How big is the real problem of tax competition?
Guest blog by Chanh-Nghi Lam
Foreign Direct Investments: these are at the top of the wish-list of developing countries and something they have been fighting over for 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 sufficient funds to invest in heavy capital projects which would only produce benefits in the long term. Likewise, countries in the early stages 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.
The next logical question for these 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, which is the one we wish to take a closer look at.
What are they? A tax incentive is a gift from the government to certain industries that allow them to avoid paying certain taxes over a certain period of time (income tax or import-export taxes for example), or delay the moment they will start paying taxes.
Although attractive at first sight, tax incentives have shown to be actually only of secondary importance for investors. According to recent surveys and studies, investors are much more sensitive to a clear, sound and coherent taxation system than incentives¹.
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 and 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 like 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 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, even though you are not even playing in the same league. Given the fact there is no real competition, there is no point for you to provide a discount.
The same process goes for incentives, FDI and developing countries. Sometimes countries will simply provide incentives because they believe 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.
To be clear, the point of this paper is not to suggest 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 situations providing a tax incentive package could be an effective leverage, leading to FDI. However, this does not hold true for all investment situations and that is the point of this article.
It has proven difficult to determine whether 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 geographical locations. Let’s consider a hydro energy plant for example. Laos possesses the greatest potential in South East Asia in terms of water resources compared to its neighbours. Thus, it looks like the natural candidate for an investor in the hydro energy business. To compensate, neighbouring countries deliver generous incentives to attract this type of investment, which may seem irrelevant since even the strongest incentives cannot bring water to your plant. However, it creates a surrounding pressure on the government of Laos which, at the end of the day and despite its natural advantage, still grants tax holidays ranging from 4 to 10 years for these projects. In such cases, choices for investors are quite limited and projects simply immobile, which renders 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, 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.) and 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 clear proof of their efficiency, it seems more strategic in the long term to invest in other domains that will benefit the country. Transparency is of key importance. A first step for countries could be to focus on providing access to data on the cost of these incentives and publish concrete reports on this matter. This would give them a chance to stop the useless expenditure of public money. Countries need to know the extent of this issue, which sectors profit the most from it, how it benefits the country and which incentives cost the most, 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, a clear taxation system and greater transparency. Hence, countries should stop trying to attract FDI by lowering their standards and racing to the bottom, but rather aim 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
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