A report on the options for low income countries to use tax incentives has been prepared for the G20 Development Working Group by the IMF, OECD, UN and World Bank.
Based on practical experience the report suggests that there is room for the effective use of tax incentives by low income countries to attract investment. Generally however tax incentives have not been ranked highly in policy priorities in low income countries partly because of the view that the same investment would take place if the tax incentives were not offered. Also the cost of offering tax incentives in terms of lost revenue can be high.
Tax incentives must be effective and efficient. The effective use of tax incentives means that they achieve the stated objective, to raise higher investment or foreign direct investment (FDI) of a kind that yields the intended social benefits. Studies that have been carried out in connection with incentives suggest that host country taxation significantly affects investment in developed economies, but the effect in developing countries appears to be smaller.
The report emphasizes that tax incentives must be carefully designed to be effective. Instead of using tax holidays and income tax exemptions in attracting investment low income countries could use investment tax credits and accelerated depreciation which can attract more investment per dollar outlay. Tax incentives aimed at encouraging export-oriented sectors and mobile capital are regarded as more effective than those aimed at domestic markets or extractive industries.
Other general conditions such as good infrastructure and economic and political stability are important for the effectiveness of tax incentives. Investment incentives must therefore be considered as part of the broader design of tax policy. The incentives should be designed so that they achieve clear goals and are more effective and efficient than other policies that could achieve the same objectives.
Currently countries are often reluctant to reduce inefficient incentives as a result of vested interests, political inertia or tax competition. There should be transparency in the process of setting tax incentives so that accountability and opportunities for corruption are reduced. There should be an annual review of the incentives and their fiscal costs. Granting tax incentives should be subject to strict rules rather than being left to the discretion of the administration.
Tax incentives are often made available because a government is aware that similar incentives have been made available by other countries. Where tax incentives are a result of international tax competition the situation could be improved by more regional coordination. A first step towards coordination could be the introduction of common reporting standards and data collection. Coordination would also require a supranational enforcement mechanism.
Assessment of the effectiveness of tax incentives is important for informed decision making. In many low income countries this is not possible owing to a lack of data and insufficient analytical tools and skills. The report therefore provides guidance on developing the data and tools for analysis and emphasizes the importance of concerted action by stakeholders to make progress on the issue.