Options for the Effective and Efficient Use of Investment Incentives in Low-Income Countries PDF

# Options for the Effective and Efficient Use of Investment Incentives in Low-Income Countries ## Report by the IMF, OECD, UN and World Bank to the G20 Working Group on Development The report was prepared by the International Monetary Fund, the Organisation for Economic Co-operation and Developmen...

# Options for the Effective and Efficient Use of Investment Incentives in Low-Income Countries ## Report by the IMF, OECD, UN and World Bank to the G20 Working Group on Development The report was prepared by the International Monetary Fund, the Organisation for Economic Co-operation and Development, the United Nations and the World Bank at the request of the G20 Working Group on Development. It has benefited from consultations with other organizations working in the field of taxation, officials from developing countries, civil society organizations and business representatives. This report was prepared under the responsibility of the secretariats and staff of the mandated organizations. It reflects a broad consensus of these services, but should not necessarily be considered as an official expression of the views of these organizations or their member states. The report was presented to the G20 Working Group on Development in September 2015, and to the IMF Executive Board for information in October 2015. ## Summary - **Numerous opportunities exist for LICs to improve the effectiveness and efficiency of their investment incentives.** In surveys of the investment climate in LICs, these incentives are often seen as unimportant and redundant. Yet, investment would have been made even without them. However, these incentives can be costly to the government, limiting the availability of resources for public investments in infrastructure, public services or social protection. - **For incentives to be effective and efficient, they must be carefully designed.** Many LICs use tax holidays and exemption from corporate income tax, rather than investment tax credits or accelerated depreciation that provide a greater return on investment. Targeted incentives for domestic or extractive industries tend to have little impact, while those targeting export-oriented or mobile capital seem to be relatively effective. The effectiveness of investment incentives depends on the broader investment environment, including infrastructure, macroeconomic stability, the rule of law and effective governance. - **Good governance of incentives is a key factor in their effectiveness and efficiency.** Transparency is essential for ensuring that incentives are applied and administered fairly, thus reducing the risk of rent-seeking and corruption. Incentives should be subject to the legislative process and integrated into the tax law. Fiscal costs should be subject to annual scrutiny. Multiple stakeholders may be involved in the approval of incentives, but ultimately, the authority to approve incentive schemes should rest with the Finance Minister. The administration should be responsible for implementation and monitoring. Where possible, incentives should be based on rules, and not on discretionary power. - **Coordination across jurisdictions is crucial.** The proliferation of incentives is often the result of international tax competition. Regional coordination can help dampen this competition if there is political will and a supranational mechanism to ensure implementation, which is often lacking. Common standards for reporting and data collection can be a useful first step in that direction. - **More systematic evaluations of incentives are essential to inform decision-making.** In most LICs, it is difficult to evaluate the effectiveness and efficiency of incentives due to limited data availability and inadequate analytical capacity. The attached reference document provides guidance on strengthening these capacities. To ensure that decisions are transparent and evidence-based, all stakeholders need to play their part. ## Table of Contents * Introduction * Efficiency and Efficiency * Prevalence * “Effective use” * “Efficient use” * Guidance on the Use of Investment Incentives * Design * Governance * Reform * International Coordination * Conclusions * Annex: Consultations ## Introduction This report responds to a request from the G20 Working Group on Development for a study on how to more effectively and efficiently utilise investment incentives in low-income countries (LICs). The report focuses on three key areas: * **Improving the design and governance of investment incentives**: The report sets out key principles for the design and governance of investment incentives, and provides guidance on best practice in these areas. * **Responding to concerns about international tax competition**: Given that pressure for incentives is partly driven by incentives offered in other countries, the report considers the potential for international coordination. * **Improving the analysis of investment incentives**: The report outlines the crucial role of impact and cost-benefit analysis in informing decisions about incentives, and provides practical advice on how to conduct these analyses. The report begins by considering the role of investment incentives in the broader context of tax policy. It then examines the evidence on the incidence and effectiveness of incentives, and concludes that better design, governance and coordination are essential if LICs are to avoid wasting public resources on incentives that have little impact. ## Efficiency and Efficiency ### Prevalence Across the globe, various tax incentives are used to attract investment. However, the nature of those incentives varies across countries. In high-income countries, investment tax credits and preferential treatment for R&D are common. In LICs, tax holidays and reduced tax rates are more common, while middle-income countries tend to use preferential tax regimes in special zones. ### “Effective use” The main objective of incentives is to increase investment, typically FDI in the case of LICs. FDI can generate benefits beyond the inflow of capital and jobs. It can also enhance competition and contribute to wider economic efficiency. A growing body of research suggests that the impact of incentives on investment is relatively small, with many studies finding little or no evidence of an effect on overall investment. This suggests that many incentives are **redundant**, in that the investment would have taken place anyway. There may be a number of reasons for this, including: * **Limited data and analytical capacity.** In many LICs, it is difficult to reliably assess the effectiveness and efficiency of investment incentives, due to a lack of data and analytical capacity. * **Specific industry concentration.** In some cases, incentives are concentrated in specific industries, sectors or locations, which may already be attracting investment. * **International tax competition.** Firms may locate in a country with a lower tax rate than they would otherwise choose, even if the incentives were not available. Several studies have found that the effectiveness of investment incentives varies significantly by sector and location. In cases where the incentive is narrowly targeted, it may be effective, but may simply attract investment that would have taken place anyway. ### “Efficient use” The “efficient use” of incentives is a separate issue from their “effectiveness.” Even if an incentive is effective at increasing investment, it may not be efficient if the costs outweigh the benefits. The report uses a simple conceptual framework to assess the costs and benefits of investment incentives. The key elements of this framework are: **Benefits:** * **Net increase in investment.** This accounts for the **redundancy effect** - investment that would have happened anyway - and the **displacement effect** - investment that is diverted from other activities. * **Net increase in employment and wages.** The overall impact on employment must be considered. New jobs may be created, but this may result in the displacement of existing jobs. * **Increased productivity.** A key consideration is whether the incentive contributes to a broader increase in productivity. * **Positive spillover effects.** Spillover effects occur when investment in one sector increases the productivity of other sectors. For example, spillover effects from FDI could stimulate the growth of local supplier firms or companies operating in related industries. **Costs:** * **Net loss in government revenue.** Incentives often reduce government revenue. This loss can be partially offset by the gains in investment and employment. * **Administrative costs.** The administrative costs of operating and monitoring incentives can be substantial. * **Opportunity costs of public funds.** Incentives can be seen as directing public resources to a particular sector, region or type of investment, and away from other sectors, regions or types of investment that might have a greater social benefit. The report argues that “in principle”, **incentives are socially valuable if the social benefits they generate exceed their social costs.** While this is clearly a general principle, it is often difficult to quantify the benefits and costs, and particular challenges arise in the case of LICs. ## Guidance on the Use of Investment Incentives ### Design Designing incentives effectively is essential if they are to achieve their objectives. The report outlines three key considerations: * **Choosing the right instrument.** Several instruments can be used to incentivize investment, including tax holidays, reduced tax rates, accelerated depreciation, investment tax credits and investment grants. The report argues that incentives that reduce the cost of capital - such as accelerated depreciation or investment tax credits - are more likely to be **efficient** than those that directly reduce profitability, such as tax holidays. That is, tax holidays may encourage investment that would have taken place anyway, while tax credits or accelerated depreciation may encourage investment that would not otherwise happen. * **Identifying qualifying investments.** The report recommends that incentives be **narrowly targeted** rather than being broadly available. Otherwise, there is a higher risk of **redundancy** - investment that would have occurred anyway. A number of criteria can provide a basis for targeting incentives, including the investment's size (for example, a minimum investment value or a minimum number of employees). The report also argues for considering the **nature of the investment** and whether it contributes to specific national development priorities (for example, certain sectors or regions), or to the creation of new jobs or export-oriented companies. * **Designing a clear implementation and monitoring framework.** To ensure that incentives achieve their objectives, it is essential to develop a clear framework for their administration. The report suggests a number of key features for this framework, including: * **Codifying incentives in legislation.** This promotes accountability and transparency. * **Prioritizing incentives that address clear government objectives.** This ensures that incentives are not simply given to the wrong type of investment. * **Building a robust monitoring and evaluation framework.** This helps to ensure that incentives are being used effectively and efficiently. ### Governance Good governance is a vital element of successful investment incentive programs. It is important to address: * **The rule of law.** This ensures that incentives are granted based on a transparent and accountable process. * **Institutional coordination.** This is essential to ensure that different parts of the government are working together to achieve common objectives. * **Transparency.** Transparency is essential for ensuring that all parties involved in the process - including businesses, civil society, and the public - are informed about the decision-making process. It is also essential for monitoring the cost of incentives. ### Reform The report highlights reform efforts to address the proliferation and potential misuse of incentives in LICs. * **Jamaica (2013):** The Jamaican government embarked on a comprehensive reform of fiscal incentives in order to reduce tax exemptions and discretionary power. * **India (2009):** The Indian government proposed a new code of direct taxes that would shift incentives from those based on profit to those based expenditure. * **Egypt (2005):** The Egyptian government introduced a new corporate tax law that phased out temporary exemptions. * **Mauritius (2006):** The Mauritian government aligned the tax regime for companies operating in special zones with that of the rest of the economy, and phased out tax holidays and investment tax credits with the exception of temporary exemptions for small and medium-sized companies. * **The Philippines (2004):** The Philippines government introduced greater transparency and more rigorous administration of investment incentives. <start_of_image> Schematic diagram of how the use of investment incentives (and their reform) fits into the broader tax policy landscape: **Tax Policy Landscape** * **Broad taxation system:** * Basic tax code: Simple, equitable and efficient. * Tax administration: Effective and well-resourced. * **Investment incentives:** * Narrowly targeted and transparent. * Carefully designed to maximize benefits, minimize costs. * Regularly reviewed and reevalued. **Reform:** * Aim for simplicity, transparency and effectiveness. * Focus on improving the rule of law and administrative capacity. * Coordinate with other countries where appropriate. * Regularly evaluate the effectiveness and efficiency of incentive programs. ## International Coordination The report highlights the potential downsides of international tax competition, and argues that coordination is important. * **Coordination can reduce the harmful effects of international tax competition.** The report concludes that international tax competition can lead to a downward spiral in tax rates globally, and hinder a country’s ability to raise revenue for public purposes. * **Coordination can take different forms.** These include: * **Developing common standards for reporting and data collection** This can facilitate more systematic evaluation and greater transparency. * **Developing a code of conduct on incentives.** This could involve a commitment to refrain from using certain incentives. * **Harmonizing tax regimes.** This could involve a commitment to align rates or tax bases across countries, especially within a region. * **Developing a common framework for investment incentives.** This could provide a common set of guidelines for incentive design and the collection of data. The report highlights the challenges of international tax coordination. A key challenge is to ensure that all stakeholders are committed to the process and that there is a robust framework for monitoring and enforcement. The report outlines a number of important considerations for regional coordination efforts: * **Ensure broad participation so that the approach is not too narrow.** If it is too narrow, countries may simply shift their incentives to other areas of their economies. * **Ensure that the benefits of coordination outweigh the costs.** Countries may experience a degree of revenue loss in the short term as they begin to phase out high-cost incentives. * **Consider the potential for unintended consequences.** For example, coordination may result in a race to the bottom in other aspects of tax policy. The report concludes that international coordination is essential for ensuring that a country’s investment incentives are used more effectively and efficiently for the benefit of the country, the region and the global economy. ## Conclusions - **Investment incentives in LICs have considerable potential but are often designed and governed poorly.** The report sets out a number of key guidelines for designing and governing incentive regimes that maximize their effectiveness and efficiency. - **International coordination is essential to reduce wasteful tax competition.** Countries must focus on ensuring that incentives are being used effectively and efficiently, and that international tax competition is minimized. - **Action must be taken by a wide range of stakeholders.** These include governments, donors, businesses and other organizations, with different roles to play in the reform process. ## Annex: Consultations The report has drawn on experience gained from working with developing countries, and from ongoing dialogue on tax policy reform. A number of consultations have been held, both in person and online, with a broad range of stakeholders. During those consultations, there was general agreement that the proliferation and inefficiency of incentives are a major challenge for LICs. However, there were also differences of opinion about how those challenges should be addressed. There was a strong consensus that: * **Better analysis of incentives is needed.** More systematic data collection and analysis is essential to inform decision-making. * **Greater transparency is needed.** Governments must be more transparent about the design, implementation and evaluation of incentives. * **International coordination is needed to address the problem of tax competition.** This requires a broader, inclusive dialogue. * **There is a need for a more robust and supportive framework to guide the use of incentives.** This requires a shift toward greater emphasis on the legislative process for setting incentives. The report concludes by highlighting the importance of continued dialogue: “The challenge is to ensure that investment incentives are designed and governed in a way that maximizes their contribution to national development objectives."