Tax Incentives and Tax Base Protection in Developing Countries
Joosung Jun
Draft paper prepared for Fourth High-Level Dialogue on FINANCING FOR DEVELOPMENT in Asia and Pacific, United Nations ESCAP, Bangkok, April 28-29, 2017
Tax incentives have been widely used in developing countries to promote economic growth, though their cost effectiveness has been challenged by fiscal experts for many years. In addition to foregone revenue, tax incentives can incur distortions in resource allocation, complicate tax administration and provide opportunity for corruption and rent-seeking.
The empirical evidence on theirbenefits, though, is vdistortions ind inconclallocation, complicatee thadministration and andve made use of such a seemingly ineffective and inefficient instrument,inlieuof a regular budget expenditure,to support a targeted activity.4 Oneimmediate answer in the practical context of policy-making is that unlike budget expenditure, tax breaksdo not require a new source of revenue to finance anactivity. Tax revenue in developing countries is generally low so that their governments have to operate a tight budget in financing infrastructure and public education. Instead of introducing a new spending item, governments may find it convenient to choose a tax expenditure that can even be heralded as a ‘tax cut.’
A more standard explanation for the continued popularity of tax incentives is related to foreign investment that could bring capital and technology to a host country. While tax is one of the many factors that determine multinational corporations’ investment location, governments might prefer to use a more visible and readily available tool like tax holidays rather than making efforts to improve the overall investment climate such as macroeconomic stability and adequacy of public infrastructure.However, the literature has consistently doubted the efficacy of investment incentives per se, emphasizing the importance of the synergy of tax and nontax factors. The observation that investment incentives were often used as a way to compensate for investment climate deficiencies in many countries (OECD 2008)was frequentlycited as a worst practice, though thisnegative connotation will be challenged in this paper.The literature also noted the possibility of ‘a race to the bottom’ engendered by increased tax competitionas legal and economic barriers on capital mobility have been lifted.
This prediction of tax base erosion seems to be exaggerated considering the complex nexus of investment motives of multinationals and the differing attributes of host countries. In practice, as argued below, smallereffectsof investment incentives would likely beoffsetby lower revenue costs unless these incentives are literally redundant. Rather, a more worrisome base-erosion threat in the context of international investment may beprofit shifting by foreign firms through such tax saving devices as transfer pricing.
The existing literature has also noted that administrative complexity and statutory arbitrariness associated with tax incentives would provide an opportunity for corruption and rent-seeking, incurring a variety of social costs. If governments in poorer countries are less able to withstand the inevitable political pressures to favor some sectors over others, they might choose policies contrary to overall national welfare. James (2013) showsthat ‘discretionary’ tax incentives, which are more prone to abuse and waste than an automatic triggering mechanism, are still prevalent in many regions of the world.6 Corruption has been one of the major policy challenges facing developing countries and its implications for tax revenue have been recognized in the literature.7 The prevalence of corruption weakens the culture of compliance, thereby increasing tax evasion. In order to reduce the abuse of tax laws for private gain, taxpolicy should be designed in a way to minimize the discretion of tax officials. In addition, administrative capacity needs to be enhanced so that more information on taxable transactions is available to government authorities. After all, corruption and tax evasion arise because they are hard to observe.
The Korean example is puzzling since the effects of tax incentives on marginal investment by local firms areestimated to be weak.11 If investmentallowancesand credits werenot sufficiently effective, why then would the government keep these incentives in place despite their implied revenue and efficiency costs?Political factors might well have worked to some extentconsidering the cozyrelationship between large firms and the government there. But this alone could not be an adequateexplanationfor the continuity of tax incentives. It is hard to imagine that a countrycanmakesuch a remarkable economic progress while wasting valuable fiscal resources in such a way. Notably,tax revenue has steadily increased from 17% of GDP in 1980 to the current 25% in Korea.One possibility is, this paper suggests, that there is an alternative route through which tax incentives may promote investment.That is, incentivescan be used to support firms that pay more in taxes, and the increased revenue can be used to finance growth-promoting infrastructure. Probably, the Korean government has favored local companies because they made a greater contribution to its revenue base than foreign investors.
The comparison of Singapore and Korea implies that tax policy needs tobe designed and evaluated taking into account country-specific factors. Among developing countries there can be large differences in economic and political structures, with different countries facing different constraints. Even among countries that pursue a growth-oriented tax policy, a tax structure that might be desirable for one could be undesirable for another. In the context of tax incentives, therefore, best practices based on optimal tax theory andtheexperienceof advanced countries should be considered with caution formost developing countries. In countries with strong investmentclimates such as Hong Kong and Singapore, investment incentives could generate expected results. For most developing countries, however, it is a remote possibility to build infrastructure and human resources in a short period of time. Providing tax incentives then can be a second-best option if appropriately designed taking into account country-specific factors. This paper examines various channels through which tax incentives can be better exploited, with differing suggestions reflecting different economic structures.
Tax Incentives and Tax Base Protection in Developing Countries
Joosung Jun
Draft paper prepared for Fourth High-Level Dialogue on FINANCING FOR DEVELOPMENT in Asia and Pacific, United Nations ESCAP, Bangkok, April 28-29, 2017
Tax incentives have been widely used in developing countries to promote economic growth, though their cost effectiveness has been challenged by fiscal experts for many years. In addition to foregone revenue, tax incentives can incur distortions in resource allocation, complicate tax administration and provide opportunity for corruption and rent-seeking.
The empirical evidence on theirbenefits, though, is vdistortions ind inconclallocation, complicatee thadministration and andve made use of such a seemingly ineffective and inefficient instrument,inlieuof a regular budget expenditure,to support a targeted activity.4 Oneimmediate answer in the practical context of policy-making is that unlike budget expenditure, tax breaksdo not require a new source of revenue to finance anactivity. Tax revenue in developing countries is generally low so that their governments have to operate a tight budget in financing infrastructure and public education. Instead of introducing a new spending item, governments may find it convenient to choose a tax expenditure that can even be heralded as a ‘tax cut.’
A more standard explanation for the continued popularity of tax incentives is related to foreign investment that could bring capital and technology to a host country. While tax is one of the many factors that determine multinational corporations’ investment location, governments might prefer to use a more visible and readily available tool like tax holidays rather than making efforts to improve the overall investment climate such as macroeconomic stability and adequacy of public infrastructure.However, the literature has consistently doubted the efficacy of investment incentives per se, emphasizing the importance of the synergy of tax and nontax factors. The observation that investment incentives were often used as a way to compensate for investment climate deficiencies in many countries (OECD 2008)was frequentlycited as a worst practice, though thisnegative connotation will be challenged in this paper.The literature also noted the possibility of ‘a race to the bottom’ engendered by increased tax competitionas legal and economic barriers on capital mobility have been lifted.
This prediction of tax base erosion seems to be exaggerated considering the complex nexus of investment motives of multinationals and the differing attributes of host countries. In practice, as argued below, smallereffectsof investment incentives would likely beoffsetby lower revenue costs unless these incentives are literally redundant. Rather, a more worrisome base-erosion threat in the context of international investment may beprofit shifting by foreign firms through such tax saving devices as transfer pricing.
The existing literature has also noted that administrative complexity and statutory arbitrariness associated with tax incentives would provide an opportunity for corruption and rent-seeking, incurring a variety of social costs. If governments in poorer countries are less able to withstand the inevitable political pressures to favor some sectors over others, they might choose policies contrary to overall national welfare. James (2013) showsthat ‘discretionary’ tax incentives, which are more prone to abuse and waste than an automatic triggering mechanism, are still prevalent in many regions of the world.6 Corruption has been one of the major policy challenges facing developing countries and its implications for tax revenue have been recognized in the literature.7 The prevalence of corruption weakens the culture of compliance, thereby increasing tax evasion. In order to reduce the abuse of tax laws for private gain, taxpolicy should be designed in a way to minimize the discretion of tax officials. In addition, administrative capacity needs to be enhanced so that more information on taxable transactions is available to government authorities. After all, corruption and tax evasion arise because they are hard to observe.
The Korean example is puzzling since the effects of tax incentives on marginal investment by local firms areestimated to be weak.11 If investmentallowancesand credits werenot sufficiently effective, why then would the government keep these incentives in place despite their implied revenue and efficiency costs?Political factors might well have worked to some extentconsidering the cozyrelationship between large firms and the government there. But this alone could not be an adequateexplanationfor the continuity of tax incentives. It is hard to imagine that a countrycanmakesuch a remarkable economic progress while wasting valuable fiscal resources in such a way. Notably,tax revenue has steadily increased from 17% of GDP in 1980 to the current 25% in Korea.One possibility is, this paper suggests, that there is an alternative route through which tax incentives may promote investment.That is, incentivescan be used to support firms that pay more in taxes, and the increased revenue can be used to finance growth-promoting infrastructure. Probably, the Korean government has favored local companies because they made a greater contribution to its revenue base than foreign investors.
The comparison of Singapore and Korea implies that tax policy needs tobe designed and evaluated taking into account country-specific factors. Among developing countries there can be large differences in economic and political structures, with different countries facing different constraints. Even among countries that pursue a growth-oriented tax policy, a tax structure that might be desirable for one could be undesirable for another. In the context of tax incentives, therefore, best practices based on optimal tax theory andtheexperienceof advanced countries should be considered with caution formost developing countries. In countries with strong investmentclimates such as Hong Kong and Singapore, investment incentives could generate expected results. For most developing countries, however, it is a remote possibility to build infrastructure and human resources in a short period of time. Providing tax incentives then can be a second-best option if appropriately designed taking into account country-specific factors. This paper examines various channels through which tax incentives can be better exploited, with differing suggestions reflecting different economic structures.