viewpoint
T H E W O R L D B A N K G R O U P P R I V A T E S E C T O R A N D I N F R A S T R U C T U R E N E T W O R K
As more and more governments try to attract
multinational companies and enhance the associated
technology spillovers, fiscal incentives
have become a global phenomenon—from tax
holidays and import duty exemptions to investment
allowances and accelerated depreciation.
Although hardly new, this trend appears to have
strengthened since the early 1990s.
At first glance the impact on foreign direct
investment of tax incentives appear ambiguous.
Over the past few decades time-series econometric
analysis and numerous surveys of international
investors have shown that tax
incentives are not the most influential factor for
multinationals in selecting investment locations.
More important are such factors as basic
infrastructure, political stability, and the cost
and availability of labor. Both analysis and surveys
have confirmed that tax incentives are a
poor instrument for compensating for negative
factors in a country’s investment climate.
But that does not mean that tax incentives
have no effect on foreign direct investment. It
is no coincidence that in 1985–94 foreign
direct investment grew more than fivefold in
tax havens in the Caribbean and South Pacific.
And Ireland’s tax incentives have been recognized
as key in attracting international
investors over the past two decades. In recent
years there has been growing evidence that tax
rates and incentives influence the location
decisions of companies within regional economic
groupings, such as the European Union,
North American Free Trade Area, and
Association of Southeast Asian Nations.
Similarly, in the United States incentives can
play a decisive role in the final location decisions
of foreign companies once the choices
are narrowed down to a handful of sites with
similar characteristics. So, more accurate
would be to say that tax incentives affect the
decisions of some investors some of the time.
The increasing mobility of international firms and the gradual
elimination of barriers to global capital flows have stimulated
competition among governments for foreign direct investment, often
through tax incentives. This Note reviews the debate about the
effectiveness of tax incentives, examining two much-contested questions:
Can tax incentives attract foreign investment? And what are the costs of
using them?
Tax Incentives
Jacques Morisset Using Tax Incentives to Attract Foreign Direct Investment
(jmorisset@ifc.org),
Private Sector Advisory
Services
T A X I N C E N T I V E S U S I N G T A X I N C E N T I V E S T O A T T R A C T F O R E I G N D I R E C T I N V E S T M E N T
Other evidence is emerging around the
world that tax incentives have a more apparent
effect on the composition of foreign direct
investment than on its level. Indeed, most governments
use tax policies to attract particular
types of investment—or to change conduct—
rather than to increase the overall level of
investment. A recent study found that large foreign
companies—such as those in the automobile
sector—are generally in a better position
to negotiate special tax regimes and thus
extract rents from host governments (Oman
2000).
These new findings have reenergized the
debate about the effectiveness of fiscal incentives.
Two main questions have held the attention
of researchers: What kind of tax incentives
are likely to have the greatest impact on the
investment location decisions of multinational
companies? And which companies or what
kinds of investment are likely to be the most sensitive
to tax changes?
Which tax instruments work?
In using tax instruments to attract foreign
investors, many governments rely on a targeted
approach. In developing countries favoring such
an approach, a popular tax incentive is a reduction
in the corporate income tax rate, through
tax holidays or temporary rebates for certain
types of investment or companies (box 1).
Another targeted approach used in many
countries, especially in the industrial world, is to
allow fast write-offs of investment expenditures—
for all investments or for those that the government
wants to promote—through tax allowances
or credits.1 Investment tax allowances promote
new investment rather than giving windfall gains
to owners of old capital, as a reduction in corporate
tax rates does. Still, investment tax
allowances have limitations and drawbacks, especially
for projects with long gestation periods and
in unstable macroeconomic environments.
Moreover, they pose management difficulties for
tax administration and require well-developed
accounting systems.
A few countries have chosen a non-targeted
approach, which is to lower the effective corporate
tax rate for all firms with no or limited
incentives. Small economies such as Hong
Kong, Lebanon, and Mauritius have typically
chosen this option. International investors look
favorably on a country offering a low statutory
tax rate, especially one well below the international
norm of 35–40 percent. A low corporate
rate signals that the government is interested in
letting the market determine the most profitable
investments. But this approach can
reduce tax revenues, at least during a transitional
period (in the longer run the simplicity of
the tax system may attract more investors,
increasing the tax base and thus compensating
for the initial reduction).
Finally, an extreme approach has been to
simply eliminate taxes for all investors or for specific
ones. Countries that have become tax
havens generally suppressed all direct income
taxes and rely on indirect consumption and
employment taxes. Other countries have limited
the incentives to export-oriented activities
in specific areas known as export processing
zones. These extreme approaches have had
mixed results, especially when the aim was to
attract sustainable, high-value-added investment
projects. These regimes have also been
increasingly contested by OECD countries and
multilateral organizations because they have
often been associated with suspicious capital
flows.
2
Box The pros and cons of tax holidays
Tax holidays are among the most widely used incentives,
especially in developing countries. In 1995,
according to the United Nations Conference on Trade
and Development (UNCTAD) as many as 67 countries
offered this incentive. Tax holidays provide benefits as
soon as a company begins earning income, while the
benefits of a lower corporate tax rate accrue more
slowly and over a longer time. But tax holidays benefit
primarily short-term investments, typical of “footloose”
industries in which companies can move quickly from
one jurisdiction to another. They also tend to reward
the founding of a company rather than investment in
existing companies, and to discriminate against investments
that rely on long-lived depreciable capital. And
they can lead to an erosion of the tax base as taxpayers
learn how to evade taxation of income from other
sources. For all these reasons fiscal experts have generally
been highly critical of tax holidays.
1
What firms respond?
The effectiveness of tax incentives is likely to
vary depending on a firm’s activity and its motivations
for investing abroad. Growing evidence
shows, for example, that tax incentives are a crucial
factor for mobile firms or firms operating in
multiple markets—such as banks, insurance
companies, and Internet-related businesses—
because these firms can better exploit different
tax regimes across countries. Such strategies
may explain the success of tax havens in attracting
subsidiaries of global companies—and the
spending by multinationals on economists and
accountants to justify their transfer prices,
designed to suit their tax needs. Similarly, tax
rates generally have a greater effect on the
investment decisions of export-oriented companies
than on those seeking the domestic market
or location-specific advantages, because such
firms not only are more mobile but also operate
in competitive markets with very slim margins.
What are the costs of tax incentives?
Since tax policy appears to have some effect on
the location decisions of multinational firms,
especially within regional markets, there is a risk
that governments will “race to the bottom” with
competitive tax incentives. Such competition
has already started in some regions, most
notably in Asia. The concern is that countries
may end up in a bidding war, favoring multinational
firms at the expense of the state and the
welfare of its citizens. This risk has pushed governments
to try to harmonize their tax policies
under regional or international agreements
(box 2).
Beyond the risk of a bidding war, tax incentives
are likely to reduce fiscal revenue and create
frequent opportunities for illicit behavior by
companies and tax administrators. These issues
have become crucial in developing countries,
which face more severe budgetary constraints
and corruption than do industrial countries.
There is no doubt that tax incentives are
costly. The first and most direct costs are those
associated with the potential loss of revenues for
the host government. In Tunisia, relatively successful
in attracting foreign direct investment,
the fiscal costs associated with the incentive
regime amounted to almost 20 percent of total
private investment in 2001. The U.S. state of
Alabama paid Mercedes Benz a subsidy of
US$200,000 per employee in 1996, while
Germany paid an astounding US$3,400,000 per
employee to Dow Chemical in 1996 (Moran
1998). The question in such cases is whether the
new investment would have come to the country
if it had offered lower incentives or none at all.
If the answer is yes, free-rider investors benefit
while the treasury loses, and the economy reaps
no net gains. These examples illustrate the need
to clearly evaluate the welfare implications of tax
incentives, both at the firm and global levels.
Tax incentives also have many other, less
obvious costs. Because they influence the investment
decisions of private companies, they can
distort the allocation of resources. And they can
attract investors looking for short term profits
exclusively, especially in countries where the
basic fundamentals (such as macroeconomic
and political stability) are not yet in place.
Another problem with incentive measures
relates to the cost and difficulty of administering
them effectively. Incentive regimes generally
impose a large administrative burden, so they
must be more than marginally effective to cover
the costs of their implementation and produce
a net benefit. Discretionary regimes, which rely
3
Box
Regional efforts to harmonize tax
policies
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
transparent tax rules. As a first step, in December
1997, member states adopted a code of conduct for
business taxation, agreeing not to introduce “harmful”
tax measures and to roll back existing harmful measures.
Similarly, several West African countries have been
working to harmonize their tax incentives for foreign
direct investment in one unified investment code within
the Monetary Union of West African States.
These efforts have been slow, and the political and
economic challenges remain great. And as capital and
companies become increasingly mobile, and investment
environments increasingly similar, the temptation to use
tax incentives to attract foreign direct investment will
certainly increase.
2
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viewpoint
on case-by-case evaluations, are especially difficult
to administer. These regimes result in delay
and uncertainty for investors, which can
increase the cost of investment. They have also
led to significant corruption, effectively
screened out desirable investments, and undermined
sound policymaking and the development
of competitive markets. Non-discretionary
regimes, which grant incentives to any company
meeting clearly stated requirements, are easier
to implement. These regimes generally involve
such incentives as investment tax credits, accelerated
depreciation, and subsidies linked to
indicators that can be easily measured (exports,
technology imports, skilled labor).
A few governments, such as those of Ireland
and Singapore, have had marked success with
targeted tax incentives. But many more have
failed to attract foreign direct investment with
such incentives, explaining why the recent trend
has been to eliminate and streamline tax incentive
programs. These moves appear to be sensible
ones, since multinationals appear to give
greater weight to simplicity and stability in the
tax system than to generous tax rebates, especially
in an environment with great political and
institutional risks (see Ernst & Young 1994).
New challenges
The debate about the impact of tax incentives
on foreign direct investment is far from over. So
far the benefits appear uncertain, while the costs
are large. Nevertheless, old questions will lead to
new answers, and new questions will arise.
The emergence of global companies will
have a significant impact on government revenues.
These companies are likely to be more
sensitive to tax incentives, because they will be
better able to exploit them by transferring their
activities from one country to another. Indeed,
the Internet could increase tax competition by
making it much easier for multinationals to shift
their activities to low-tax regimes that are physically
far from their customers but virtually only
a mouse-click away. As The Economist (2000)
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.”
Notes
This note is based on Wells and others (2001).
1. These allowances take three forms: accelerated
depreciation, which allows companies to write off capital
more quickly for tax purposes than for accounting; investment
expenditure allowances, which permit companies to
write off a percentage of qualifying investment expenditures
from their taxable income; and investment tax credits,
which allow companies to reduce taxes paid by a
percentage of their investment expenditures.
References
The Economist. 2000. “Globalization and Tax.” January
29, p. 5.
Ernst & Young. 1994. “Investment in Emerging
Markets: A Survey of the Strategic Investment of Global
1000 Companies.” New York.
Moran, T. 1998. Foreign Direct Investment and
Development. Washington, D.C.: Institute for International
Economics.
Oman, C. 2000. “Policy Competition for Foreign
Direct Investment: A Study of Competition among
Governments to Attract FDI.” Development Centre
Studies. Organisation for Economic Co-operation and
Development, Paris.
Wells, L., N. Allen, Jacques Morisset, and Neda Pirnia.
2001. Using Tax Incentives to Compete for Foreign Investment.
FIAS Occasional Paper 15. Washington, D.C.: World Bank.
UNCTAD (United Nations Conference on Trade and
Development). 1995. “Incentives and Foreign Direct
Investment; Background Report.” Geneva.