THE IMPACT OF GLOBALISATION ON TAX POLICY AND THE USE OF TAX INCENTIVES

 

PAPER PRESENTED TO THE PORTFOLIO COMMITTEE ON FINANCE

25 OCTOBER, 2000

Tax Policy Chief Directorate:

The Budget Office

 

NATIONAL TREASURY – SOUTH AFRICA

PRETORIA

REPUBLIC OF SOUTH AFRICA

 

  1. Introduction

Globalisation has exerted a profound influence on the economies of both developed and developing countries over the past 50 years. Reducing barriers to trade and the free movement of capital and other factors of production have fundamentally changed the economic relations between nations and regions of the world. The benefits of globalisation are manifold. However, these benefits do not come without costs that must be managed, including the limitations imposed on the freedom of governments to develop and apply fiscal and other macroeconomic policies. Differently put, it brings an element of fiscal competition with it, leading in the final analysis to a certain convergence of tax policies.

Globalisation and regionalism has fundamentally changed the framework within which governments formulate their policies, including fiscal policies in general and tax policy in particular. This paper explores the scope for government’s to use tax policy as a tool for economic policy, with particular emphasis on the effectiveness of tax incentives.

The paper is structured as follows:

  1. The impact of Globalisation

In recent decades, the pace at which the economies of the world have become more integrated has been overwhelming. Capital accounts have been liberalised and barriers to trade have been reduced or eliminated in some instances. Factors of production, especially capital and highly skilled workers have become more able to scour the globe for opportunities to maximise wealth creation.

These simple statistics speak volumes for the impact of globalisation, which can be seen and felt in all facets of economic activity. Rapid advances in technology, especially telecommunications and information technology, have made an enormous contribution to this process. The benefits have been tangible, including:

Notwithstanding these benefits, globalisation is not without its difficulties or challenges for policymakers. These include the potential for global negative externalities to become more significant, such as the negative impact that the increase in trade has had on the global environment, or the spread of diseases (e.g. AIDS). One must also consider how the free movement of goods and services has enabled easier penetration of unwanted products (e.g. illicit drugs and weapons), which has placed an enormous burden government resources to detect and prevent this. It indeed highlights the need to introduce highly effective and intelligent management information systems for the use of border control or customs authorities in their task of monitoring cross-border shopping and trading activities.

The income gap between rich and poor nations (including those of the SADC regions) has increased in recent decades. While the percentage of the world’s population living on $1 a day has fallen (from 28.3% in 1987 to 24% in 1998), the absolute number (1.2 billion) has not changed over that time. The number of people living on $2 a day is alarming at 2.8 billion, or just under half of the world population of 6 billion people!

The primary challenge facing policymakers is to ensure that the benefits of globalisation are maximised, while the structural challenges it presents are managed and minimised. This will include utilising opportunities for regional groupings to engage with each other, yielding net social benefits, as well as utilising the strength of a union in the global marketplace. In addition, countries will need to ensure domestic fiscal policy, especially tax policy, is consistent with international best practice and that tax policy changes take cognisance of the new structural character of the economy. Similarly, regional country groupings aiming for increased economic integration need to consider the most appropriate path towards tax co-ordination and/or a certain degree of tax harmonisation.

  1. Globalisation and tax policy
    1. Introduction
    2. Globalisation has also exerted a profound influence on the freedom of government to develop and implement fiscal policies in general and tax policy in particular. Global capital markets impose strict discipline on governments to maintain stable and consistent deficit policies. Expenditure policy is necessarily limited by the ability of government to raise taxes and finance expenditure through debt. Tax policies itself is limited by the integration of the world’s trade, financial and factor markets. Hence, there appears to be a growing need for macro-economic stability and the need to implement common monetary and fiscal policies in this regard.

      In general, the tax systems of the world were developed before the globalisation was a reality and governments were able to design fiscal and other policies in relative isolation from the activities of other countries. In short, governments were able to fully exercise their respective fiscal sovereignty. In this context, countries relied heavily (almost exclusively) on source-based taxes. In other words, taxes were levied on income earned and consumption taking place within the jurisdiction’s borders, without considering the potential spillover effects of these policies.

      Globalisation and the integration of all markets have rendered it impossible for countries to make tax policy without considering the broader international context. Tax policy has truly become an instrument to compete for foreign direct investment. This has opened up opportunities for some countries, e.g. small tax-haven countries that compete for highly-mobile financial capital, but in the main has presented significant challenges to tax policymakers. This is particularly acute in small, open economies, such as South Africa and many of the other countries in the SADC region.

      Tanzi (1998) introduces some of the areas in which international dimensions have impacted considerably on tax policy. Drawing on the themes presented there, it is clear that such international considerations cannot be ignored in designing appropriate tax policy in the countries of the SADC region. It is also clear that there must at least be some degree of co-operation and co-ordination within the SADC region to avoid the negative externalities that can easily arise. The remainder of this section considers how globalisation has affected particular aspects of tax policy.

    3. Consumption taxes

Traditionally, consumption taxes comprise destination-based taxes on the consumption of goods and services. These include broad-based sales taxes such as the General Sales Tax (GST) and the Value-added Tax, which are levied on the consumption of goods and services (though often many services, e.g. financial services are excluded from the base) within a jurisdiction. In addition to this, jurisdictions often impose selective custom and excise duties, which have a multitude of objectives, besides raising revenue. For instance:

The integration of global markets for consumption goods and improvements in technology have limited the scope for countries to set consumption tax policy independent of other countries policy stance. Improved information, reduced transport costs, Internet shopping, and enhanced international mobility of individuals have increased the opportunities for cross-border shopping, especially for high-value, low-volume products. In this context, countries cannot afford to set tax rates that are far out of line with international norms to avoid an erosion of the tax base, as individuals seek to acquire the same consumption goods from other jurisdictions at a lower cost. In principle, the scope for differing tax rates is limited by the transaction costs of cross-border shopping, which are falling all the time.

These trends have far-reaching implications for revenue authorities, which are required to protect their respective jurisdictions’ tax bases against avoidance and evasion. To counter these tax base eroding effects, jurisdictions in both the developed and developing world need to invest heavily in state-of-the-art customs or advance cargo information systems in order to track consignment of goods across borders, to expedite the legal processing of customs clearance procedures but also to arrest the ongoing smuggling activities.

    1. Corporate Taxation

The impact of globalisation on corporate income tax is multi-faceted. Of particular interest are issues such as transfer pricing and the impact of taxation on direct investment into a jurisdiction. Tanzi notes that trade between different parts of multinational groups accounts for a significant part of the growth in world trade. It has been estimated that intra-firm trade has grown from 20 per cent of total world trade in the 1970s to about one-third in the early 1990s – a trend that has undoubtedly continued throughout the decade.

The increasing mobility of investment capital has brought about downward pressure on and a degree of convergence of effective and statutory tax rates on corporations across the globe. As countries compete with each other for investment capital, Governments have been forced to reduce the effective tax rates on corporate profits. This has been achieved in two ways. First, countries have generally been reducing the statutory tax rates on corporate profits, while broadening the tax base by reducing / eliminating tax incentives for corporate investment (i.e. a broad base/low rate approach). Other countries have achieved lower effective tax rates by maintaining higher rates and introducing a number of selective tax incentives. Table 1 outlines a survey of statutory corporate tax rates undertaken by the accounting firm KPMG in 1999.

 

Table 1: KPMG Corporate Tax Rates Survey – January 1999

Country

1 Jan 1998

(%)

1 Jan1999

(%)

 

Argentina

33

35

­

Australia

36

36

 

Austria

34

34

 

Bangladesh

35

35

 

Belgium

40.17

40.17

 

Belize

35

N/A

 

Bolivia

25

25

 

Brazil

33

33

 

Canada

44.6

44.6

*

Chile

15

15

 

China

33

33

 

Colombia

35

35

 

Costa Rica

30

30

 

Czech Republic

35

35

 

Denmark

34

32

¯

Dominican Republic

25

25

 

Ecuador

25

15

¯

EI Salvador

25

25

 

Fiji

35

35

 

Finland

28

28

 

France

41.66

40

¯

Germany

56.66/43.60

52.31/43.60

¯ *

Greece

35/40

35/40

 

Guatemala

30

27.5

¯

Honduras

40.25/30

25

¯

Hong Kong

16.5

16.5

 

Hungary

18

18

 

Iceland

30

30

 

India

35

35

 

Indonesia

30

30

 

Ireland

32

28

¯

Israel

36

36

 

Italy

41.25

41.35

 

Japan

51.6

48.0

¯

Korea, South

30.8

30.8

 

Luxembourg

37.45

37.45

*

Malaysia

28

28

 

Mexico

34

35

­

Netherlands

35

35

 

New Zealand

33

33

 

Norway

28

28

 

Pakistan

30

35

­

Panama

37

37

 

Papua New Guinea

25

25

 

Paraguay

30

30

 

Peru

30

30

 

Philippines

34

33

¯

Poland

36

34

¯

Portugal

37.4

37.4

 

Singapore

26

26

 

Spain

35

35

 

Sri Lanka

35

35

 

Sweden

28

28

 

Switzerland

27.8

25.1

¯

Taiwan

25

25

 

Thailand

30

30

 

Turkey

44

33

¯

Uruguay

30

30

 

United Kingdom

31

31

 

United States

40

40

*

Venezuela

34

34

 

Vietnam

30 - 35

30 – 35

 

Note:

* = approximate rate

Although it must be noted that statutory corporate tax rate comparisons are insufficient to determine the effective tax rate on corporate profit, it is clear that the broad trend in corporate tax policy has been to reduce tax rates in recent years. This is confirmed in the case of South Africa where the basic corporate tax rate has been reduced from 35 per cent to 30 per cent in 1999. Table 2 outlines the statutory tax rates in Southern African countries.

Table 2: Corporate tax rates in SADC

Country

Corporate tax

Angola

N/A

Botswana

15% plus ACT of 10%

DRC

45%a

7.84% subcontractors of oil companies

Lesotho

15% (manufacturing p )

35%(other p )

Malawi

38%

0% (EPZ)

24% (Life assurer)

Mauritius

35%

Mozambique

N/A

Namibia

40%

Seychelles

0 – 40%

South Africa

30%

Swaziland

37.5%

Tanzania

30%

Zambia

35% (general rate)

30% (listed on ZSE)

35%, 45% banks

Zimbabwe

35/% (normal)

10% (manufacturing companies in ‘growth point areas)

15% (EPZ licensees)

35% (holders of special mining leases)

Throughout the Southern African Development Community, there has also been downward pressure on corporate tax rates. In the SADC region, there has also been a tendency to introduce special tax incentives to stimulate economic activity. The efficacy of such measures will be discussed further in section 4.

A second issue, which has been a primary influence on the convergence of statutory corporate tax rates, is "transfer pricing". Transfer prices are the prices that different parts of multinational groups charge each other for goods and services provided within the group. By manipulating these prices, groups of companies seek to channel taxable income into the part of the group of companies located in the lowest tax jurisdiction. This shifting of accounting profits within a group of companies is influenced by the statutory tax rate (i.e. not the effective tax rate on investment). As multinational companies have become more influential in the global arena, the incentive for countries to reduce their corporate tax rates has been compounded to protect the corporate tax base. These practices have also been influential in encouraging tax authorities in different jurisdictions to co-operate more with each other to ensure that the global corporate tax base is distributed effectively and fairly. However, often transfer pricing issues are wider than between two taxing jurisdictions, requiring co-operation on a broader scale. In this context, the transition to a residence-based income tax system provides additional protection against diversionary transactions that potentially involve transfer pricing and underpin the existing transfer pricing rules.

    1. Taxes on individual incomes
    2. In recent years, individuals have been presented with great scope to diversify their investment portfolios internationally. With the liberalisation of capital accounts, the relaxation of exchange controls and the improvements in technology, international investment portfolios have become a reality for many. There has been a noticeable increase in the proportion of investment income accruing to individuals from sources outside their countries of residence. This has created numerous problems for tax authorities as such income is often underreported, or not reported at all, which erodes the income tax base and fundamentally alters the distribution of the tax burden.

      Jurisdictions have sought to protect themselves by reinforcing their residence-based income tax systems with rules dealing specifically with passive income and by engaging with each other through exchange of information provisions in tax treaties. However, this has not always been successful, especially given the proliferation of tax havens that have their own motives for assisting individuals to conceal income from their domestic tax authorities. However, as shall be explored further below, multilateral organisations such as the OECD and the European Union are actively seeking co-ordinated solutions to the problems created by tax havens in the international community, with special reference to highly mobile financial service activities.

    3. Taxation of capital income
    4. The sophistication of global financial markets and the ease with which financial capital can be reallocated around the globe renders it exceedingly difficult for jurisdictions to tax capital income. In particular, interest income is difficult to tax, especially for small, open economies as in the SADC region. In many instances, developing countries have not sought to tax interest income accruing to foreigners, as is the general case in South Africa. This is motivated by fears of capital flight that could occur, as investors disinvest seeking a higher after-tax real return on their investment. Given that the primary issuer of debt in developing countries tends to be Government, such capital flight would only result in higher borrowing costs for the public sector, which would largely offset the increase in tax revenue.

      Such fears are not unfounded, if one considers the experience of Germany when it posited a withholding tax on interest in 1989. Haufler (1999: 137) reports that in 1989 Germany introduced a 10 per cent withholding tax on interest, which applied to residents and non-residents. In anticipation of the tax, German long-term capital exports reached a record level of DM85 billion in 1989 – almost four times the level of 1987. The German government was forced to withdraw the tax.

      A further complication for tax authorities in the new global environment is the ease with which derivative and other exotic/synthetic financial instruments can be used to avoid taxes. Tax authorities do not deal with these products on a daily basis and often lag behind financial institutions and investors that are developing new products, often tailored to the specific requirements of clients. These instruments are used to circumvent tax laws by recharacterising income into a lower-taxed or untaxed form, to defer tax liabilities or to shift income around the globe in a tax-efficient manner. The ever-closer integration of financial markets and the development of more complex and faster electronic banking systems will exacerbate the challenges facing tax authorities and policymakers.

    5. Globalisation – increasing need for tax harmonisation or co-ordination?

The relentless process of Globalisation forces small open economies into various degrees of economic integration such as customs unions, free trade unions or even common markets. Also Africa is not immune to these pressures for greater economic integration in order to benefit from resulting economies of scale and being able to compete more effectively in the world markets. As the process for economic integration has in certain regions in Africa advanced, the question of harmonising or co-ordinating tax systems of these evolving economic regions needs to be addressed.

The process of tax harmonisation is very complex and politically sensitive as it touches on the key issue of fiscal sovereignty of an independent state. However, as countries move towards an economic union, it needs to be recognized that an internal market requires at least in terms of the indirect taxes (broadly-based consumption taxes such as VAT, general sales tax, excises and customs duties) a harmonisation approach because if different taxes are levied on different basis or at different rates across markets of member states of a trade block, serious obstacles would be created for the free movement of goods and services.

Based on the tax harmonisation experiences of the European Union, the main provision for tax co-ordination are Articles 95 to 99 of the 1992 EC Treaty, which almost exclusively deal with indirect taxation James (2000: 263). Other international experience in this regard suggests that the process of tax harmonisation or co-ordination is primarily advanced in the area of indirect taxation. For example, the European Court’s rulings seemingly advance the development of an integrated system of indirect taxation, but is gradually also taking direct tax issues into account. As the Court is required, inter alia, to abolish obstacles to free movement of goods, persons, services and capital and entrench a system whereby competition in the internal market is not distorted, the process of tax harmonisation / co-ordination needs to cover not only indirect – but definitely also matters of direct tax.

Clearly, policies in terms of corporate and personal income taxation need to be harmonised / co-ordinated to avoid tax incentives for labour and capital to migrate (also known as fiscal competition) within the borders of the common market primarily for tax reasons. Needless to say, SADC will not be immune to similar trends and their implications for tax policy making. The various degrees or approaches towards tax harmonisation / co-ordination will be discussed in more detail when tax policy issues relevant for SADC will be reviewed.

At this stage it suffices to state that the strongest case for tax harmonisation is its support for economic efficiency, lower transaction costs and lower unit costs, thereby advancing the cause of an integrated or common market. As political support for integration grows, so will the need for co-ordinated tax policies.

Arguments against tax harmonisation really centre on the issue of complete harmonisation as differences in certain tax areas would have beneficial competitive results. These matters have been adequately been argued in the field of fiscal federalism. This is the principle of subsidiarity and if the fiscal competition argument would be applied pragmatically, striving towards complete harmonisation would be unnecessary. Hence, the debate should rather focus on what taxes should be co-ordinated to advance the economic integration process, for example in the case of SADC and which taxes might be left to the members states (at a lower jurisdictional level) to support fiscal sovereignty or, alternatively put, to support the principle of subsidiarity at the level of individual member states James (2000: 269).

 

  1. Tax incentives – a policy tool?
  2. Developing countries face formidable economic development challenges, which are particularly acute in Africa and the SADC region. Raising living standards, eradicating poverty and reducing inequality in the distribution of income and wealth require periods of rapid, sustained economic growth, accompanied by enhanced employment opportunities and rising real wages. The central questions facing policymakers are: What role should governments assume in meeting these development challenges? What are the policy tools available to government to enhance the growth potential of their economies or indeed the rate of economic growth? Thirdly, should the tax regime be part of this range of policy instruments and, if so, how?

    In general, the economic study of taxation focuses on designing a tax regime capable of raising the revenue required to finance government spending in the most efficient and equitable way possible. Despite this, tax incentives often assume a central place in government programmes for increasing the investment rate and, thereby, the rate of economic growth. In fact, most tax systems around the world contain special provisions intended to achieve objectives other than raising revenue, such as encouraging investment, advancing research and development, increasing saving for retirement, promoting charitable giving and a host of other activities. While recognising that tax incentives are often used to encourage a variety of activities, the central focus in this discussion paper is on tax incentives to promote investment, particularly foreign direct investment, though many of the discussion points raised are generic to all tax incentives.

    In recent times, the efficacy of tax incentives to achieve their stated objective has come under scrutiny. It has been forcefully argued that tax incentives are often inefficient and ineffective, possibly even having deleterious effects on the economic system. This has become a particularly important question in the SADC region.

    Section 4 proceeds by considering the ‘appropriate’ role for government in fostering economic growth, followed by an assessment of the general impact of taxation on investment activities and a discussion of the various types of tax incentives most often encountered. The issues related to harmful tax competition are considered in detail, as well as international efforts at tax co-operation to minimise the deleterious effects of such activities in the global arena.

    1. Government and Economic Growth
      1. Introduction
      2. Economic growth is a function of the accumulation of capital (etc buildings, machinery) in an economy, increases in the labour force participation rate and the rate of technological progress (the methods used to produce goods and services is enhanced by the acquisition of skills and new production techniques to produce outputs more efficiently). A central question in economics is the relative contribution of the "factors of production" (labour and capital) and technological progress to economic growth. The traditional view emphasises that permanent economic growth is the result of improvements in technology. Thus, while improvements in physical and human capital can give impetus to the rate of economic growth, such growth is only sustainable if accompanied by improvements in technological expertise.

        Other analysts, however, suggest that accumulation of capital and labour is the most important factor determining a country’s growth performance. The debate on the relative importance of these factors is inconclusive. In the context of a developing country, however, achieving higher rates of economic growth is likely to be found in a balance of increasing the rate of capital accumulation, mobilising the labour force and adopting advanced technology and production methods to produce goods and services more efficiently. In other words, increasing the rate of accumulation of physical and human capital will likely lead to higher rates of economic growth, which will be further enhanced by technological progress.

      3. Lessons from East Asia

A key question facing policymakers is what can governments do to increase the rate of economic growth, thereby ensuring a sustained increase in the living standards in the country. In seeking answers to this question, policymakers have often analysed the growth performance in East Asia, where governments seemed to take an active role in encouraging economic growth. Sarel (1996:12) identifies three schools of thought on Government’s role in the "miraculous" economic growth rates witnessed in East Asia since 1960. These include:

Sarel (1996) outlines the main arguments advanced to explain the rapid growth in the East Asian economies. The two primary explanations have focussed on rapid investment growth and export promotion as the "engines of growth". In the context of investment, it is suggested that increasing investment permanently increases the growth rate through economies of scale and other beneficial side effects. The impact of export promotion on economic growth is often thought to arise from exposing domestic industries to foreign technology and foreign competition, thereby improving the rate of technological progress.

The initial levels of investment and export orientation prior to the period of rapid economic growth in East Asia do not seem to support the hypothesis that increased investment and export orientation are the catalysts for growth. Rather, these were complementary to the growth in the region. Sarel concludes the analysis that "from a normative point of view, it is far from clear what specific policies government should pursue, beyond the standard set of policies aimed at getting the basics right".

Stiglitz (1996) reviews the performance of the "East Asian Miracle" in an attempt to distil the broad policy measures adopted to encourage economic growth and to distil policy lessons for other developing economies. On analysis of the multi-faceted approach adopted by the "East Asian Tigers", Stiglitz (1996: 174) concludes as follows:

"No single policy ensured success, nor did the absence of any single ingredient ensure failure. There was a nexus of policies, varying from country to country, sharing the common themes that we have emphasised: governments intervened actively in the market, but used, complemented, regulated, and indeed, created markets, rather than supplanted them. Governments created an environment in which markets could thrive. Governments promoted exports, education, and technology; encouraged co-operation between government and industry and between firms and their workers; and at the same time encouraged competition."

      1. Government’s appropriate role

Theoretically, economic growth is a function of the growth in physical and human capital, as well as technological progress. Recognising this, however, does not give rise to a set of government policies that will engender rapid, sustained economic growth of the magnitude necessary to ensure rising living standards in developing countries. This is particularly true in economies where governments recognise the primacy of markets (and the institutional arrangements required to make markets work) to allocate resources to their most productive uses. It is clear, however, that government can, and should intervene in instances where markets are non-existent or are plagued by market failure, which is certainly more prevalent in developing countries than developed ones.

Missing markets

A prime example of "missing markets" in developing countries is the absence of well-regulated financial markets to ensure savings are channelled efficiently into productive uses. For instance, many developing countries do not have well-developed stock exchanges, banking systems, foreign exchange markets or insurance markets allowing investors to effectively share the risk burden of investment projects.

Market failure

"Market failure" arises where the private and social costs and/or benefits arising from a particular activity are not the same, often referred to as "externalities". In the context of facilitating economic growth, a clear area for legitimate government attention is the encouragement of particular sectors, e.g. high-technology sectors, or particular activities, e.g. research and development. In these sectors and activities, the positive benefits accruing to society as a whole exceed the private benefits accruing to the individual or firm undertaking the activity. In the absence of government intervention, this would lead to under-investment in these activities.

Another area of traditional government intervention is the promotion of regional economic development, e.g. advancing the economic development of historically underdeveloped regions of the country.

The governments of East Asia played an important role in ensuring domestic industries had access to foreign markets for exports, recognising that promoting international trade can have numerous spin-offs for the domestic economy. It is well known that international trade allows countries to focus on the activities in which they have a "comparative advantage" over other countries, with the resulting trade raising social welfare. In addition, international trade:

While the benefits of free international trade are clear, what role should Government (especially developing country governments) play in facilitating such trade? Given the positive benefits to society from international trade (in excess of the private benefits accruing to the trader) Government can, and should play an active role, including facilitating (and even leading) trade negotiations on behalf of business, promoting a country’s products in international markets, and other fiscal stimuli to encourage investment in export-oriented sectors.

Information asymmetry

The ability of markets to allocate resources efficiently is based on an assumption of "perfect information". Very often, the parties to a transaction do not have full information and cannot acquire the necessary information without incurring considerable transactions costs. Problems of "asymmetric information" arise in the context of lending arrangements, where financial institutions appear unwilling to lend to particular segments of the economy, as they cannot accurately assess the credit risk, e.g. small business sector. Another example arises in the context of marketing particular products, sectors, or even countries and regions.

A role for government?

This discussion obviously points to the catalytic role for government to facilitate the allocation of scarce economic resources to their most productive use. Having identified the need for an active role by government, one must consider the policy tools available to government and the most appropriate intervention. Government intervention can take many forms, including:

  1. The complete ownership of resources and active participation in certain industries and sectors (e.g. public utilities, banking sector).
  2. Regulation (e.g. financial market regulation, exchange controls).
  3. Expenditure policies (e.g. expenditure on scientific research, infrastructural development).
  4. Taxation policy (e.g. tax incentives).

The central focus of this section is the efficacy of tax incentives as a policy tool for government intervention to encourage investment and growth.

    1. The role of tax incentives

The tax system can exert strong influences on the decisions of investors, including the types of investment undertaken, the manner in which such investment is financed and the activities of multinational corporations. Before considering this impact in more detail and the effectiveness of tax incentives to achieve particular development objectives, it is imperative to reflect on the fundamental objective of tax policy and tax design. This exercise is particularly important for a developing economy, faced with the imperatives of globalisation and the realities of the modern, technology-based international economy. In this context, the tax system should be designed to:

  1. Raise sufficient revenue to finance public expenditure programmes, while maintaining a sustainable public sector borrowing requirement;
  2. Raise revenue in an efficient and equitable manner. In other words, the burden of taxation should be shared fairly across and within income groups. Taxes imposed should minimise the incentive effects on the decisions of producers and consumers.
  3. Be simple to administer and to minimise the compliance burden imposed on taxpayers.
  4. Be consistent with international norms of taxation.

These challenges are often exacerbated in developing countries, including those in the SADC region, due to:

It is in this context that one must consider the role for tax policy to contribute to extraneous objectives of government and, in particular the potential for tax policy to be used as part of an industrial development strategy.

      1. Taxation and investment
      2. The central role of physical capital accumulation – investment – in economic growth has been outlined in section 2. Many facets of the tax system can influence the level of investment, the nature of investment (i.e. the type assets accumulated); and the financing of investment. These factors include the tax rates, the tax treatment of asset depreciation and the tax treatment of different forms of capital income, i.e. interest, dividends and capital gains.

        Because of the theoretical potential for the tax system to influence investment decisions, many developing countries attempt to stimulate investment, particularly foreign investment (both direct and indirect) through the tax system. It is not uncommon for developing countries (and developed ones, for that matter) to utilise particular tax incentives to encourage investment and to divert investment to particular activities, e.g. export promotion.

        Before evaluating the effectiveness of these incentives in turn, one must outline other, perhaps even more critical factors influencing the investment decision, particularly domestic and foreign fixed investment.

      3. Factors affecting foreign direct investment

It is often argued that in the absence of tax incentives, developing countries will not be able to attract foreign direct investment, particularly of the levels required to sustain economic growth sufficient to address the development challenges in those countries.

In this context, it is important to set out some of the general theoretical and practical factors affecting foreign direct investment. This serves two purposes. First, it outlines that the tax system is only one of many factors that can influence investment decisions. Second, it will lead to a policy recommendation that the tax system cannot compensate for other deficiencies in the investment environment, as outlined below.

Hines (1996) reviews the impact of taxation on the activities of multinational corporations, including decisions regarding the volume and location of investment. Reviewing recent empirical evidence (most of which relates to US direct investment abroad) regarding the relationship between investment and the after-tax rate of return, the study suggests the following:

"The answer that emerges in a variety of contexts and from a variety of approaches is that, in spite of all the other political and economic considerations that are clearly very important, taxation exerts a significant effect on the magnitude and location of FDI".

At face value, conclusions such as this would seem to support the introduction of tax incentives to attract investment. However, this conclusion must not be interpreted narrowly and additional factors must also be borne in mind, including:

  1. The "after-tax return" referred to includes taxes in the host country as well as the home country of the multinational firm making the investment.
  2. The limitations of data and methodological techniques leave rather "unsatisfying elements in existing studies of the effect of taxation on FDI" (Hines, 1996: 17), perhaps affecting the accuracy of the inferences drawn from the studies, which include:

"In the absence of a complete general equilibrium model, it is impossible to predict with certainty the impact of tax changes on capital demanded through a multinational firm. The available FDI evidence is suggestive, and further evidence is provided by studies of the ways in which multinational firms are financed."

  1. Notwithstanding the evidence outlined in the paper, Hines (1996: 8) notes:

"The complexity of international investment planning, given the uncertainty firms face in forecasting future economic and political conditions, convinces some observers (such as Vernon, 1997) that tax differences are too small to have anything other than trivial effects on investment location".

Chunlai (1997) reviews the major determinants of foreign direct investment into developing countries. After reviewing the theoretical literature on the subject, Chunlai (1997: 20), suggests that a discussion of the factors affecting the attractiveness of a particular developing country for foreign direct investment can usefully be viewed from the perspective of two types of investment, as well as more general factors:

  1. Market-oriented investment aims to set up in a country to supply the local market primarily. The kinds of industries usually undertaking such investment are those with high product differentiation, high absolute capital costs, large potential economies of scale, high multi-plant requirements and high entrepreneurial needs. It is submitted that developing countries with larger markets, faster rates of economic growth and higher degrees of economic development are likely to attract this type of investment.
  2. Export-oriented investment seeks to use a specific resource at a lower real cost in the host country to produce output for export to the rest of the world. The attractiveness of a developing country for this type of investment depends on a relative abundance of a particular immobile factor of production, e.g. mineral deposits, or cheap (yet productive) labour.

Given the array of significant factors affecting international investment into a country, it is important to maintain perspective on the potential for tax incentives to affect such a decision, particular in respect of irreversible investment in plant, machinery and equipment. Having outlined this general context, attention is now focussed on discussing the efficacy of the various tax incentives found in international practice.

    1. tax incentives
    2. Section 4.2 discusses in very broad terms the factors contributing to economic growth and section 4.3 considers the general role of tax policy, placing it in the context of a developing country seeking to attract foreign direct investment. Many countries offer various forms of tax incentives as part of economic development strategies, often on the justification that they are a pre-condition to attracting investment into a particular country or region. This section seeks to assess the efficacy of tax incentives in obtaining their stated objectives.

      1. Defining tax incentives
      2. The Commission of Inquiry into Certain Aspects of the Tax Structure of South Africa ("the Katz Commission") characterised a tax incentive as "a form of special pleading, a preferential treatment to a particular target group, enterprise or objective" (RSA, 1994: 196)" and provided the following definition of an incentive:

        "Revenue losses attributable to provisions of the Federal tax laws which allow special exclusion, exemption or deduction from gross income or which provide special credit, preferential rates of tax or a deferral of tax liability" (Congressional Budget Act of 1974 – cited in Katz, 1994: 196).

        This definition focuses on the direct cost of providing a tax incentive, and is associated with the desire to compile a tax expenditure budget to ensure the costs of tax incentives are reported in a transparent manner. An alternative definition provided by Willis and Hardwick (quoted in Dilnot and Johnson, 1993: 45) is perhaps more appropriate, but complicates efforts to quantify the impact of a tax incentive. According to Willis and Hardwick,

        "a tax expenditure is an exemption or relief which is not part of the essential structure of the tax in question but has been introduced into the tax code for some extraneous reason…" (Dilnot and Johnson, 1993: 45).

      3. Advantages of tax incentives

It has been noted that tax incentives can influence the investment decisions of both domestic and international investors. Incentives are most often targeted to real investment in productive activities by international investors, on the grounds that this will augment the domestic capital stock, introduce into the domestic economy technological advances, thereby meaningfully contributing to economic growth and job creation. Despite advice to the contrary, many developing, developed and transition economies make use of tax incentives to promote these activities, which leads to a consideration of the perceived advantages of such incentives, including:

  1. Tax incentives can be more flexible than other means of government intervention, as they allow the firm or individual to decide on the quantity and often the form of the activity undertaken.
  2. Because the decisions are made at the level of the firm or individual, they decentralise decision-making, which reduces the possibility of administrative discretion or political interference in the activity being promoted. For instance, providing tax deductions (or other tax incentives) for contributions to religious or non-profit organisations allows taxpayers discretion over the entities supported by this government policy. In certain instances, this can be particularly beneficial for encouraging taxpayer participation in civic processes, thereby deepening democracy.
  3. Tax incentives are automatic, whereas expenditure decisions are often subject to administrative discretion. In many contexts, especially where governance institutions are not efficient or effective, or where such bureaucratic discretion can lead to inappropriate behaviour (e.g. corruption), allowing automatic access to particular government programmes can be of benefit.
  4. Easson (1992) reports in a study conducted on behalf of the World Bank that 50 out of 74 projects (in ten different countries) claimed that they had located in a particular host country because of the tax incentives offered by the host country government.

      1. Disadvantages of tax incentives
      2. While tax incentives are undoubtedly more flexible and decentralised than government expenditure programmes, one must view the potential advantages in the context of the arguments against the use of selective tax incentives to promote investment or encourage particular economic activity. Global fiscal experts are growing increasingly sceptical regarding the efficacy of tax incentives, encouraging jurisdictions to resist their implementation on a number of grounds.

        Revenue effect and erosion of the tax base

        Special tax preferences aimed at attracting mobile factors of production narrow the tax base. In fact, it is often argued that in the face of globalisation, a jurisdiction must offer at least the same incentives as other jurisdictions to avoid capital flight and a reduction in foreign investment inflows. It is perhaps trite, but nevertheless important, to note that offering tax incentives erodes the tax base and, if the policy is to be revenue-neutral, requires a higher tax rate on the narrower tax base or additional taxes on other bases. Alternatively, tax revenue will fall, requiring reductions in expenditure programmes or additional recourse to debt to finance expenditure.

        Tax incentives and the erosion of tax bases is currently an important topic for discussion in the European Union. For example, the Dutch Ministry of Finance has commissioned studies to evaluate the impact of tax incentives on effective corporate tax rates in countries across the union. These studies have focussed on how tax incentives have created divergences between the statutory corporate tax rate and the effective corporate tax rate actually paid by companies.

        Austria, Belgium and Portugal have the greatest difference between their statutory corporate tax rates and the effective rates faced by firms operating within their jurisdictions, while Sweden, France and the Netherlands have the closest correlation between the statutory rates and the effective rates. The results are summarised in Table 3, with countries ranked according to the divergence between the statutory and effective tax rate.

         

        Table 3: Statutory vs. Effective Corporate Tax Rates in EU member countries.

        Rank

        Country

        STR

        ETR

        STR – ETR

        1

        Sweden

        28.54

        27.47

        1.07

        2

        France

        34.70

        32.82

        1.88

        3

        Netherlands

        35.00

        31.80

        3.20

        4

        Finland

        34.02

        29.82

        4.20

        5

        United Kingdom

        33.35

        29.00

        4.35

        6

        Luxembourg

        39.40

        34.09

        5.31

        7

        Denmark

        35.78

        29.40

        6.38

        8

        Ireland

        21.94

        13.86

        8.08

        -

        EU average

        36.45

        26.86

        9.59

        9

        Spain

        35.30

        24.11

        11.19

        10

        Germany

        50.05

        38.53

        11.52

        11

        Greece

        32.53

        20.85

        11.68

        12

        Italy

        50.48

        35.32

        15.16

        13

        Austria

        36.02

        17.67

        18.35

        14

        Belgium

        40.28

        20.99

        19.29

        15

        Portugal

        39.29

        17.19

        22.10

        Source: Buijink, Janssen and Schols, 1999: 34.

        The average effective tax rate across all EU countries is almost 10 percentage points below the average statutory rate, largely due to the erosion of the tax base that results from tax incentives available to business. It is clear from the table that the effective tax rate in three countries (Austria, Belgium and Portugal) is about half the statutory rate in these countries.

        Italy and Germany (prior to the 1999 sweeping tax reforms) have the highest statutory and effective tax rates. However, Belgium has the third-highest statutory rate, yet the effective rate is in the lowest third of all the EU countries. Similarly, Portugal has the fifth-highest statutory rate, but second lowest effective rate.

        It is also pertinent to note that the effective tax rates are more "centred" than the statutory tax rates across all European countries, i.e. the standard deviation of the effective rates is smaller than that for the statutory rates (Buijink, Janssen and Schols, 1999: 3). There are two broad approaches to achieve competitive tax systems to attract foreign investment. First, one could use a proliferation of tax incentives to mitigate the effect of high statutory rates as is used in Italy, Germany and Belgium, with the associated negative implications for efficiency and equity. Second, one could maintain a low statutory rate, with few incentives that erode the tax base, as is the case in Sweden, France and the Netherlands. In considering this, one must also consider the capital stock in each of the countries. Some countries, such as Sweden are likely to be close to the "optimal level of capital stock", which would imply that they would not need to utilise specific incentives to encourage capital formation. On the other hand, smaller countries such as Portugal may have greater scope for using tax incentives to encourage capital formation, as their capital stock is likely to be below the optimal level.

        Generally, the second option has been preferred by the South African Government to promote both foreign and domestic investment, while at the same time protecting the overall integrity of the tax system. South African empirical evidence also suggests that this improves, inter alia, revenue collections from the corporate sector, as evidenced in recent years’ consistent collection overruns.

        Tanzi (1998: 342) notes that many tax experts hold the view that the growing tax competition arising out of tax incentives as nations compete to attract highly mobile international capital is leading to "fiscal degradation", which, it is submitted, is likely to increase as competition for global capital heightens.

        Efficiency costs

        While the direct cost of tax incentives are measurable and can be reported the often-understated costs arise from the misallocation of productive investment resources. Because selective tax incentives ‘artificially’ increase the rate of return to investment, investors make economic decisions giving undue weight to tax considerations. In addition, tax incentives for promoting investment tend to focus too narrowly on the effect of accumulating capital as a source of economic growth. Such an approach disregards the impact in terms of capital deepening, which can exacerbate unemployment in an economy where the labour market that is not equipped for the type of capital investment subsidised. These costs are difficult to measure, but represent a real welfare loss to the economy.

        The problems of resource misallocation are compounded by the difficulty in targeting tax incentives to the promotion of new investment. If investment that would have taken place in the absence of the tax incentive can avail itself of the incentive, the tax authorities are merely conferring economic rents (at the expense of other taxpayers) on investors, and not achieving the objectives of the programme. Programmes designed to minimise this possibility and improve the targeting and effectiveness of the incentive are inherently difficult to implement and administer.

        Equity of the tax system

        A fundamental principle of tax design holds that the burden of taxation should be distributed fairly – the equity principle. This connotes both horizontal and vertical equity. In other words, taxpayers with similar abilities to pay taxes should bear a similar tax burden (horizontal equity) and taxpayers with greater ability to pay should incur a greater tax burden than taxpayers with less ability to pay (vertical equity).

        Tax incentives can fundamentally impinge upon the fairness of the tax system. Firstly, because not all taxpayers are in a position to take advantage of a particular tax incentive, taxpayers with similar economic power will incur different tax liabilities, damaging the horizontal fairness of the system. Perhaps even more importantly, wealthier (well-advised) taxpayers are most often in a better position to take advantage of tax incentives than less well off ones are, compromising the vertical equity of the system. When a tax system is perceived to be inequitable or unfair, tax morality can be adversely affected, further compounding the negative effects of tax incentives.

        Tax planning and tax arbitrage

        International experience suggests that tax incentive schemes encourage tax arbitrage activities through tax planning (i.e. legal arrangements or manipulations in the form of intra-company transfer pricing by switching taxable income to tax entities that enjoy tax preferred status). Tax preference schemes lead to extensive tax evasion with a concomitant escalation of tax administration and enforcement costs due to the accompanying complexity of the tax system. The objective of striving for simplicity in tax administration is thereby ignored and monitoring costs are bound to increase, placing considerable burden on revenue authorities. Moreover, in the absence of sustained - and costly - attempts to enhance tax enforcement procedures, the tax compliance gap is bound to widen, which developing countries can ill-afford.

        In reviewing the potential impact of taxation in the East Asian crisis, Nellor (1999) suggests that while taxation was not a primary cause of the crisis, it certainly contributed to it. In an effort to attract highly mobile capital, jurisdictions introduced numerous tax incentives, particularly in the financial system. These incentives introduced a "myriad of tax arbitrage possibilities", which were exposed by investors and certainly contributed to the crisis in some way.

        Lobbying activity

        Tax incentives lead to political lobbying activity on two fronts. First, the introduction of tax incentives in many developing countries can be traced to implicit and explicit lobbying by powerful investors. The dependence of developing countries on international capital and the high degree of mobility of such capital combine to give global investors very strong bargaining positions vis-à-vis developing country governments. In this context, it is perhaps unsurprising that many developing countries have resorted to providing tax incentives, even though the investments make commercial sense in the absence of incentives.

        Second, the existence of tax incentives increases lobbying for their preservation, when they are perceived to be under threat, especially in the context of a broad tax reform programme, or when tax holidays expire. In such instances, the support galvanised around the retention of a tax incentive can be overwhelming, leading Holland and Vann to lament:

        "The fact that many industrial countries maintain tax incentives after the tax reforms of the 1980s is less a statement that they are considered to be effective and more a testament to the political difficulty in removing them once they have been introduced."

        Tax sparing

        Tax sparing occurs when a country (home country) adjusts its taxes to allow multinationals resident in that country to take full advantage of tax reductions offered by the host country in which the investment takes place. For instance, if the UK has a tax sparing agreement with South Africa and South Africa were to grant an investment tax allowance, the UK would tax the income accruing to the multinational, as if it had borne full taxation in South Africa (i.e. the UK would still grant credit for taxes that would have been paid in the absence of the tax incentive). In the absence of such agreements, developing countries are merely transferring their tax base to the home country of the multinational investor, as the tax saved in the host country will be recouped in the country in which the investor is resident.

        In an interesting analysis of the effect of tax sparing on the volume and location of foreign direct investment, Hines (1998) compares the FDI activities of companies resident in the USA (which does not grant tax sparing provisions under any circumstances) and Japan (which has tax sparing provisions in some of its Double Taxation Agreements). Hines concludes that Japanese FDI in countries with which it has tax sparing agreements is 1.4 – 2.4 times greater than it would have been otherwise and these Japanese firms are subject to 23 per cent lower tax than their American counterparts.

        This analysis suggests that tax-sparing agreements are important for determining the effectiveness of tax incentives and the volume and location of foreign direct investment. It furthermore confirms the view that in the absence of tax-sparing agreements, developing countries should focus on other means of attracting foreign direct investment. It is important to note, however, that there is growing scepticism in many developed countries regarding the efficacy of tax sparing agreements, and a heightened reluctance to grant such provisions to developing countries. This position is intensified because of the growing tax competition that threatens the tax bases of even developed countries. In the light of this, it is imperative that regional blocs, such as SADC, develop a common position in respect of the appropriate use of tax incentives and use this as a platform to negotiate tax sparing agreements with developed economies, thereby improving the prospects for inward investment and the efficacy of such tax incentives.

      3. Review of tax incentive schemes

Tax incentives used in developing countries have taken many guises, but falling within the following generic categories:

In this section, each of these general incentive schemes is reviewed, outlining the advantages and disadvantages of each.

Tax holidays

Tax holidays are directed at new firms, which are exempt from taxation for a period of time. Tax holidays are the most popular tax incentives used by developing countries. However, there are a number of shortcomings associated with the use of tax holidays and technical design issues, all of which suggest that they should be viewed with a healthy degree of circumspection. These include:

  1. Tax holidays have an inherent propensity to encourage short-term investments, since such investments benefit most from this tax preference. Long-term investments only benefit if the initial tax holiday period can be extended or renewed; which will only occur after a protracted negotiating process, involving high transaction costs.
  2. The usefulness of tax holiday schemes depends on the profitability of the qualifying companies or the date from which the holiday is effective (e.g. the commencement of the project or from when it becomes profitable). If a firm is in a profit situation, it benefits immediately from a tax holiday, since its return on investment is raised due to the tax-exempt status of profits. However, a loss-making company enjoys no benefit whatsoever, since losses are not taxed anyway. Tax holidays are of very limited use as an investment incentive for "green-field projects", as most firms in the start-up phase remain loss-making entities for a considerable period, especially if the projects are of a long-term nature. Furthermore, it makes little sense to grant special tax benefits to new firms that are profitable from the start-up phase because the opportunity of making sound returns on investment should be sufficient incentive in its own right.
  3. In general, the usefulness of tax holiday schemes is also a function of a jurisdiction’s provisions for the tax treatment of depreciation allowances. If accrued, initial or annual depreciation allowances cannot be carried forward (or backward) in the tax holiday period, the effectiveness of the tax holiday incentive is substantially eroded, although allowing depreciation allowances to be deferred beyond the project increases the tax incentive considerably.
  4. Because tax holidays target companies (not actual investment), the final revenue loss associated with the tax incentive scheme is very difficult to quantify in advance. Particularly since the revenue loss depends on the actual profitability of the firm enjoying the tax holiday.
  5. Tax holiday schemes are open to tax avoidance practices as existing firms may sell their assets into ‘new’ firms to take advantage of the incentive scheme, although no actual investment has been created. This process is usually repeated toward the end of the holiday period, ensuring the same firm, with the same assets re-qualifies for the tax incentive. Alternatively, existing firms enter into joint ventures with qualifying firms and use internal transfer pricing to ensure profits are sheltered in the firm enjoying the tax holiday. Policing such abusive practices is very difficult and places considerable pressure on already constrained revenue administrations, especially in developing countries.
  6. Tax holidays are inflexible, as once they are granted they are difficult to remove without creating distortions between new and existing firms.
  7. Because tax holidays are negotiated in advance for a fixed term, there is an incentive for the participating industries to lobby for the extension of the programme at the end of the initial tax holiday period.
  8. South Africa introduced a tax holiday scheme in 1996, essentially providing tax holidays for up to six years depending on the type of industry into which an investment is made; the number of jobs created and the geographic location of the investment (two year tax holiday for each component). The South African revenue services reports that of the 321 applications received for the investment scheme, 211 were approved, generating projected employment of 21 123 jobs and R8,5 billion investment. Of this, 102 of the projects involved foreign investment, generating 12 290 jobs, with investment of R4,5 billion.

Investment tax credits

"Investment tax credits" allow for a reduction in the actual tax liability depending on the expenditure incurred on the investment. Investment tax credits, like investment tax allowances, seek to reduce the cost of capital for investment, without conferring windfall gains on investors with existing assets, as would be the case under a general tax rate reduction programme.

A special form of investment tax credit is the "incremental investment tax credit", which grants the credit only for investment expenditure above a certain threshold. The incremental investment tax credit is thought to address the problem of granting windfall gains to investors that would have undertaken the investment even in the absence of the tax incentive. Such incentives have the potential to provide the same stimulus to investment, but at much lower cost in terms of revenue foregone than other incentive schemes.

An econometric study of the Investment Tax Credit in the USA by Professor J. Bradford DeLong indicates that when the ITC has been in place in the USA, the share of GDP committed to equipment investment has been between one-half and one-percentage point higher than at times when it has been repealed. He further suggests that a ten percent non-incremental ITC would generate between $30 billion and  $60 billion of additional equipment purchases, generating additional growth of about 0.3 percentage points a year. While one must bear in mind that these studies pertain to the particular circumstances of the US economy and may have little relevance for developing countries, the powerful conclusion is drawn that "an ITC is the most cost-effective way of reducing the cost of capital for equipment". It is also noted that a broad-based, permanent non-incremental ITC is superior to the incremental or temporary version, as it is more equitable and neutral across time.

Investment tax credits have a number of advantages over tax holidays, including:

Notwithstanding the many advantages over a tax holiday, there are inherent weaknesses with investment tax credits, including the following.

  1. Unless larger credits are provided for long-lived assets, investment tax credits distort incentives in favour of short-lived assets.
  2. If the incentive is temporary, it may only encourage an inter-temporal reallocation of investment decisions. However, if it is permanent, the revenue loss associated with it could become unmanageable.
  3. Qualifying agents may abuse the system by reselling the same asset merely to qualify for the investment incentive again.
  4. Loss-making firms cannot benefit, as they have no current tax liability that the credit would offset. Hence, the investment tax credit would favour existing, profitable firms over start-up operations.
  5. Incremental investment incentives are very difficult to design in a way that they are simple to administer, provide equal incentives to all taxpayers (in fact, industries with traditionally high investment rates can be penalised by such an incentive vis-à-vis their competitors).
  6. A number of complex design issues must be addressed, including:

Hence, although investment tax credits are far superior to tax holidays as a means of encouraging investment, there are a number of shortcomings with such tax incentives that are difficult to address and many of the general disadvantages associated with tax incentives pertain. In addition, there is substantial uncertainty regarding the responsiveness of investment spending to changes in the tax-cost of capital, especially if these are deemed to be temporary (in which case the changing investment pattern could be only temporary, or short-term). While studies in developed countries may be instructive in this regard, they cannot be used as conclusive evidence of the responsiveness of investment in developing countries, which is likely to vary from country to country due to the heterogeneity of the circumstances.

Investment tax allowances

"Investment allowances" allow for deductions in the calculation of taxable income, depending on the expenditure on a particular investment. These incentives are closely related to investment tax credits - the only difference is that instead of providing a credit against the companies income tax liability, the allowance provides a deduction in the determination of the company’s taxable income.

The only real difference between an allowance system and a credit system arises in the level of incentive provided when a country operates a graduated corporate tax rate system. An investment tax credit provides the same relief to all taxpayers, regardless of their statutory tax rate. Thus, for instance, for a 5% investment tax credit, a company investing R1 000 000 would have its tax liability reduced by R50 000, irrespective of the statutory tax rate. However, if the incentive was provided in the form of an investment allowance, the actual incentive would depend on the statutory tax rate. Thus, if an investment allowance of 10% is provided for investment, a company investing R1 million would be allowed to deduct R100 000 from its taxable income before determining its tax liability. If the statutory corporate tax rate were 50% this incentive would be worth R50 000 to the firm, but if the statutory corporate tax rate were 30%, the incentive is worth R30 000.

Investment tax allowances enjoy all the same advantages as investment tax credits over tax holidays, but also suffers the same shortcomings and challenges outlined in the previous section.

Accelerated depreciation

Tanzi (2000: 27) notes:

"Providing tax incentives in the form of accelerated depreciation has the least of the shortcomings associated with tax holidays and all of the virtues associated with investment allowances/tax credits – and overcomes the latter’s weaknesses to boot."

Two additional advantages of accelerated depreciation regimes are identified. Firstly, they are least costly in terms of revenue foregone. Secondly, if a temporary accelerated depreciation regime is introduced it could easily bring about a short surge in investment spending, as it will bring forward future investment plans. However, one must caution that accelerated depreciation regimes may lead to capital deepening, which may exacerbate problems of structural unemployment found in many developing countries. Hence, any accelerated depreciation programme should be reviewed regularly to assess its impact on capital intensity of industry, and its consequential negative impact on employment.

Export processing zones / Industrial Development Zones

Many countries have used export-processing zones (EPZs) to promote export-oriented investment. The central feature of these initiatives is that a "zone" is designated within which enterprises can incorporate and enjoy fiscal benefits, which frequently entail specific tax incentives such as duty-free import of machinery and raw materials, zero-rating of VAT, tax holidays as well as access to streamlined and efficient tax administration processes.

Holland and Vann (1998: 1007) note that much of the investment into export processing zones is "highly-mobile, cost conscious and tax sensitive", usually vacating the country as soon as the tax incentives are withdrawn. It has been submitted that there is very little benefit to the local economies in countries establishing EPZs as:

Finally, while the EPZs are theoretically easier to administer (as they are ‘cordoned off’ from the rest of the economy) there is still scope for tax avoidance activities, as firms seek to transfer profits into the EPZ, thereby taking advantage of all the tax incentives. Furthermore, depending on the nature of the EPZ, there is a risk of it being classified as a harmful tax practice by bodies for international co-operation such as the EU or the OECD.

Graduated corporate tax rates

Many developed and developing countries impose graduated tax rates on corporate income, often differentiated on the asset base, turnover, taxable income or even activity of the entity involved. Such a system, especially in the context of small business promotion, can provide significant cash-flow benefits, stimulating the growth of these businesses and encouraging job creation. The major drawbacks associated with this regime are associated with designing and implementing a regime that can be effectively policed to ensure only legitimate entities can take advantage of the system.

      1. General rate reductions

An across the board reduction of the corporate tax rate is regarded as the most efficient and effective investment incentive available in a policy environment characterised by very difficult trade-offs. Such trade-offs include the need to maintain an efficient and neutral tax system, which is also equitable; the need to generate sufficient revenue for government programmes, without imposing onerous burdens on private economic activity. International experience suggests that the most appropriate manner to accommodate the inherent trade-offs associated with tax policy is to maintain a broad tax base and strive for statutory rates that are as low as possible. In general, the main advantages of such a strategy can be summarised as follows:

  1. Generally, lower tax rates guarantee higher after-tax returns for all the investors in an economy. In particular, this approach is of tremendous benefit to small, medium and micro enterprise, which are generally regarded as the main agents of job creation.
  2. Compared to the selective nature of tax holiday schemes and the accompanying erosion of horizontal and vertical equity, across-the-board rate reductions in the corporate tax rate are more equitable and easier to administer. Furthermore, the need for the costly monitoring of tax avoidance would fall away since the incentive for intra-company transfer pricing would be virtually nil.
  3. A stable, low rate corporate tax regime, with minimal changes over time and no ill-conceived, short-term incentives, enhances the local and international perceptions of a stable and predictable tax system. That, more than anything else, will increase the positive perceptions with regard to a country as a favourable investment destination.

The main drawback with such an approach to encouraging investment is that when the change is introduced, it confers significant windfall gains to existing owners of capital, i.e. existing corporate shareholders.

  1. Harmful tax competition
  2. The challenges of globalisation for tax policy include "harmful tax competition", which results when countries compete with each other to attract mobile (and footloose) capital, with potentially deleterious effects for the welfare of domestic citizens. It is very difficult for individual countries acting on their own to address the challenges of tax competition. In this context and given that tax competition is a real threat to the ability of individual governments to effectively raise revenue to meet their expenditure programmes, multilateral organisations such as the European Union (EU) and the Organisation for Economic Co-operation and Development (OECD) have been co-ordinating efforts to mitigate the impact of ‘harmful tax competition’.

    While their efforts have been directed at their member states, efforts have been made to include non-member countries in the deliberations and extend the efforts to seek a broad-based solution. While the benefits of this to developing countries may not seem immediately obvious, countries such as South Africa with daunting development challenges would certainly not benefit from a race to the bottom or the "tax degradation" that results from unproductive tax competition.

    1. Defining harmful tax competition

According to the EU, harmful tax measures resulting in significantly lower effective levels of taxation, including zero taxation, can be delineated by the following characteristics:

  1. Whether particular benefits are given exclusively to non-residents of the Member State in question, or are given only in respect of transactions carried out with non-residents (the exclusivity aspect).
  2. Whether benefits are otherwise ring-fenced from the domestic market so that the tax preferential scheme does not negatively affect the national tax base.
  3. Whether tax benefits are available without there being any real economic activity.
  4. Whether the basis of profit determination in respect of activities within a multinational group of companies departs from internationally accepted principles, notably those agreed upon within the OECD.
  5. Whether the measure lacks transparency. This provision includes certain statutory rules that are relaxed at administrative level in a non-transparent way for other tax jurisdictions (for example, the IDZs proposed minimal reporting requirements and semi-privatisation arrangements for customs control in the development zones).

The above-mentioned measures and moral suasion practices established by the EU have been matched by the OECD’s design of a comprehensive package of guidelines against harmful tax practices. On 9 April 1998 the OECD Council, representing 29 countries adopted 19 recommendations against harmful tax competition. It furthermore sanctioned the decision to get non-member countries involved in the campaign against this global threat of a zero-sum game that culminates in outbidding each other in respect of ‘attractive’ tax incentives.

The OECD has identified the following characteristics of harmful tax competition:

  1. No, or very low, tax rates for particular industries or activities.
  2. Ring-fencing of a tax-privileged enclave, e.g. in an export-processing zone. If the host country feels compelled to protect its own economy from the potentially disruptive effects of the preferential tax regime by ring-fencing particular sectors or industries, one would reasonably suspect such a regime to be a harmful tax practice. Such ring-fencing can include:

  1. Lack of transparency in the tax system and administration. This can include negotiated tax rates, administrative discretion in respect of provisions of the tax code and the failure to use commonly used administrative practices (e.g. standard audit procedures).
  2. Lack of administrative exchange of information between revenue authorities.
  3. Other factors that are suggestive of harmful tax competition include:

    1. OECD ministerial report

Harmful tax practices identified

On the basis of the above criteria developed in its earlier work, the OECD’s Committee on Fiscal Affairs has submitted a report on harmful tax competition to the Ministerial Council and proposed recommendations for addressing the negative effects of such activities. In essence, the report is seen as a first step toward reducing the impact of tax havens and harmful tax competition on the global tax base and protecting the integrity of the world tax system. As outlined above, the report emphasises the impact of harmful tax practices aimed at geographically mobile financial and other service activities. Within this framework, the OECD has identified the regimes as potentially harmful, which are set out in table 4.

 

Table 4: Harmful tax practices

Country

Regimes1

Insurance

Australia

Offshore Banking Units

Belgium

Co-ordination Centers

Finland

A land Captive Insurance Regime

Italy

Trieste Financial Services and Insurance Centre2

Ireland

International Financial Services Center

Portugal

Madeira International Business Center

Luxembourg

Provisions for Fluctuations in Re-Insurance Companies

Sweden

Foreign Non-life Insurance Companies

Financing and Leasing

Belgium

Co-ordination Centers

Hungary

Venture Capital Companies

Hungary

Preferential Regime for Companies Operating Abroad

Iceland

International Trading Companies

Ireland

International Financial Services Center

Ireland

Shannon Airport Zone

Italy

Trieste Financial Services and Insurance Centre3

Luxembourg

Finance Branch

Netherlands

Risk Reserves for International Group Financing

Netherlands

Intra-group Finance Activities

Netherlands

Finance Branch

Spain

Basque Country and Navarra Co-ordination Centers

Switzerland

Administrative Companies

Fund Managers4

Greece

Mutual Funds/Portfolio Investment Companies [Taxation of Fund Managers]

Ireland

International Financial Services Center [Taxation of Fund Managers]

Luxembourg

Management companies [Taxation of management companies that manage only one mutual fund (1929 holdings)]

Portugal

Madeira International Business Center [Taxation of Fund Managers]

Banking

Australia

Offshore Banking Units

Canada

International Banking Centers

Ireland

International Financial Services Center

Italy

Trieste Financial Services and Insurance Centre3

Korea

Offshore Activities of Foreign Exchange Banks

Portugal

External Branches in the Madeira International Business Center

Turkey

Istanbul Offshore Banking Regime

Headquarters Regimes

Belgium

Co-ordination Centers

France

Headquarters Centers

Germany

Monitoring and Co-ordinating Offices

Greece

Offices of Foreign Companies

Netherlands

Cost-plus Ruling

Portugal

Madeira International Business Center

Spain

Basque Country and Navarra Co-ordination Centers

Switzerland

Administrative Companies

Switzerland

Service Companies

Distribution Center Regimes

 

Belgium

Distribution Centers

France

Logistics Centers

Netherlands

Cost-plus/Resale Minus Ruling

Turkey

Turkish Free Zones

Service Center Regimes

 

Belgium

Services Centers

Netherlands

Cost-plus Ruling

Shipping5

Canada

International Shipping

Germany

International Shipping

Greece

Shipping Offices

Greece

Shipping Regimes (Law 27/75)

Italy

International Shipping

Netherlands

International Shipping

Norway

International Shipping

Portugal

International Shipping Register of Madeira

Miscellaneous Activities

Belgium

Ruling on Informal Capital

Belgium

Ruling of Foreign Sales Corporation Activities

Canada

Non-resident Owned Investment Corporations

Netherlands

Ruling on Informal Capital

Netherlands

Ruling on Foreign Sales Corporation Activities

United States

Foreign Sales Corporations6

  1. The preferential tax regimes are listed category-by-category. Certain regimes allow investors to carry out many different types of activities. Forty-seven preferential regimes are identified, but some are included in more than one category of the listing.
  2. Non-operational.
  3. Non-operational.
  4. The taxation of fund managers is complex, given the various legal forms that can be used to structure fund management advice. These issues will be studied further in connection with the development of the application notes described in paragraph 13 in order to ensure that all similar regimes are treated the same.
  5. The analysis of shipping is complex given the particularities of the activity. The criteria must be developed so as to take into account and be consistent with those particularities and will be considered further in connection with the development of application notes as regards shipping.
  6. Also, such further consideration shall compare tax equivalence of alternative regimes and should aim to establish similar standards for all comparable regimes.
  7. As is the case with all regimes, the foreign sales corporation regime is only within the scope of the report to the extent that it applies to mobile financial and other service activities. It should be noted that the treatment of the foreign sales corporation regime or any other regime for purposes of this report has no bearing on its classification or treatment in connection with trade disciplines.

In addition, the OECD has recommended that additional work is required in respect of "holding company regimes", which it has noted may constitute harmful tax competition. The OECD report also identified jurisdictions that were found to be "tax havens" according to the criteria set out in its 1998 report. These are set out in table 5.

 

Table 5: Jurisdictions meeting "Tax Haven" criteria in 1998 OECD report

Andorra

Anguilla – Overseas Territory of the United Kingdom

Antigua and Barbuda

Aruba – Kingdom of the Netherlands

Commonwealth of the Bahamas

Bahrain

Barbados

Belize

British Virgin Islands – Overseas territory of the United Kingdom

Cook Islands – New Zealand

The Commonwealth of Dominica

Gibraltar – Overseas territory of the United Kingdom

Grenada

Guernsey/ Sark/ Alderney – Dependency of the British Crown

Isle of Man – Dependency of the British Crown

Jersey – Dependency of the British CrownLiberia

The Principality of Liechtenstein

The Republic of the Maldives

The Republic of the Marshall Islands

The Principality of Monaco

Montserrat – Overseas territory of the United Kingdom

The Republic of Nauru

Netherlands Antilles – Kingdom of the Netherlandsa

Niue – New Zealandb

Panama

Samoa

The Republic of the Seychelles

St Lucia

The Federation of St. Christopher & Nevis

St. Vincent and the Grenadines

Tonga

Turks & Caicos – Overseas Territory of the United Kingdom

US Virgin Islands – External Territory of the United States

The Republic of Vanuatu

a) The Netherlands, the Netherlands Antilles, and Aruba are the three countries of the Kingdom of the Netherlands.

b) Fully self-governing country in free association with New Zealand.

It is interesting to note that certain offshore jurisdictions that would have been included on the list of tax havens made during June 2000 advance agreements with the OECD to eliminate the elements of their tax regimes that made them tax havens. These countries were Bermuda, the Cayman Islands, Cyprus, Malta, Mauritius and San Marino. Aforesaid jurisdictions are committed to eliminate harmful tax practices in terms of highly mobile financial service income by the end of 2005, to embrace international tax standards for transparency, exchange information and adopt fair tax competition policies.

    1. A world tax organisation?

Vito Tanzi (1998) has argued that globalisation has introduced certain difficulties into the international tax arena, especially in the area of unproductive tax competition and fiscal spillovers. While some commentators may see these competitive developments as good – leading to smaller governments – Tanzi notes correctly that unbridled tax competition is likely to lead to:

Because there is no supranational body to regulate these matters, he has suggested the creation of an "World Tax Organisation", because individual governments cannot address the issues on their own and the current initiatives of the OECD and the EU do not include enough countries to be fully effective. While the ultimate objectives and functions of such a body would be the subject of negotiation by member states, some of the functions suggested by Tanzi (1998: 342-3) include:

  1. Identifying major tax trends and potential problems at international level.
  2. Compiling and generating tax statistics and information for as many countries as possible.
  3. Issuing an (annual?) World Tax Development Report, highlighting trends, problems and potential solutions.
  4. Providing technical assistance to countries in respect of tax policy and administration, with the objective of improving harmony and co-ordination among countries.
  5. Establishing basic norms for tax policy and tax administration.
  6. Developing a forum for the exchange of ideas on tax matters.
  7. Providing a world forum for tax arbitration.
  8. Providing surveillance over tax developments (in a similar way to the IMF’s role in surveying macroeconomic developments).

While this is an interesting idea that could be explored in the medium term, some commentators are more sceptical – preferring regional, voluntary approaches to tax co-operation. SADC seems to offer such opportunity for regional co-operation.

  1. Concluding comments

Globalisation has limited the scope for governments to design and implement tax policy independently of international considerations. This is especially true in the case of mobile tax bases, such as financial capital and highly skilled labour, but equally applicable in the area of consumption taxes.

In respect of tax policy as a tool of economic development, the paper has considered the appropriate role of government in this process and the scope for using the tax system to encourage particular economic activities.

In the light of the above discussion, the following general policy conclusions are advanced as a framework to shape the tax reform process.

  1. Government has an important role to play in fostering economic and social development. Rather than being one of direct intervention and control, this is a facilitative role, where government endeavours to realise the potential of the market economy to allocate resources to their most productive use. In this context, government intervention is warranted in instances where markets are incomplete (e.g. some insurance markets); or in instances of market failure; (e.g. where the benefits to society from a particular activity exceed the private benefits and government can encourage the activity, thereby improving social welfare).
  2. Intervention should not, however, be undertaken to compensate for other structural problems in the economy (e.g. macroeconomic imbalances, over/under-valued exchange rates, artificially high/low real interest rates, market regulation that interferes with the proper functioning of a market). These problems should rather be addressed directly.
  3. Government intervention can take a variety of forms, including regulation, direct expenditure policy, tax policy or administrative action. Care must be taken to ensure the method of intervention is appropriate to the particular circumstances and policy objectives.
  4. In principle, the tax system should focus on obtaining five central objectives: efficiency, equity, inter-sectoral neutrality, simplicity and international comparability.
  5. In respect of tax incentives, especially ones aimed at encouraging investment, the following proposals are advanced:

  1. Tax incentives should not be given undue weight in any industrial development strategy. Other, arguably more important factors, must be addressed first, including:

  1. Before any new incentives are introduced, existing incentives should be thoroughly reviewed to determine their efficacy in achieving their stated objectives, identify shortcomings and ensure their consistency with aforesaid tax policy goals.
  2. Tax expenditure budgets must be developed to ensure transparency and accountability to Parliament for existing and potential tax incentives.
  3. New incentives should only be considered where:

  1. A basic philosophy of minimising the tax rate and broadening the tax base should be preferred to selective tax incentives, which entail significant economic and political costs. Also, there is a need to replace existing tax instruments with more efficient ones that cannot be avoided that easily.
  2. Tax holiday schemes are ineffective elements of investment promotion strategies for greenfield operations and should be avoided.
  3. Investment allowances and investment tax credits may be able to encourage investment, as evidence from developed economies seems to illustrate, but this must be weighed against the potential costs in terms of erosion of the tax base, distorted investment decisions, potential tax avoidance and very costly tax administration.
  4. Accelerated depreciation regimes are the most obvious candidate for policies to encourage investment in particular industries, sectors or types of assets with particularly large social benefits (e.g. new production techniques). These incentives have the obvious added advantage of falling within the existing tax structure and being relatively simple to administer.
  5. When new incentives are considered, the utmost care must be taken to minimise the potential for economic distortions and tax avoidance.

  1. At the level of the international community, South Africa should:

  1. Continue to foster closer economic ties in the SADC region, thereby combining the regions markets and creating a more attractive investment environment.
  2. Actively engage with developed countries to negotiate tax-sparing agreements, particularly in respect of incentives that conform to the criteria set out here. In the absence of such agreements, developing countries should resist tax incentives entirely, focussing on other means of encouraging investment.
    1. Monitor developments in regional bodies (e.g. the EU and OECD) as well as any potential World Tax Organisation initiative to ensure the interests of developing countries are adequately represented.

  3. Through the SADC tax Sub-committee advance a programme to encourage countries within the SADC region to seek a degree of co-ordination of fiscal (especially tax) policy to avoid the undermining effects on regional development that would arise from unproductive tax competition – or the so-called race to the bottom.

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