Tax competition: Debunk the myth

How big is
the real
problem of tax competition?

Foreign
Direct Investments
: these are at the top of the
wish-list of developing countries, for which they have been fighting over the
past years. Indeed, in order to fill the gap between the North and the South,
developing countries have relied on investments from both local and foreign
investors. Nonetheless, sometimes, countries just lack the sufficient funds to
invest in heavy capital projects which would only produce benefits in the long
term. Likewise, countries in their early stage of industrialization may lack
the know-how, experience and technology to set up plants or start new
industries. As a consequence, they can only rely on foreign direct investments
to carry out such projects.

Furthermore, FDI usually comes with numerous
positive spillovers in the economy: technology transfers, creation and
formation of the workforce, and dynamism in the region. Hence, given all the
advantages, there is a strong and understandable desire coming from developing
governments to attract these kinds of investments.  

image

The next question for governments would be:
how do we attract these investors?
Investment decisions rely on multiple factors impacting the risk of the
projects: transport infrastructures, energy supply, business environment,
political stability, financial soundness of the project and many others,
including tax incentives, for which we wish to take a closer look at.

What are they? A tax incentive is a gift
from governments to certain industries that allow them to avoid paying certain
taxes over a certain period (income tax, import-export taxes for example) or delay
the moment they will start paying taxes.

Although attractive at first sight, tax incentives
are actually only secondary for investors. According to recent surveys and
studies, investors are much more sensitive to a clear, sound and coherent
taxation system than incentives[1].

In addition to the uncertainty of the
outcome of using tax incentives, there are also some heavy costs attached to
it: loss of public revenue, possibility of attracting financially unstable
projects, distortion of the market or the risk of corruption. And above all, once
an incentive is provided, it appears difficult to then dismiss it further down
the road.

Considering the growing needs of developing
countries combined with a constrained public budget, these costs appear to be
even heavier. Indeed, it deprives governments from funds they could use for
social investments for example: infrastructure, education or health care among
many others.

At the end of the day, if the efficiency of
these incentives is so uncertain and the needs of developing countries are growing
even further, why are there still so many incentives out there and why is this
trend on the rise?

One of the reasons consists of simple competitive
behaviour: if everyone around you is giving away incentives, there is a
pressure for you to provide incentives as well. Let’s take an example: imagine
a situation where you are trying to sell your house, a nice, renovated, fully
equipped house. Meanwhile, all your neighbours are also trying to sell theirs,
which are on the opposite, old shabby plain houses. So to compensate, they are providing
discounts to attract buyers. As a consequence, this pressure from both the
environment and the buyers themselves may convince you that providing a
discount is a good idea but you are not even playing in the same league. Given
the competition, there is no point for you to provide discount.  

The same process goes for incentives, FDI
and developing countries. Sometimes, countries will simply provide incentives,
believing they are a decisive factor for investors in their decision making
process whereas investors may just be using peer pressure to gain an additional
advantage.    

Let us be clear though, the opinion of this
paper is not to maintain that tax incentives are ineffective or useless. There
are indeed situations where several countries with similar features are
competing for investments and in this kind of situation, providing a tax
incentive package could be an effective leverage, leading to FDI. However, it
does not concern all investments situations and this is the point of the
article.

It has proven difficult to determine if tax
incentives have been effective in attracting FDI. Indeed, on one hand, some
investments may have taken place anyway, with or without incentives, whereas on
the other hand, some investments may have been decided thanks to these
incentives. The catch is: how to accurately measure this decision?

There is competition only when there is a
choice for the investors between different destinations. Let’s consider an hydro
energy plant for example. Lao possesses the greatest potential in South East
Asia in terms of water resources compared to its neighbours. Thus, it looks as
the natural candidate for an investor in the hydro energy business. To
compensate, neighbouring countries deliver generous incentives to attract this
investment anyway which may seem irrelevant since even the strongest incentives
cannot bring water to your plant. However, it creates a surrounding pressure
for the Lao government who, at the end of the day and despite its natural
advantage, still grants tax holidays from 4 to 10 years for these projects. Sometimes,
choices for investors are quite limited and projects simply immobile, hence,
incentives useless.

Moreover, even when a choice is possible,
it does not mean that investors have to choose only one project. If all the
projects are financially viable, given the prospects of future benefits,
investors may have the possibility to invest on both fronts if the demand is
there.

As a consequence, even before delivering
tax incentives, countries should thoroughly evaluate whether there is a real
competition for investments or not, depending on its specificities (natural
resources, workforce, energy supply, etc.), its main sectors targeted by FDI
and evaluate their strengths to clearly assess if it is worth the multiple
costs mentioned above.

When there is no competition, incentives
could be reduced or even stopped. And, even when there is competition, instead
of trying to make a difference by providing incentives, countries within a
region could create a regional strategy and agree to stop tax incentives and
rather compete through other channels: infrastructure networks, administrative
efficiency, low level of corruption or transparency.

Also, since providing incentives always
comes with a cost, until there is a clear proof of their efficiency, it seems
more strategic in the long term to invest in other domains that will benefit
the country anyway, such as transparency for example. A first step for countries
could be to focus on providing access to data on the cost of these incentives and
publish concrete reports and data on this matter to give them a chance to stop any
useless expense of public money. Countries need to know the size of this issue,
which sectors profit the most out of it, what are the costliest incentives and
how does it benefit the country, to clear all possible suspicion of corruption.
Information is key in this issue.

The need for public infrastructure will always
remain and if investors do not pay their fair share, someone else will have to foot
the bills and, most of the time, the responsibility falls on the local
population. It is high time to stop giving away advantages when none are
needed. Instead, more than tax incentives, investors need a sound business
environment, clear taxation systems and greater transparency. Hence, countries
should stop trying to attract FDI by lowering their standards, racing to the
bottom but rather aiming for the top by providing a productive and sound
business environment which would create a win-win situation for both countries
and investors. And it begins with transparency and public disclosure of data.

image

[1] See David Holland and Richard J. Vann ,“Income Tax Incentives for Investment
See United Nations conference on trade and development, Geneva” Tax Incentives and Foreign
Direct Investment : A Global Survey
”, , 2000

“Written by Chanh-Nghi, a student of economics
all the way from Paris to come see the other side of the picture here in The
Hague. He likes to play volleyball in his free time if he can find some people
to join him. He loves coming out for dinner with the others and trying all the
different Dutch beers that are around but secretly he still likes his wine!”

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