«Tax Incentives: Protecting the tax base Eric Zolt Michael H. Schill Distinguished Professor of Law, UCLA School of Law This paper is preliminary ...»
Paper for Workshop on Tax Incentives and Base Protection
New York, 23-24 April 2015
Tax Incentives: Protecting the tax base
Michael H. Schill Distinguished Professor of Law, UCLA School of Law
This paper is preliminary document for
circulation at the “Workshop on Tax Incentives United Nations
and Base Protection” (New York, 23-24 April Department of Economic and Social Affairs
2015) to stimulate discussion and critical United Nations Secretariat, DC2-2178 comments. The views and opinions expressed New York, N.Y. 10017, USA herein are those of the author and do not Tel: (1-212) 963-8762 • Fax: (1-212) 963-0443 necessarily reflect those of the United Nations e-mail: TaxffdCapDev@un.org Secretariat. The designations and terminology http://www.un.org/esa/ffd/events/cd-2015-tibpemployed may not conform to United Nations workshop.html practice and do not imply the expression of any opinion whatsoever on the part of the © United Nations Organization.
1.1 Definition of tax incentives
1.2 Different types of tax competition
1.3 Additional investment incentives
1.4 Role of non-tax factors
1.5 Review of empirical evidence
2. Tax incentives: benefits and costs, design and administrative considerations
2.1 Benefits and costs of tax incentives
2.1.1 Benefits of tax incentives
2.1.2 Costs of tax incentives
2.2 Design considerations for tax incentives
2.2.1 Eligibility issues
2.2.2 Implementation issues
2.2.3 Review and sunset provisions
2.2.4 Guidance for policymakers
Impact of developed countries’ tax systems on the desirability or 3.
effectivenessof tax incentives
3.1 Simple model
3.2 A more complex view
4. How does the OECD project on BEPS change the tax environment for tax incentives in developing countries?
4.2 Relative change in tax burdens
4.2.1 Relative tax burdens of activities that qualify or do not qualify for tax incentives
4.2.2 Relative tax burdens in doing business in developing and developed countries
4.3 Additional tools
The present chapter seeks to provide an overview of key issues facing policymakers in deciding whether to use tax incentives to attract investment and how to best design and administer these incentives to minimize erosion of the tax base in developing
countries. It focuses on three key questions:
(a) How can developing countries best design and administer tax incentives to increase their effectiveness?
(b) How do tax systems in developed countries influence the desirability or effectiveness of tax incentives in developing countries?
(c) How does the project launched by the Organisation for Economic Cooperation and Development (OECD) to deal with base erosion and profit shifting (OECD project on BEPS) change the tax environment related to developing countries’ tax incentives?
Before turning to these questions, the following are some initial observations.
Some contend that tax incentives, particularly for foreign direct investment, are both bad in theory and in practice. Tax incentives are bad in theory because they distort investment decisions. Tax incentives are bad in practice because they are often ineffective, inefficient and prone to abuse and corruption.
Yet almost all countries use tax incentives. In developed countries, tax incentives often take the form of investment tax credits, accelerated depreciation, and favorable tax treatment for expenditures on research and development. To the extent possible in the post-World Trade Organization (WTO) world, developed countries * Michael H. Schill Distinguished Professor of Law, UCLA School of Law.
See Organisation for Economic Co-operation and Development, Addressing Base Erosion and Profit Shifting (Paris: OECD, 2013), available at http://www.oecd.org/tax/bepsreports.htm; and Ibid., Action Plan on Base Erosion and Profit Shifting (Paris: OECD, 2013), available at http://www.oecd.org/ctp/BEPSActionPlan.pdf.
Parts of the discussion in the present chapter rely on Alex Easson and Eric M. Zolt, “Tax Incentives,” World Bank Institute (Washington, D.C.: World Bank Group, 2002), available at http://siteresources.worldbank.org/INTTPA/Resources/EassonZoltPaper.pdf.
also adopt tax regimes that favor export activities and seek to provide their resident corporations a competitive advantage in the global marketplace. Many transition and developing countries have an additional focus. Tax incentives are used to encourage domestic industries and to attract foreign investment. Here, the tools of choice are often tax holidays, regional investment incentives, special enterprise zones, and reinvestment incentives.
Much has been written about the desirability of using tax incentives to attract new investment. The United Nations, the International Monetary Fund (IMF), the OECD, and the World Bank have produced useful reports that provide guidance to policymakers on whether to adopt tax incentives and how to best design them. The empirical evidence on the cost-effectiveness of using tax incentives to increase investment is inconclusive. While economists have made significant advances in determining the correlation between increased tax incentives and increased investment, it is challenging to determine whether tax incentives caused the additional investments. This is partly because it is difficult to determine the amount of marginal investment associated with the tax benefit — that is to say, the investments that would See, for example, United Nations Conference on Trade and Development, “Tax Incentives and Foreign Direct Investment,” (United Nations publication, Sales No.
E.96.II.A.6); and “Tax Incentives and Foreign Direct Investment: A Global Survey,” (United Nations publication, Sales No. E.01.II.D.5).
See, for example, George E. Lent, “Tax Incentives for Investment in Developing Countries,” (1967) Vol. 14, No. 2 Staff Papers, International Monetary Fund, 249; Howell H.
Zee, Janet Gale Stotsky and Eduardo Ley, “Tax Incentives for Business Investment: A Primer for Tax Policy Makers in Developing Countries,” International Monetary Fund (Washington, D.C.: IMF, 2001); Alexander Klemm, “Causes, Benefits and Risks of Business Tax Incentives,” International Monetary Fund (Washington, D.C.: IMF, 2009); David Holland and Richard J. Vann, “Income Tax Incentives for Investment,” in Victor Thuronyi, ed., Tax Law Design and Drafting (Washington, D.C.: IMF, 1998), Vol. 2, 986-1020.
See, for example, Organisation for Economic Co-operation and Development, Tax Effects on Foreign Direct Investment: Recent Evidence and Policy Analysis, Tax Policy Study No. 17, (2007); Ibid., “Tax Incentives for Investment: A Global Perspective: experiences in MENA and non-MENA countries,” in Making Reforms Succeed: Moving Forward with the MENA Investment Policy Agenda (Paris: OECD, 2008).
See, for example, Robin W. Broadway and Anwar Shah, “Perspectives on the Role of Investment Incentives in Developing Countries,” World Bank (Washington, D.C.: World Bank, 1992); Sebastian James, “Effectiveness of Tax and Non-Tax Incentives and
Investments: Evidence and Policy Implications,” World Bank Group (Washington, D.C.:
WBG, 2013); Sebastian James, “Incentives and Investments: Evidence and Policy Implications,” World Bank Group (Washington, D.C.: WBG, 2009); Alex Easson and Eric M.
Zolt, “Tax Incentives,” supra note 2.
not otherwise have occurred “but for” the tax benefits. While foreign investors often claim that tax incentives were necessary for the investment decision, it is not easy to determine the validity of the claim. Governments often adopt tax incentives in a package with other reforms designed to improve the climate for investment, making it difficult to determine the portion of new investment that is attributable to tax benefits and the portion that relates to other pro-investor reforms. With these qualifications, it is sometimes easy to conclude that a particular tax incentive scheme has resulted in little new investment, with a substantial cost to the government. In other cases, however, tax incentives have clearly played an important role in attracting new investment that contributed to substantial increases in growth and development.
One place to start thinking about tax incentives is to consider what role governments should play in encouraging growth and development. Governments have many social and economic objectives and a variety of tools to achieve those objectives. Tax policy is just one option, and taxes are just one part of a complex decision as to where to make new domestic investment or commit foreign investment.
Governments have a greater role than focusing on relative effective tax burdens.
Governments need to consider their role in improving the entire investment climate to encourage new domestic and foreign investment, rather than simply doling out tax benefits. Thus, while much of the focus on tax incentives is on the taxes imposed by government, it is also important to examine the government spending side of the equation. Investors, both domestic and foreign, benefit from government expenditures. A comparison of relative tax burdens requires consideration of relative benefits from government services.
1.1 Definition of tax incentives
At one level, tax incentives are easy to identify. They are those special provisions that allow for exclusions, credits, preferential tax rates, or deferral of tax liability. Tax incentives can take many forms: tax holidays for a limited duration, current deductibility for certain types of expenditures, or reduced import tariffs or customs See, generally, Richard M. Bird and Eric M. Zolt, “Tax Policy in Emerging Countries,” (2008) Vol. 26, Environment and Planning C: Government and Policy, 73-86;
Richard M. Bird, “Tax Incentives for Investment in Developing Countries,” in Guillermo Perry, John Whalley and Gary McMahon, eds., Fiscal Reform and Structural Change in Developing Countries (London: Canada: Macmillan in association with the International Development Research Centre, 2000), Vol. 1, 201-21.
duties. At another level, it can be difficult to distinguish between provisions considered part of the general tax structure and those that provide special treatment.
This distinction will become more important when countries become limited in their ability to adopt targeted tax incentives. For example, a country can provide a 10 per cent corporate tax rate for income from manufacturing. This low tax rate can be considered simply an attractive feature of the general tax structure as it applies to all taxpayers (domestic and foreign) or it can be seen as a special tax incentive (restricted to manufacturing) in the context of the entire tax system.
Tax incentives can also be defined in terms of their effect on reducing the effective tax burden for a specific project. This approach compares the relative tax burden on a project that qualifies for a tax incentive to the tax burden that would be borne in the absence of a special tax provision. This approach is useful in comparing the relative effectiveness of different types of tax incentives in reducing the tax burden associated with a project.
Commentators contend tax incentives may now play a larger role in influencing investment decisions than in past years. Several factors explain why tax considerations may have become more important in investment decisions. First, tax incentives may be more generous now than in past years. The effective reduction in tax burden for investment projects may be greater than in the past, as tax holiday periods increase from two years to ten years or the tax relief provided in certain enterprise zones comes to include trade taxes as well as income taxes. Second, over the past several decades there has been substantial trade liberalization and greater capital mobility. As non-tax barriers decline, the significance of taxes as an important factor in investment decisions increases. Third, business has changed in many ways.
Firms have made major changes in organizational structure, production and distribution methods, and the types of products being manufactured and sold. Highly mobile services and intangibles are a much higher portion of cross-border transactions than in past years.
Howell H. Zee, Janet Gale Stotsky and Eduardo Ley, “Tax Incentives for Business Investment: A Primer for Tax Policy Makers in Developing Countries,’’ supra note 3.
Alex Easson, “Tax Incentives for Foreign Investment, Part I: Recent Trends and Countertrends,” (2001) Vol. 55, Bulletin for International Fiscal Documentation, 266.
Fewer firms now produce their products entirely in one country. Many of them contract out to third parties (either unrelated third parties or related “contract manufacturers”) some or all of their production. With improvements in transportation and communication, component parts are often produced in multiple different countries, which results in increased competition for production among several countries. In addition, distribution arrangements have evolved, where the functions and risks within a related group of corporations are allocated to reduce tax liability through so-called “commissionaire” arrangements. Finally, there has been substantial growth in common markets, customs unions and free trade areas. Firms can now supply several national markets from a single location. This will likely encourage competition among countries within a common area to serve as the host country for firms servicing the entire area.