Page 3 - Working Paper (Tax Incentives: An Alternative to Revenue Enhancement)
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DDTC Working Paper 1115

                   1. Introduction                                  and regional non-economic objectives; and (v) the
                                                                    effects on firm’s organization . A report prepared
                    The debaTe on The effecTiveness of              by the World Bank in 2005 found that, as a result
                       Tax incenTives is always relaTed             of  foreign  direct  investment,  foreign  firms  create
                         To how one counTry is able To              important spillover effects. The present of export
                   leverage Their invesTmenT climaTe,               oriented foreign firms is positively correlated with
                     labor producTiveness, as well as               the  likelihood  of  domestic  firms  making  foreign
                      improve insTiTuTional condiTion               sales.
                         and noT solely on governmenT
                                            fiscal policies.           Investors, on the other hand, consider
                                                                    locating  their  investments  based on several
                                                                    factors  such  as cheap labor, currency  exchange
                      The  increasing mobility of  international    as well as fiscal policies related to tax incentives.
                   firms  and  the  gradual  elimination  of  barriers  to   Developing  countries  mostly  classified  of  having
                   global  capital  flows  have  stimulated  competition   underdeveloped capital  markets and depend
                   among governments to attract foreign direct      on  foreign markets to  leverage their  domestic
                   investment, often through  tax policies . Taxation   production. Developing countries must find ways
                   is  a  government  main  fiscal  policy  to  generate   to attract foreign investment that is good enough
                   revenues  to  finance  government  spending  on   to outweigh the economic  political  or social
                   the goods  and services.  The  ideal tax  system in   instabilities that can arise. Measures to reduce the
                   developing countries, in essence, face formidable   negative influence of nontax issued are addressed
                   challenges.  First,  economy structures in  these   through  the  implementation  of  beneficial  tax
                   particular  developing and transient economies   policies,  which  may include tax  incentive, tax
                   still rely heavily on agriculture or informal sectors   holidays, and tax  sparing provisions . These
                   where  they  are  seldom  paid  a  regular  and  fixed   policies could also lead to harmful tax competition
                   wage. This creates a difficulty in calculating their   that  may cause negative economic  consequences
                   taxes. Secondly, it is difficult to create an efficient   for developing countries.
                   tax  administration  without  a  well-educated and
                   well-trained  staff, when  money is  lacking  to  pay   Similar  to  other  policies,  tax  policies
                   good  wages  to  tax  officials  and  to  computerize   implemented in developing  countries are based
                   the operation, and when taxpayers  have limited   on trial and error. The  problem is  that  emerging
                   ability to keep account. As a result, governments   economies  do not have a model to rely on that
                   often take the path of least resistance, developing   demonstrates the efficient use of their tax systems
                   tax  systems  that  allow them to exploit  whatever   to provide the critical ingredients for development,
                   options are available  rather than  establishing   including increasing and retaining investment and
                   rational, modern, and efficient tax systems . Third,   at  the  same time increasing tax  revenue .  Some
                   income distribution  is unevenly distributed and   notable  experts mentioned  that  there are other
                   constant economic growth is not easily maintained.  problems like poverty, corruption,  inadequate
                                                                    infrastructure, low employment, and limited
                      With  regards to boosting investment and      reasonable  educated  officials  need  to  be  solved
                   upgrading productivity, most transient economies   before implementing tax incentives. Foreign direct
                   exercise tax incentives. These incentive include tax   investment will  surely have  direct and indirect
                   credit for new  foreign and  domestic investment;   effects to those problems alleviation; however, the
                   tax holidays for specific limited time frame for new   question is  whether  tax  incentives  are the right
                   firms; exemptions from import duties particularly   approach.
                   to capital  good and establish  special  economic
                   zones for exporting companies. The debate on the    This paper starts with exploring the rationale
                   effectiveness of tax  incentives is always related   behind providing tax  incentives and empirical
                   to how one country is  able to leverage their
                                                                    3. Shah, Anwar and Robin Broadway, “How Tax Incentives  Affect
                   investment climate, labor productiveness, as well
                                                                    Decisions to Invest in Developing Countries”, Policies Research Working
                   as improve institutional  condition.  Other factors   Paper, WPS 1011, The World Bank, November 1992.
                   to  be considered  in designing  tax  incentives  are   4.  Pisani,  Andres E.  Bazo,”Do  Developing  Countries’ Tax  Incentives
                                                                    Attract Investment or Create Disaster”, Tax Notes International, October
                   (i)  inflation  –  where  incentives  should  offset  the
                                                                    2008. Tax sparing provision is a devise used both by countries taxing
                   effects of inflation; (ii) tax evasion; (iii) technology   worldwide income, which allow a foreign tax credit as well as exemption
                   transfer; iv) the fulfillment of social, environmental   countries  which allow a foreign tax credit  for certain kinds of income
                                                                    (like dividends) that are not exempt. The object is to permit developing
                                                                    countries  to reduce their income taxes under an incentive  scheme for
                                                                    foreign taxpayers without having the residence country collect the spared
                   1.  Morriset,  Jacques,”Using  Tax  Incentives  to  Attract FDI”,  The  World   tax (William B. Barker, 2007)
                   Bank Note Number 253, February 2003              5.  Baker,  William  B,”  An International Tax  System for  Emerging
                   2. Tanzi, Vito and Howell Zee, “Tax Policy for Developing Countries”, IMF   Economies, Tax Sparing, and Development: It is All About Source” 29 Pa.
                   Working Paper, IMF, March 2001.                  J. Int’l L. 349 (Winter 2007).
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