Page 7 - Working Paper (Tax Incentives: An Alternative to Revenue Enhancement)
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DDTC Working Paper 1115

                          Table 3 - Proponent and Opponent to       is applied to all foreign investors . The investments
                                   Tax Incentives                   that  benefit  from  tax  incentives  are  additional
                                                                    to what would take place  in the absence of the
                    Proponent            Opponent
                                                                    incentives.  An  investment  is  financially  feasible
                                         Revenue loss due to        and viable  in the host country but  could  earn a
                    Higher profits to the firms
                                         redundancy                 higher risk-adjusted rate of return in another new
                    Positive externalities  -   Revenue loss due to partial   location, and the profit differential is high enough
                    spillover effects from the   redundancy         that  tax  incentives  will  compensate the location
                    accumulation of knowledge                       change. Additionally, tax  incentive gives  positive
                    Signal a country’s                              effect if an  investment  is not  viable  under the
                    commitment to facilitating   Revenue loss due to reverse   current tax set up, but becomes so due to the tax
                                         foreign aid
                                                                    break. As stated  in Table  3 above, tax  incentives
                                         Indirect Revenue cost      do  cause  some  negative  results.  Some  selective
                                         – this occurs if the tax-
                                         favored activities undercut   incentives do no or only change little the attitude of
                    Tax competition
                                         the profitability of other   foreign investors. These categorized as superfluous
                                         producers who do pay taxes   and partial redundancy tax incentives. An example
                                         due to harsh competition.  is a resource-based investment such as Mahakam
                    Capital mobility – attracting   Revenue leakage through   project block  in East Kalimantan  operated  by
                    inward flows of foreign   avoidance and evasion  TOTAL E&P Indonesia. As long as the project is still
                                                                    financial  and  economically  viable,  TOTAL  cannot
                                         Revenue leakage through    simply pull up their operations elsewhere.
                    Compensating for other   avoidance and evasion
                    deficiencies in the   – company churning:
                    investment climate   establishing new company to
                                         get the facility           4. Economic Analysis of Tax Incentives
                                         Transfer pricing practice on
                    Revenue gains                                      John  Maynard  Keynes’s  General  Theory
                                         purchases and sales
                                                                    set investment  as a  central  variable  in the
                                         Revenue leakage due to false
                    Political cover                                 determination of the aggregate level of output. The
                                         export declaration
                                                                    level of investment is a function of the marginal
                    Practicality that contributes
                    to other policy objectives   Increasing the tax burden on   efficiency  of  capital  weighed  against  the  market
                    such as investment   other activities and persons.  interest rate (see  Figure 1).  The  market interest
                    promotion and job creation.                     rate  itself is  considered  as the cost  of  capital
                    Experience shows that                           for investors.  As interest rate or cost of capital
                    incentives can work                             decreases (from r to r*), investment will increase
                    Effectiveness and Economic Impact of Tax Incentives in the SADC Region, 2004  (from Io to I*). The application of tax  incentives
                                                                    reduces cost of capital, assume all other variables
                   difficult  to  administer.  Conversely,  the  authority   constant, will improve investment. However, there
                   may see a discretionary triggering mechanism as   are few elements that  the central  government
                   preferable to an automatic one because it provides   needs to identify.
                   them with more flexibility.
                                                                       First, the government should be able to measure
                      This  advantage is likely to be outweighed,   loss of revenue due to tax incentives and match it
                   however, by a variety of problems associated with   with the benefit originating from future investment.
                   discretion, most notably a lack of transparency in   There is no doubt that tax incentives are costly. The
                   the decision-making process, which could in turn   first  and  most  direct  associated  costs  are  those
                   encourage corruption and rent-seeking activities.   associated with the potential loss of revenue for the
                   If the concern about having an automatic triggering   authorities. Second, possibility of creating adverse
                   mechanism is the loss of discretion in handling   selection problems because most of the incentives
                   exceptional  cases, the preferred  safeguard would   for intended specific sectors and regions and not on
                   be  to formulate the qualifying criteria in as   the performance of each entities. Third, conducive
                   narrow and specific a fashion as possible, so that   central  and local  regulatory frameworks. These
                   incentives are granted only to investments meeting   regulations are mostly pertaining to industrial and
                   the highest objective and quantifiable standard of   trade. From Figure 1  below, dark blue  rectangle
                   merit. On balance, it is advisable to minimize the   measures the amount of tax revenue forgone (or
                   discretionary element  in the incentive-granting   tax  expenditure) by imposing tax  incentives and
                   process.                                         the light blue  triangle is the dead-weight loss of
                                                                    creating such policies. Measuring the dead-weight
                      General  tax  incentives  may reduce  the risk  of
                                                                    loss is not easy as it looks. Tax incentives may have
                   corruption in developing countries since the policy
                                                                    17. Pisani, Op.Cit., 301
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