Tax incentives and exemptions not necessary to attract investment

20 December 2012

Research evidence suggests that developing countries do not need to grant tax incentives and exemptions to attract Foreign Direct Investment (FDI) as the decision to invest is largely based on the country's overall investment climate.

Chinese building project in Kenya
Photo: Sven Torfinn / Panos

This was the view of the majority of participants who attended the International Centre for Tax and Development (ICTD) Annual Centre Meeting, from 11-13 December in Cape Town, South Africa.

The meeting brought together tax administrators, researchers and civil society from 20 countries, including revenue commissioners from the Burundi, Tanzania and Uganda revenue authorities.

In line with this year's theme, 'Investigating Tax Incentives and Exemptions', participants shared valuable experiences and research findings on the use of tax incentives and exemptions, and their implications for tax revenues in Africa. The presentations were informative and followed by lively discussions among participants.

How effective are tax incentives?

Many developing countries offer tax incentives and exemptions to direct foreign investment particularly to areas which would otherwise be considered undesirable for investment.

The effectiveness of tax incentives in attracting FDI is widely debated among tax professionals amidst the rising demand for natural resources from emerging economies and increasing concerns about the 'resource curse' that plagues many resource-rich countries in Africa.

While certain types of incentives help reduce poverty and have been successfully implemented in less developed countries such as Malaysia and Mauritius, experience in Africa suggests that the costs of tax incentives far outweigh the benefits. Recent studies in Africa have found that they result in revenue losses, undermine governance processes and the efforts of developing countries to fight poverty (African Tax Administration Forum presentation (PDF))

According to Adolf Ndunguru from the Tanzania Revenue Authority, Tanzania tax incentives in that country have led to a loss of around 3% of GDP in tax revenues (Ndunguru's presentation on tax exemptions and incentrives in Tanzania (PDF)).

Similarly, Tax Justice Network and ActionAid estimate Kenya's revenue loss at KES 100 billion (USD 1.1 billion) a year from all tax incentives and exemptions.

Some tax experts argue that tax incentives are not necessary for attracting investment, as investors will generally consider other factors that improve a country's investment climate as more important.

An investor survey conducted in Burundi, Rwanda, Tanzania shows that the majority of investors were not highly motivated by tax incentives or exemptions when making investment decisions. Those decisions were largely based on market potential, access to finance, reliable electricity supply and good infrastructure.

Only 7.9% of all respondents in all three countries said they would not have invested without the tax and fiscal incentives they received. The quality of the mineral resource and favourable conditions for extracting and exporting them is more important than extensive tax incentives.

"If resources are good enough, companies will come", adds Olav Lundstol, a Country Economist at the Royal Norwegian Embassy in Tanzania.

Why use tax incentives if they're not so effective?

Despite insufficient evidence of their effectiveness, tax incentives are still an important part of the policy initiatives used by countries in Africa to increase their appeal to foreign investors.

Tax administrators and researchers highlighted the difficulty in measuring the effectiveness of tax incentives due to the absence of high quality firm level datasets on investment in most countries. Evidence-based case studies on the role of tax incentives in influencing FDI are also scant, resulting in weak policy analysis. Participants recognised the need for further research to increase knowledge that will help policymakers and administrators to develop appropriate analytical tools to monitor tax incentives and make informed decisions.

The work of the ICTD becomes important in this regard as it fulfils the need to generate high quality research to build stronger tax systems that contribute to broader development goals.

Other challenges include corruption in some government institutions and lack of cooperation between policy makers and administrators at national and regional levels. Convincing governments to review tax incentive programmes is also a challenge due to lack of political will.

Some of the recommendations from participants include a review of the policies governing incentive schemes, consistent monitoring of the impact of tax incentives and their effectiveness, as well as regional economic cooperation between policy makers and tax administrators.

This article was written by Yolanda Vamusse, Research Uptake Manager for the International Centre for Tax and Development.

Image credit: Svenn Torfinn / Panos