The 2015 edition of the OECD publication Policy Framework for Investment published on the OECD on its website on 14 September 2015 provides guidance on improving the environment for investment in a number of fields of policy. The publication highlights the questions that policy makers should be examining when considering the climate for investment in their country. The publication examines investment policy generally, investment promotion, trade and competition policy as well as tax policy.

The publication examines among other issues the implications of investment promotion for tax policy. The publication points out that tax collection and investment promotion have different aims and objectives, especially in developing countries. The policy makers in a country therefore need to take a wholistic view and balance the tax mix and social needs with the need to attract investment.

In examining the influence of the tax system on investment the policy makers need to look at the effect of the main statutory tax provisions; the effects of tax planning strategies used by businesses; and the compliance costs that may result from complexity of the system and lack of transparency. As a result of the analysis they may need to adjust the tax parameters. Generally the tax burden on business can be estimated by examining the main statutory tax rate as well as effective tax rate after allowing for depreciation or investment allowances, other tax relief and incentives.

Governments routinely opt for tax incentives to attract investment and in particular foreign direct investment (FDI). Tax incentives are cheaper and easier to implement than alternative incentives such as improved infrastructure or more highly skilled labor. As investment is attracted to a country it may create positive externalities such as technology and know-how transfers, improved human capital formation and enterprise development.

When a business is considering an investment in a country the tax considerations are only one of many factors taken into account. Investors must also consider the costs and risks of the economic and business conditions in the country; the cost of complying with local laws and regulations; market size; labor force conditions and location-specific opportunities. Where a country offers sufficient location-specific profit opportunities the policy makers may be less inclined to offer tax incentives.

Policy makers should compare the tax rate in their country to those of its competitors. If they move to lower the tax rate to a more competitive level they should assess the likely reactions of their competitors. A race to the bottom must be avoided. It is therefore preferable for governments to work together on a regional basis when setting their tax rates.

The OECD recommends the prudent use of incentives. Different businesses may have different effective tax rates according to size, ownership structure, business activity or location. Some businesses may be specifically targeted with incentives in some countries.

Tax relief must be properly justified – for example compensating for market failure by reflecting benefits to the larger society; or compensating asymmetric information or monopoly power of larger firms that makes it difficult for small and medium enterprises (SMEs) to raise finance. Some incentives may have a redistributive purpose. Efficient targeting of incentives requires accurate estimates of tax revenue foregone by offering those incentives. The costs then need to be compared to the benefits of continuing the incentives.

An assessment of the costs and benefits of a particular tax incentive should be done before it is implemented; and again after it is has been in effect for a time. The analysis should take into account the direct impact of the incentives on investment; the indirect impact through other changes to income and consumption; the positive externalities such as technology transfers; and the social and environmental benefits.

The costs of introducing a tax incentive include loss of tax revenue; further revenue losses through unforeseen tax planning activities based on the incentive; the additional compliance costs for taxpayers and costs for the tax administration in running the incentive; and costs to the economy through distortion of competition.

Transparency and clarity are important. Discretion in the allocation of tax incentives increases uncertainty for potential investors. The nature of the tax system itself may also cause uncertainty if it is poorly designed with complex, opaque rules and excessive administrative discretion. Sometimes various different Ministries may be involved in granting incentives and these can be given under various pieces of legislation such as investment laws and Special Economic Zone legislation or separate decrees in addition to the tax law. The OECD considers that it is preferable to consolidate the incentive legislation into one law as this enables an overview of the extent of the incentives being offered.