Page 5 - Working Paper (Tax Incentives: An Alternative to Revenue Enhancement)
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DDTC Working Paper 1115

                   tax rates and other favorable provisions to reduce   circumstances .  Reducing  import  tariffs  as  part
                   the tax burden on foreign companies. Developing   of  an  overall  program  of  trade  liberalization  is
                   countries are competing  against  each other to   a  major policy  challenge  currently facing  many
                   provide better tax  and  economic situations  for   developing  countries. Tariff reduction should not
                   foreign investors,  but  without  a well-established   lead to unintended changes in the relative rates of
                   tax  structure they bring negative effects to their   effective protection across sectors. One simple way
                   own economies  and to  international  commerce   of ensuring that unintended consequences do not
                   as well .  Developing  countries  often  establish   occur would be to reduce all nominal tariff rates by
                   tax  incentives without  having the proper policy   the same proportion whenever such rates need to
                   planning, so the design and implementation of the   be changed.
                   tax measure is not well structured – but the need
                   to collect more revenue from foreign investment is   While  granting  tax  incentives to promote
                   helping to create jobs and build infrastructure, this   investment is  common in countries  around the
                   may lead one of the conclusion that the incentive   world, evidence suggests that  their effectiveness
                   are working .  Moreover,  by  granting  preferences   in attracting  incremental  investments—above
                   and incentives, emerging economies  give up  a   and beyond the level that  would have been
                   substantial portion of their tax base. IMF studies   reached had no incentives been granted—is often
                   have documented that widespread tax exemptions   questionable. As tax incentives can be abused by
                   have led to low tax ratios, which are major fiscal   existing enterprises disguised as new ones through
                   factors in contributing to fiscal crises in emerging   nominal  reorganization,  their  revenue  costs  can
                   market economies .                               be high. Moreover, foreign investors, the primary
                                                                    target of most tax incentives, base their decision to
                      As shown  in Table  1 above, neighboring      enter a country on a whole host of factors of which
                   countries  utilized  a  mix  of  tax  incentives  to   tax  incentives are frequently far from being the
                   channel  investment  to  specific  regions,  sectors   most important one. Tax incentives could also be
                   and to enhance corporate performance as well as   of questionable value to a foreign investor because
                   to transfer of technology. Similar to Batam Special   the true beneficiary of the incentives may not be
                   Zone in Indonesia, Malaysia also establishes special   the investor, but  rather  the treasury  of  his  home
                   economic zone in Labuan Offshore Financial Center.   country.
                   The majority of tax  incentives granted by these
                                                                       This can come about when any income spared
                   countries relate to investment  in manufacture,
                                                                    from taxation in the host country is taxed by the
                   oil and other mineral  resources extraction,  and
                                                                    investor’s home country. Evidence from emerging
                   tourism.  Malaysia,  Singapore,  and  Philippines
                                                                    economies suggests that tax incentives have a more
                   also employ additional incentives  to attract
                                                                    apparent effect on the composition of FD than on
                   headquarters  of  companies  through reduced
                                                                    its level. Indeed, most government uses tax policies
                   corporate tax rates. Foreign companies engaged in
                                                                    to attract  particular  types of investment  rather
                   agriculture, forestry, or animal husbandry located
                                                                    than to increase the overall level of investment .
                   in a remote undeveloped area will receive a 15 – 30
                                                                    A recent study found that large foreign companies,
                   percent reduction of income tax rate for a further
                                                                    such as those in the automobile sector, are generally
                   10 years after  the expiration  of the initial  tax
                                                                    in a better position to negotiate special tax regimes
                   exemption and reduction period.
                                                                    and thus to extract rents from host governments .
                   3. Types of Tax Incentives                          Of all the forms of tax incentives, tax holidays
                                                                    (exemptions from paying tax for a certain period
                      Tax incenTives can be jusTified if            of time) are the most popular among developing
                    They address some form of markeT                countries.  According  to  the  United  Nations
                            failure, mosT noTably Those             Conference  on  Trade  and  Development,  as  many
                                 involving exTernaliTies.           as 67 countries offered tax holidays. Tax holidays
                                                                    provide benefits as soon as the companies generate
                                                                    income. In practice, tax holiday offers larger benefit
                      Tax incentives  are  part of  the tax  system  of
                                                                    for short-term (i.e. footloose industries) investment
                   developing countries  and are usually established
                                                                    that  might  move easily from one jurisdiction  to
                   by the Government to grant foreign investors more
                                                                    another. Therefore, tax holiday usually prefers the
                   attractive conditions to invest in their country. This
                                                                    establishment  of new multinationals  companies
                   incentive must be created  under  stable  political
                                                                    12. Pisani, Op.Cit., page 300
                                                                    13. Morriset, Jacques, Op.Cit., page 3
                   9. Pisani, Op.Cit., 302
                                                                    14. Oman, C,”Policy Competition for FDI: A Study of Competition among
                   10. Ibid.                                        Governments to Attract FDI”, Development Center Studies, OECD, Paris,
                   11. Baker, Op.Cit., at 8                         2000.
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