than investment in projects with long gestation periods and in unsta- existing companies, and to discriminate against invest- ble macroeconomic environments. Moreover, ments that rely on long-lived depreciable capital. And they pose management difficulties for tax admin- they can lead to erosion of the tax base as taxpayers istration and require well-developed accounting learn how to evade taxation of income from other systems. sources. For all these reasons fiscal experts have gener- A few countries have chosen a nontargeted ally been highly critical of tax holidays. approach: lowering the effective corporate tax rate for all firms while providing limited or no incentives. Small economies such as Hong Kong Other evidence emerging around the world (China), Lebanon, and Mauritius have typically suggests that tax incentives have a more appar- chosen this option. International investors look ent effect on the composition of foreign direct favorably on a country offering a low statutory investment than on its level. Indeed, most gov- tax rate, especially one well below the interna- ernments use tax policies to attract particular tional norm of 35­40 percent. A low corporate types of investment--or to change conduct-- rate signals that the government is interested in rather than to increase the overall level of letting the market determine the most prof- investment. A recent study found that large for- itable investments. But this approach can eign companies--such as those in the automo- reduce tax revenues, at least during a transi- bile sector--are generally in a better position tional period (in the longer run the simplicity of to negotiate special tax regimes and thus to the tax system may attract more investors, extract rents from host governments (Oman increasing the tax base and thus compensating 2000). for the initial reduction). These new findings have reenergized the Finally, an extreme approach has been to debate about the effectiveness of fiscal incen- simply eliminate taxes for all investors or for spe- tives. Two main questions have held the atten- cific ones. Countries that have become tax tion of researchers: What kind of tax incentives havens generally suppress all direct income are likely to have the greatest impact on the taxes and rely on indirect consumption and investment location decisions of multinational employment taxes. Other countries have lim- companies? And which companies or what ited the incentives to export-oriented activities kinds of investment are likely to be the most sen- in specific areas known as export processing sitive to tax changes? zones. These extreme approaches have had mixed results, especially when the aim was to Which tax instruments work? attract sustainable, high-value-added invest- In using tax instruments to attract foreign ment projects. These regimes have also been investors, many governments rely on a targeted increasingly contested by OECD countries and approach. In developing countries favoring such multilateral organizations because they have an approach, a popular tax incentive is a reduc- often been associated with suspicious capital tion in the corporate income tax rate, through flows. What firms respond? Regional efforts to harmonize tax The effectiveness of tax incentives is likely to Box policies vary depending on a firm's activity and its moti- vations for investing abroad. Growing evidence shows, for example, that tax incentives are a cru- cial factor for mobile firms and firms operating 2 Recent efforts to harmonize tax systems have been launched in both the industrial and the developing world. In the European Union, for example, member countries are discussing more stable, predictable, and in multiple markets--such as banks, insurance transparent tax rules. As a first step, in December companies, and Internet-related businesses-- 1997, member states adopted a code of conduct for because these firms can better exploit different business taxation, agreeing not to introduce "harmful" 3 tax regimes across countries. Such strategies tax measures and to roll back existing harmful meas- may explain the success of tax havens in attract- ures. Similarly, several West African countries have been ing subsidiaries of global companies--and the working to harmonize their tax incentives for foreign spending by multinationals on economists and direct investment in one unified investment code within accountants to justify their transfer prices, the Monetary Union of West African States. designed to suit their tax needs. Similarly, tax These efforts have been slow, and the political and economic challenges remain great. And as capital and rates generally have a greater effect on the companies become increasingly mobile, and investment investment decisions of export-oriented compa- environments increasingly similar, the temptation to use nies than on those seeking the domestic market tax incentives to attract foreign direct investment will or location-specific advantages, because such certainly increase. firms not only are more mobile but also operate in competitive markets with very slim margins. What are the costs of tax incentives? private investment in 2001. In 1996 the U.S. state Since tax policy appears to have some effect on of Alabama paid Mercedes Benz a subsidy of the location decisions of multinational firms, US$200,000 per employee, while Germany paid especially within regional markets, there is a risk Dow Chemical an astounding US$3,400,000 per that governments will "race to the bottom" with employee (Moran 1998). The question in such competitive tax incentives. Such competition cases is whether the new investment would have has already started in some regions, most come to the country if it had offered lower incen- notably in Asia. The concern is that countries tives or none at all. If the answer is yes, free-rider may end up in a bidding war, favoring multina- investors benefit while the treasury loses, and the tional firms at the expense of the state and the economy reaps no net gains. These examples welfare of its citizens. This risk has pushed gov- illustrate the need to clearly evaluate the welfare ernments to try to harmonize their tax policies implications of tax incentives, both at the level of under regional or international agreements the firm and globally. (box 2). Tax incentives also have many other, less Beyond the risk of a bidding war, tax incen- obvious costs. Because they influence the invest- tives are likely to reduce fiscal revenue and cre- ment decisions of private companies, they can ate frequent opportunities for illicit behavior by distort the allocation of resources. And they can companies and tax administrators. These issues attract investors looking exclusively for short- have become crucial in developing countries, term profits, especially in countries where the which face more severe budgetary constraints basic fundamentals (such as political and and corruption than do industrial countries. macroeconomic stability) are not yet in place. There is no doubt that tax incentives are Another problem with incentive measures costly. The first and most direct costs are those relates to the cost and difficulty of administering associated with the potential loss of revenue for them effectively. Incentive regimes generally the host government. In Tunisia, relatively suc- impose a large administrative burden, so they cessful in attracting foreign direct investment, must be more than marginally effective to cover the fiscal costs associated with the incentive the costs of their implementation and produce regime amounted to almost 20 percent of total a net benefit. Discretionary regimes, which rely T A X I N C E N T I V E S USING TAX INCENTIVES TO ATTRACT FOREIGN DIRECT INVESTMENT on case-by-case evaluations, are especially diffi- cult to administer. These regimes result in delay and uncertainty for investors, which can increase the cost of investment. They have also Notes led to significant corruption, effectively This Note is based on Wells and others (2001). screened out desirable investments, and under- 1. These allowances take three forms: accelerated viewpoint mined sound policymaking and the develop- depreciation, which allows companies to write off capital ment of competitive markets. Nondiscretionary more quickly for tax purposes than for accounting; invest- is an open forum to regimes, which grant incentives to any company ment expenditure allowances, which permit companies to encourage dissemination of meeting clearly stated requirements, are easier write off a percentage of qualifying investment expendi- public policy innovations for to implement. These regimes generally involve tures from their taxable income; and investment tax cred- private sector­led and such incentives as investment tax credits, accel- its, which allow companies to reduce taxes paid by a market-based solutions for erated depreciation, and subsidies linked to percentage of their investment expenditures. development. The views indicators that can be easily measured (exports, published are those of the technology imports, skilled labor). References authors and should not be A few governments, such as those of Ireland The Economist. 2000. "Globalization and Tax." 29 attributed to the World and Singapore, have had marked success with January, p. 5. Bank or any other affiliated targeted tax incentives. But many more have Ernst & Young. 1994. Investment in Emerging Markets: A organizations. Nor do any of failed to attract foreign direct investment with Survey of the Strategic Investment of Global 1000 Companies. the conclusions represent such incentives, explaining why the recent trend New York. official policy of the World has been to eliminate and streamline tax incen- Moran, T. 1998. Foreign Direct Investment and Bank or of its Executive tive programs. These moves appear to be sensi- Development. Washington, D.C.: Institute for International Directors or the countries ble ones, since multinationals appear to give Economics. they represent. greater weight to simplicity and stability in the Oman, C. 2000. "Policy Competition for Foreign tax system than to generous tax rebates, espe- Direct Investment: A Study of Competition among To order additional copies cially in an environment with great political and Governments to Attract FDI." Development Centre contact Suzanne Smith, institutional risks (see Ernst & Young 1994). Studies. Organisation for Economic Co-operation and managing editor, Room I9-009, Development, Paris. The World Bank, New challenges UNCTAD (United Nations Conference on Trade and 1818 H Street, NW, The debate about the impact of tax incentives Development). 1995. Incentives and Foreign Direct Invest- Washington, DC 20433. on foreign direct investment is far from over. So ment. Background report. Geneva. far the benefits appear uncertain, while the costs Wells, L., N. Allen, Jacques Morisset, and Neda Pirnia. Telephone: are large. Nevertheless, old questions will lead to 2001. Using Tax Incentives to Compete for Foreign Investment. 001 202 458 7281 new answers, and new questions will arise. FIAS Occasional Paper 15. Washington, D.C.: World Bank. Fax: The emergence of global companies will 001 202 522 3480 have a significant impact on government rev- Email: enues. These companies are likely to be more ssmith7@worldbank.org sensitive to tax incentives, because they will be better able to exploit them by transferring their Copyedited and produced by activities from one country to another. Indeed, Communications the Internet could increase tax competition by Development Inc. making it much easier for multinationals to shift their activities to low-tax regimes that are physi- Printed on recycled paper cally far from their customers but virtually only a mouse-click away. As The Economist (2000, p. 5) commented, "many more companies may be able to emulate Rupert Murdoch's News Corporation, which has earned profits of US$2.3 billion in Britain since 1987 but paid no corporation tax there." This Note is available online: http://rru.worldbank.org/Viewpoint/index.asp