October 2015

OPTIONS FOR LOW INCOME COUNTRIES’ EFFECTIVE
AND EFFICIENT USE OF TAX INCENTIVES FORINVESTMENTIMF staff regularly produces papers proposing new IMF policies, exploring options forreform, or reviewing existing IMF policies and operations. The following document(s)have been released and are included in this package:
A Report by Staff on “Options for Low Income Countries’ Effective and Efficient
Use of Tax Incentives for Investment;” an accompanying Background Document
including tools for assessment.
Informal Session to Brief:
The attached report was prepared by IMF staff jointly with staff of the OECD Center for
Tax Policy and Administration, the World Bank Group, and the United Nations(collectively, the “IOs”), at the request of the G20’s Development Working Group(DWG). Countries often face pressures to attract investment by offering tax incentives,
which then erode the countries’ tax bases with little demonstrable benefit in terms ofincreased investment. The IOs were asked to use their shared expertise to assist low
income countries in making better and more efficient use of tax incentives. Drawing on
recent country experiences and an extensive range of academic and other studies, theIOs prepared a report aiming to take a fresh look at tax incentive policies in low income
countries. A separate background document also attached here reviews practical tools
and models to assess the costs and benefits of tax incentives, and to enhancetransparency and support informed decision making. The report was presented to the
IMF Executive Board in an informal session on October 22, 2015. Such informal sessions
are used to brief Executive Directors on policy issues. No decisions are taken at theseinformal sessions. The views expressed in this paper are those of the IMF staff and do
not necessarily represent the views of the IMF's Executive Board.
The IMF’s transparency policy allows for the deletion of market-sensitive informationand premature disclosure of the authorities’ policy intentions in published staff reports
and other documents.
Electronic copies of IMF Policy Papers
are available to the public fromhttp://www.imf.org/external/pp/ppindex.aspx

International Monetary Fund
Washington, D.C.
© 20[xx] International Monetary Fund

Options for Low
Income Countries'
Effective andEfficient Use of Tax
Incentives for
Investment

A REPORT TO THE G-20 DEVELOPMENT
WORKING GROUP BY THE IMF,
OECD, UN AND WORLD BANK

Options for Low Income Countries’
Effective and Efficient Use of Tax
Incentives for Investment
A REPORT TO THE G-20 DEVELOPMENT WORKING GROUP BY THE
IMF, OECD, UN AND WORLD BANKThis report was prepared at the request of the G20 Development Working Group by the staff of theInternational Monetary Fund, the Organisation for Economic Co-operation and Development, theUnited Nations and the World Bank. I t h a s benefitted from consultation with other organisations
working in the tax area, officials of developing countries, Civil Society Organisations, and business
representatives. The report is prepared under the responsibility of the Secretariats and Staff of thefour organisations. It reflects a broad consensus among these staff, but should not necessarily be
regarded as the officially-endorsed views of those organisations or their member states. The report waspresented as requested to the G20 DWG in September, 2015, and to the Executive Board of the IMF for
information, in October, 2015.

October 15, 2015

OPTIONS FOR LOW INCOME COUNTRIES' EFFECTIVE AND
EFFICIENT USE OF TAX INCENTIVES FOR INVESTMENTEXECUTIVE SUMMARY
Experience shows that there is often ample room for more effective and efficientuse of investment tax incentives in low-income countries. Tax incentives generally
rank low in investment climate surveys in low-income countries, and there are many
examples in which they are reported to be redundant—that is, investment would havebeen undertaken even without them. And their fiscal cost can be high, reducing
opportunities for much-needed public spending on infrastructure, public services orsocial support, or requiring higher taxes on other activities.
Effective and efficient use of tax incentives requires that they be carefully
designed. Many low-income countries use costly tax holidays and income tax
exemptions to attract investment, while investment tax credits and accelerated
depreciation yield more investment per dollar spent. Tax incentives targeted at sectors
producing for domestic markets or extractive industries generally have little impact,
while those geared toward export-oriented sectors and mobile capital appear to berelatively effective—but the former need to be tempered by considerations of WTO
consistency and both can be instances of mutually damaging tax competition. Enabling
conditions—good infrastructure, macroeconomic stability, rule of law, etc.—areimportant for effectiveness.
Good governance of incentives is critical for their effectiveness and efficiency.
Transparency is necessary to facilitate accountability and reduce opportunities for rent
seeking and corruption. Tax incentives should therefore be subject to legislative
process, consolidated under the tax law, and their fiscal costs reviewed annually as partof a tax-expenditure review. The approval process of tax incentives may involve several
stakeholders, but is ultimately best consolidated under the authority of the Minister ofFinance and enforced and monitored by the tax administration. To the extent possible,
the granting of tax incentives should be based on rules rather than discretion. Despite
political obstacles, several countries have successfully reformed their tax incentive
regimes.
The proliferation of incentives is largely a manifestation of international tax
competition—which regional coordination can help mitigate, although this requires
political commitment and an effective supranational enforcement mechanism—which isoften lacking. Common reporting standards and data collection can be an importantfirst step toward coordination and enhanced transparency.
More systematic evaluations are needed to facilitate informed decision making. In
most low-income countries, the effectiveness and efficiency of tax incentives cannot be
assessed due to lack of data and the absence of analytical tools and skills. The
background document to this report offers guidance on how to develop the data andtools required for systematic analysis. Progress requires concerted action by several
stakeholders to ensure evidence-based, transparent decision making.

TAX INCENTIVES FOR INVESTMENT—OPTIONS FOR LICSCONTENTSINTRODUCTION __________________________________________________________________________________ 6
EFFECTIVENESS AND EFFICIENCY ________________________________________________________________ 8
A. Prevalence _______________________________________________________________________________________ 8
B. ‘Effective use’ __________________________________________________________________________________ 11
C. ‘Efficient use’ __________________________________________________________________________________ 16
GUIDANCE IN THE USE OF TAX INCENTIVES__________________________________________________ 19
A. Design _________________________________________________________________________________________ 19
B. Governance ____________________________________________________________________________________ 23
C. Reform ________________________________________________________________________________________ 28
INTERNATIONAL COORDINATION ____________________________________________________________ 29
CONCLUSIONS __________________________________________________________________________________ 32
BOXES
1. Elements of a Cost-Benefit Assessment of Tax Incentives _____________________________________ 10
2. Evidence on Productivity Spillovers from FDI __________________________________________________ 15
3. Transparency __________________________________________________________________________________ 24
FIGURES
1. Prevalence of Income Tax Incentives around the World _________________________________________ 9
2. Importance of Tax Incentive Packages Relative to Other Factors in Investor Location Surveys 12
3. Investment Incentives and FDI in Central and West Africa ____________________________________ 14
4. Governance of tax incentives by income group _______________________________________________ 25

4TAX INCENTIVES FOR INVESTMENT—OPTIONS FOR LICS

TABLE
1. Redundancy of Tax Incentives Based on Investor Surveys _____________________________________ 12
APPENDIX
I. Consultations___________________________________________________________________________________ 35
REFERENCES ____________________________________________________________________________________ 37

5TAX INCENTIVES FOR INVESTMENT—OPTIONS FOR LICS

INTRODUCTION
This paper responds to a request of the G20 Development Working Group for an explorationof options for low-income countries’ effective and efficient use of tax incentives forinvestment.1 To that end, it develops principles for the design and governance of tax incentives andprovides guidance on good practices in these areas. Since much of the pressure to offer incentives
stems from an awareness of those offered by other countries, the paper also discusses options forinternational coordination to address the risk of mutually damaging spillovers from such tax
competition. Finally, a separate background document develops practical tools and models that canhelp assess the costs and benefits of tax incentives, which is essential for informed decision making.
The aim is thus to assist low-income countries (LICs)2 in reviewing and reforming their tax incentives,
so as to better align them with their developmental objectives.
Investment tax incentives should be viewed as part of broader (tax) policy design. A goodrevenue system adopts taxes that are simple, fair and efficient. Tax incentives risk compromisingthese principles to the extent that they complicate the tax system, create horizontal inequities, anddistort production efficiency; and they may forgo revenue that could have been spent moreproductively or needs to be replaced in other and more damaging ways. At the same time, tax policy
may be able to play a purposive role in improving on market outcomes that are inefficient or unfair.
The economic rationale for tax incentives must thus be evaluated in terms of their ability to achieve
clear goals in ways that are both effective and efficient, relative to alternative policies, both tax andnon-tax, that could achieve the same objectives.
Tax incentives have been a focus of work by international organizations (IOs) for many years.3
This report draws on the ample experiences and insights that IOs have gained from interactions withcountries. IOs and many other observers4 have often found tax incentives to be ineffective,
inefficient and associated with abuse and corruption. As a result, they have frequently advisedcountries to remove them or to improve their design, transparency and administration. Yet, thisadvice has often had limited effect. The common reluctance to scale back incentives—perhaps even,as will be seen, a tendency for them to proliferate—may reflect vested interests, political inertia, andtax competition with other countries. It might also be that observers have underestimated the1

Other countries of course also make extensive use of tax incentives, and much of the analysis below is also relevantto them.
2

Definitions of LICs differ, but usually refer to countries below a certain per capita GNP. The group may consist of
between 30 and 60 countries, depending on the threshold. The analysis in this paper is relevant for a large group of
developing countries and a broad definition may thus apply.
3
Studies by IOs include Lent (1967), UNCTAD (1996, 2000), Clark (2000), OECD (2001, 2006), Tanzi and Zee (2000),
Zee, Stotsky and Ley (2002), Easson and Zolt (2004), Keen and Mansour (2010), Klemm (2010), James (2013; 2014)
and Zolt (2014). Tax incentives are also frequently discussed and evaluated in technical assistance provided by IOs.
4
Some examples are Mintz (1990), Boadway and Shah (1992), Shah (1995), Bird (2000), Eason (2001; 2004), Bolnick(2004), Gugl and Zodrow (2006) and Bird and Zolt (2008).

6

TAX INCENTIVES FOR INVESTMENT—OPTIONS FOR LICS

benefits that incentives have generated. Drawing on recent insights from interactions with countries
and an extensive range of academic and other studies, this paper aims to take a fresh look at
incentive policies in LICs in order to develop practical advice for improvement, supported by simple
tools for making progress.5
The analysis in this paper is necessarily selective. In particular, the focus is on:Tax incentives, as defined in the next section—thus ignoring non-tax incentives, such as grants,
in-kind benefits or loan guarantees: such other measures can in principle mimic the effects of tax
incentives, but are usually designed differently and subject to different governance procedures.

…for investment—excluding tax incentives aimed at other objectives, such as supporting
charitable giving or owner occupation or reducing pollution.6 The focus, moreover, is on
incentives in the tax treatment of business income; governments may also seek to attract
investment by special treatment in relation to Value Added Tax (VAT) or tariffs, for instance, butthese are touched on only briefly—both for reasons of space and because income taxation andthe associated policy concerns have been more prominent in the debate on tax incentives.

…that are implemented at the national level—those implemented at the sub-national level
raise other, broader fiscal federalism issues, which go beyond the scope of this paper.7

This paper relates to other global initiatives aimed at strengthening domestic revenue
mobilization in LICs. For instance, there are several initiatives to strengthen tax design and improve
capacity in tax administration in LICs to enhance their ability to mobilize domestic resources,
including through extensive and long-standing technical assistance by the IMF, World Bank andothers. Moreover, the G20/OECD work on base erosion and profit shifting (BEPS) aims to support
the implementation of BEPS outcomes to LICs, as suited to their circumstances, by providing
toolkits. During consultations with developing countries on BEPS, a common concern expressed by
LICs was the extent to which tax incentives erode their tax bases. This concern reflects an importanttension, which was also emphasized by the IOs in their joint report for the DWG in 2011: “Striking
the right balance between an attractive tax regime for domestic and foreign investment, by using tax
incentives for example, and securing the necessary revenues for public spending, is a key policy
dilemma.” (IMF, OECD, UN and World Bank, 2011). The underlying report explores this dilemma ingreater detail.

5

All case studies used in the paper aim to illustrate key problems, practices and achievements and are not intended
to provide country-specific recommendations. The choice of our case material is inevitably selective and there could
have been equally valid cases in other countries or periods. In selecting our examples, we used the following criteria:
cases should i) be described in publicly available and easily accessible documentation; ii) obtain a broad regional
coverage; iii) offer insight into either/both good and bad practices; (iv) preferably relate to experiences in LICs,
although experience from other countries is used where this provides concrete and useful examples for LICs.
6

While tax incentives can be targeted to ‘green’ investment, this paper does not address this dimension specifically.

7

Note that interactions between national and sub-national tax incentives covering the same activities or assets risk
producing unintended and potentially perverse results, such as negative tax burdens for certain industries.
7

TAX INCENTIVES FOR INVESTMENT—OPTIONS FOR LICS

EFFECTIVENESS AND EFFICIENCY
A. Prevalence
In this paper, by a ‘tax incentive’ is meant any special tax provisions granted to qualified
investment projects or firms that provides favorable deviation from the general tax code.
They can take several forms, such as tax holidays (complete exemption from tax for a limited
duration), preferential tax rates in certain regions, sectors or for certain asset types, or targetedallowances (tax deductions or tax credits) for certain investment expenditures.
Tax incentives have been used to pursue a variety of objectives. The primary motivation isusually to stimulate investment and—especially in LICs—attract foreign direct investment (FDI). FDI
inflows, for instance, are believed to not only bring capital and (high-wage) jobs to a country, but
can also spur competition and increase the efficiency of domestic markets more widely, thus
contributing to a country’s overall economic development. Empirical growth regressions indeed
generally find positive correlations between inward FDI and economic growth, although conclusions
about causality remain contentious (see e.g. Adams, 2009, for a review of evidence on Africa). Tax
incentive policies also often aim to promote specific economic sectors or types of activities as partof an industrial development strategy or to address regional development needs.
They are commonplace around the world (Figure 1). The use of tax incentives is widespread, andextends well beyond LICs. Countries differ with respect to the type of incentives used, with highincome countries relying more on investment tax credits and favorable tax treatment of researchand development (R&D), low-income countries relatively more often offering tax holidays andreduced tax rates, and middle-income countries most often having preferential tax zones (in which
income can be tax exempt and other favorable treatments may apply).
Over the last decades, tax incentives have become more widespread in LICs. For instance, in
1980, less than 40 percent of the LICs in sub-Saharan Africa offered tax holidays while free zones
were non-existent. By 2005, more than 80 percent offered tax holidays and 50 percent had adopted
free zones (Keen and Mansour, 2010). The number of countries in sub-Saharan Africa granting tax
holidays and establishing free zones has grown further since (James, 2014). There is also evidence,
however, that the average length of tax holidays has declined somewhat in various regions of theworld (Abbas and Klemm, 2013). With the global declining trend in corporate income tax (CIT) rates,
including in LICs, it might indeed be that the benefit for investors of receiving tax incentives has
somewhat diminished.
Broadly, a tax incentive serves a useful social purpose if the social benefits it generates
exceed the associated social costs. The background document to this report offers a simple
conceptual framework that lends practical substance to this general principle by identifying the key

8

TAX INCENTIVES FOR INVESTMENT—OPTIONS FOR LICS

components that affect the social benefits and costs of tax incentives: these are set out in Box 1.8
The next subsections look in turn at the benefit side of the calculation—the ‘effectiveness’ of
incentives in achieving their aims—and then the cost side—their ‘efficiency’.9

Figure 1. Prevalence of Income Tax Incentives around the World /1/1 Figure shows the percent of countries in each of four income groups that have the indicated incentive. The sample size
per income group is denoted between brackets.
Source: Calculations based on James (2014)

8

Sometimes the term ‘wasteful tax incentives’ is used. This concept is not always well-defined, however. This paper
adopts the framework of cost-benefit analysis to identify whether tax incentives are desirable or not.

9

In principle, this should be assessed taking into account also other ways of achieving the aims of policy: the benefits
associated with a regional tax incentive might be achieved at even lower social cost, for instance, by a regional
spending program. The point is of considerable practical importance, but since the alternative instruments are highly
context-specific, cannot be pursued in detail here.
9TAX INCENTIVES FOR INVESTMENT—OPTIONS FOR LICS

Box 1. Elements of a Cost-Benefit Assessment of Tax Incentives
Investment tax incentives ultimately aim to contribute to a country’s development and improved
living conditions for its citizens. As elaborated on in the background document, the following
elements are critical for the social benefits:Size of the net investment effect—the rise in investment should be corrected for redundancy
effects (investments that would have occurred without the incentive) and displacement effects(the reduction in any other investments) to infer the net incremental increase in capital due tothe incentive.



Net impact of higher investment on jobs and wages. New jobs can yield significant social gains if
they reduce unemployment. However, if new jobs displace existing jobs, the social benefits
depend on the productivity (and wage) differential between the new and old jobs.

Productivity spillovers. To the extent that new investment boosts productivity elsewhere in thedomestic economy, such as in supplying or competing firms (often seen as a particular benefit
from inward FDI), this magnifies social benefits by raising income levels more widely.

The social costs of tax incentives depend on the following factors:
Net public revenue losses—public revenue falls if tax incentives are redundant or create leakage
and abuse. But additional net investment and jobs can recover some of the revenue loss.

Administrative and compliance costs, which can rise due to tax incentives, especially if they arecomplex or create opportunities for rent seeking and corruption.



Scarcity of public funds. Often overlooked is that $1 of tax revenue has a higher social value than
$1 of private income, because it is the greater value of the public expenditure it finances thatjustifies transferring resources from public to private sectors through distortionary taxes. To
compare changes in private income and tax revenue, the latter thus need to be weighted by the‘marginal cost of public funds’, which will be greater than unity (as discussed further below).

Distorted resource allocation. Discrimination in favor of some and against other investment
implies that taxes, rather than productivity differences, determine resource allocation. Thisdistortion reduces average productivity and lowers income per capita.

10

TAX INCENTIVES FOR INVESTMENT—OPTIONS FOR LICS

B.

‘Effective use’Effective use is taken here to mean that tax incentives realize their stated objective. This can beassessed irrespective of associated costs, which will be explored later. Raising investment or FDI isusually a necessary but not a sufficient condition for ‘effectiveness’, as the higher investment should
be of the kind envisaged to yield the desired social benefits in broader welfare terms.
Empirical evidence finds that taxes matter for investment, although most likely less so indeveloping countries. Empirical studies on the relationship between effective tax burdens and FDI
generally conclude that host country taxation significantly affects investment (De Mooij and
Ederveen, 2008).10 Most of this evidence, however, refers to advanced economies. Recent studies
report similar results for developing countries, although the effects tend to be somewhat smaller on
average (James and Van Parys, 2009; Abbas and Klemm, 2013). One reason might be that many
developing countries do not offer attractive general investment conditions for most multinational
companies, due to for instance poor infrastructure, macroeconomic instability, unclear property
rights, and weak governance or judicial systems. In these circumstances, tax incentives do noteffectively counterbalance such poor conditions and are largely ineffective (Kinda, 2014). At thesame time, however, tax incentives might be one of the few (albeit second-best) instruments for LICs
to offset disadvantaged circumstances, address regional disparities and mitigate market failures,such as lack of financial access.
Investment surveys confirm that tax incentives usually do not top the list of investment factors
in developing countries. In 2010, the United Nations Industrial Development Organization
conducted a business survey of 7,000 companies in 19 sub-Saharan African countries active inagriculture, mining, manufacturing, utilities, construction, and services sectors. Investors wereasked to rank the importance of twelve location factors and to assess how they might havechanged, improved and worsened, in the last three years (Figure 2). The results suggest thattax incentives packages ranked 11th out of 12 in importance; and this importance fell overtime. For comparison: transparency of the legal framework ranked 5th in investors’ concernsand grew in importance. Investors thus seem to care much more about deficient legislationand onerous regulations than about the availability of tax incentives (UNIDO, 2011).
Tax incentives are often found to be redundant in attracting investment in developing
countries; that is, the same investments would have been undertaken even if no incentives had
been provided. Table 1 shows redundancy ratios, based on investor surveys in various countries,
measured by the percentage of investors who claim that they would have invested even without tax
incentives. Redundancy levels thus obtained—subject to well-known caveats, such as a discrepancy
between answers and actual behaviors under a counterfactual scenario—are high in most countries.
For example, redundancy rates exceed 70 percent in 10 out of the 14 surveys listed in Table 1. In

10

FDI comprises different components, such as new plants and equipment, plant expansions, and mergers andacquisitions (M&A). The evidence is that new plant location choices are more responsive to tax than are incremental
investment increases; and M&A tends to respond to taxation differently from greenfield investment.
11

TAX INCENTIVES FOR INVESTMENT—OPTIONS FOR LICS

Guinea, Rwanda, Tanzania and Uganda, more than 90 percent of the investments would, it seems,
have been made even without the incentives.
Figure 2. Relative Importance of Tax Incentive Packages in Investor Location Survey 2010
(Left: Relative Rank; Right: Change in Rank since 2007)
0

1

2

3

4

-0.3

0.0

0.3

Economic stability

3.82

0.31

Political stability

Political stability

3.81

0.28

Local markets

Costs of raw materials

3.65

0.24

Availability of skilled labour

Local markets

3.63

Transparency of legal framework

3.51

Availability of skilled labour

3.50

Labour costs

3.46

Quality of life

3.32

Availability of local suppliers

3.22

Bilateral agreements and treaties

3.05

Incentives package

3.05

Export market

2.94

-0.01

0.15

Economic stability

0.12

Quality of life

0.10

Transparency of legal framework

0.09

Availability of local suppliers

0.06

Bilateral agreements and treaties

0.00

Export market
Labour costs-0.22

Costs of raw materials-0.26

Incentives package

Source: UNIDO (2011)

Table 1. Redundancy of Tax Incentives Based on Investor Surveys /1
Burundi (2011)

77

Rwanda (2011)98

El Salvador (2013)37

Serbia (2009)71

Guinea (2012)92

Tanzania (2011)91

Jordan (2009)70

Tunisia (2012)58

Kenya (2012)

61

Uganda (2011)

93

Nicaragua (2009)15 or 51 /2

Vietnam (2004)

85

Mozambique (2009)78

Thailand (1999)

81/1 Percent of affirmative answers to the question if an incentive was redundant;/2 51 percent for non-exporting firms outside free zones.
Source: James (2014)

12

TAX INCENTIVES FOR INVESTMENT—OPTIONS FOR LICS

Effectiveness varies between countries and sectors. In some countries, tax incentives seem tohave played an important role in attracting new investment and spurring economic growth. Famous
examples include Korea and Singapore, where tax incentives—offered as part of a broader strategy
to attract investment—seem to have encouraged rapid industrialization (Tanzi and Shome, 1992).
However, in many instances tax incentives have resulted in little or no new investment, as indicatedby the redundancy ratios in Table 1. Studies offer some insight into the factors determining
effectiveness. For instance, FDI that is resource-seeking (to exploit the presence of natural
resources), market-seeking (to penetrate a local market), or strategic asset-seeking (to exploit local
know-how or technology) is generally found to be less responsive to tax than FDI that is efficiencyseeking (to exploit cost advantages in production for the world market).11 Indeed, tax incentives
tend to have the greatest salience where investment is oriented toward exporting firms (Grubert andMutti, 2004).
China is often quoted as an example of effective (tax) incentive policies. During its transition period
between the mid-1980s and mid-2000s, it experimented with a wide range of industrial policy
instruments, including tax incentives for special economic zones, reduced tax rates for FDI, and tax
holidays for strategic industries. FDI inflows accelerated during this period and the country became
a top destination for many multinationals. In a panel of 29 regions between 1985 to 1995, Chen
and Kwan (2000) find, for instance, that special economic zones systematically boosted FDI inflows.
Examples of less effective tax incentives can be found in Africa. Figure 3 shows how FDI was
influenced by changes in investment codes between 1994 and 2006 in countries of the CFA franczone and the Economic Community of Central African States. The vertical lines in the figure denotethe introduction of new investment codes, such as tax incentives and legal protections. Providing
more generous tax incentives did not have any demonstrable effect on FDI (Van Parys and James,
2010).
The effectiveness of incentives in attracting investment also depends on the international tax
rules in place. Multinationals taxed on a “territorial” basis in their home country are able to retain
the benefits of host country tax incentives, since there is no offsetting home country tax on theforeign source income. Multinationals might be subject to home country tax on foreign source
income due to controlled foreign corporation (CFC) rules12 or tax upon repatriation under a ‘worldwide’ system—as used in e.g. the US, China and India. The tax incentive can then become ineffective,
since the benefit will be taken away by increased tax payments in the multinational’s homecountry—although tax deferral until repatriation of income often effectively mitigates such aneffect.13

11This classification of types of FDI is due to Dunning (1993).

12

CFC rules vary, but are in essence provisions that bring immediately into tax passive income—the complement ofactive business income—arising abroad that has not paid at least some minimum amount of tax. For worldwide
countries, CFC rules in principle provide some protection against tax avoidance through deferral; for territorial
countries, they simply ensure that only active income is exempt in the residence country.

13

Moreover, some tax treaties provide for ‘tax sparing’, whereby the residence country of a corporation determines
the foreign tax credit based on the taxes that would have been paid if the incentive had not existed.
13

TAX INCENTIVES FOR INVESTMENT—OPTIONS FOR LICS

Figure 3. Investment Incentives and FDI in Central and West Africa
BFA

CAF

CIV

CMR

COG

GAB

MLI

NER

SEN

TCD

TGO

40
20
0
-20
-20

0

20

40

FDI perc GDP

-20

0

20

40

BEN

1995

2000

2005

1995

2000

2005

1995

2000

2005

1995

2000

2005

year
FDI perc GDPchange inv climate

Graphs by country_code

Source: Van Parys and James (2010)

The ability of multinationals to avoid host-country taxes may blunt the impact of tax
incentives—so measures to restrict that ability may make tax incentives more effective. A
multinational that can readily avoid host-country taxes (by, for instance, using interest deductions toshift profits to a low tax jurisdiction) may see little additional benefit from tax incentives. By thesame token, actions that make such avoidance more difficult, from the G20/OECD BEPS project for
example, would make tax incentives more attractive for them.
Where tax incentives increase FDI, domestic investment may be displaced. Displacement
reduces effectiveness in terms of the net impact of the incentive on the domestic capital stock. This
happens, for instance, if FDI reflects a mere transfer of ownership, through mergers and acquisitions,or if domestic investment is ‘round tripped’ through a foreign entity to take advantage of the tax
incentive. Displacement can also occur in labor markets, where jobs in new firms come at theexpense of employment in other sectors of the economy.
Evidence for 40 Latin American, Caribbean and African countries between 1985 and 2004
suggests that changes in the length of tax holidays systematically increased FDI inflows. These
FDI inflows did not, however, increase total investment, nor did they increase economic growth.
This suggests full displacement of domestic by foreign capital (Klemm and Van Parys, 2012).
FDI inflows can yield various other social benefits, such as economic diversification gains,knowledge and technology spillovers, new management practices, reduced unemployment, andimproved conditions in less-developed areas (Blomstrom and Kokko, 1998; OECD, 2002). FDI
spillovers may impact other firms in the same sector (‘horizontal’ spillovers) and/or
14

TAX INCENTIVES FOR INVESTMENT—OPTIONS FOR LICS

supplying/purchasing firms (‘vertical’). The available evidence—mainly for emerging economies,
rather than LICs—indicates strong empirical support of vertical spillovers, but weaker support forhorizontal spillovers (Box 2).

Box 2. Evidence on Productivity Spillovers from FDI
Empirical studies of horizontal spillovers look at the systematic variation of productivity growth in anindustry and its intensity of FDI. Early studies for Morocco, Russia and Venezuela find no support forsuch productivity spillovers in manufacturing industries; instead, and counterintuitively, they all reportnegative correlations (Haddad and Harrison, 1993; Aitken and Harrison, 1999; Yudaeva et al., 2003).
Gorodnichenko et al. (2007) find that horizontal spillover effects are generally insignificant in an analysis
for 17 countries in Eastern Europe and Central Asia. In a meta-analysis of 32 empirical studies ontechnology spillovers from FDI, Woodster and Diebel (2006) conclude that intra-sectoral FDI spillovers
are non-existent in developing countries.
Evidence for advanced economies is usually more supportive of horizontal spillovers. For instance,
studies using data for the US and the UK typically report positive correlations between domestic plants’productivity and FDI intensity (Xu, 2000; Keller and Yeaple, 2003; Haskel et al., 2007). Here, spillovers also
tend to be more prevalent in high-technology sectors and when own R&D is undertaken, reflecting agreater ability to understand and assimilate new technologies (Griffith et al., 2004). Lack of absorptive
capacity may explain why horizontal spillovers are less prevalent in developing countries.
Studies on vertical spillovers usually explore backward effects of FDI to domestic suppliers, again bymeasuring productivity gains in the manufacturing sector. A study for Zambia, for instance, finds
significant knowledge transfers from foreign to local firms (Bwalya, 2006). Similar positive spillover
effects are found for Indonesia and Lithuania (Javorcik, 2004; Girma et al., 2007). For the 17 countries in
Eastern Europe and Central Asia, Gorodnichenko et al. (2007) consistently report positive backward
productivity spillovers. For strategic industries in China, Du et al. (2011) find support for backward andforward vertical FDI spillovers.

15

TAX INCENTIVES FOR INVESTMENT—OPTIONS FOR LICS

C. ‘Efficient use’
Efficient use in this paper means that objectives are achieved at low social costs. Such costs
include revenue losses for government and other social costs, for example due to less efficient
resource allocation.
Redundancy matters for efficiency too, since it implies a loss of government revenue fromprojects that would have been undertaken also without tax incentives. Redundancy implies thatthe tax incentives are a mere cash transfer to the investor: a net social loss to the extent that themarginal cost of public funds exceeds unity (and an even greater loss in national terms if theinvestor is foreign). On the other hand, for projects that would not have been undertaken without
the incentive, there is no direct revenue loss—so long as taxation of the incentivized activity is notentirely eliminated, there may in fact be a net revenue gain from those projects. To minimize therevenue cost of tax incentives, the goal would thus be to offer tax incentives only to those marginal
investors who would not have invested otherwise.
Indirect revenue costs arise from taxpayers abusing the tax incentive regime.14 For example, if
tax incentives are only available to foreign investors, local firms may use foreign entities to route
their local investments in order to qualify. Similarly, if tax benefits are available to only new firms,
taxpayers may reincorporate or set up new corporations to be treated as a new taxpayer under thetax incentive regime. Other leakages occur where taxpayers use tax incentives to reduce the tax
liability from non-qualified activities, for instance, by shifting taxable income to a related firm that
qualifies for a tax holiday or that resides in a tax-free economic zone (McLure, 1999; Eason, 2004).
Preventing such losses requires proper anti-abuse rules and strong administrative capacity to
enforce them.15
In 2000, the government of India removed incentives for exporters, except those located inexport processing zones or qualified as export-oriented units. Investment behavior hardly
changed due to this reform. Indeed, firms that lost their incentives maintained the same levelof investment as before, despite higher tax rates, similar to the control group that kept their
incentives. However, reported profits did respond aggressively to the loss of incentives. In
particular, reported pre-tax profits dropped by half on average in firms that lost their
incentives, despite little change in sales. In contrast, pre-tax profits in firms that kept their
incentives showed an increase. Hence, companies seem to have diverted profits from affiliates
facing higher taxes to those exempt from tax due to the incentives (James, 2007).
In 1987, Bolivia established a tax credit for exporters based on the growth of their export
receipts over the previous year. This led to the emergence of what was called “tourist cows”:
14

See also the top 10 of most frequent abuses listed in Zolt (2014).

15
Anti-abuse rules can be either specific provisions in the tax law to prevent certain behaviors that are deemed
abusive, or general provisions under which behaviors can be classified as abusive based on a broad characterizationin the law. High-quality legal drafting and a robust administration are necessary to ensure effective anti-abuseprovisions.

16

TAX INCENTIVES FOR INVESTMENT—OPTIONS FOR LICS

farmers generated tax credits by moving their herds back and forth across the border in orderto maintain or increase the growth of their “export” receipts. The scheme was eliminated in1991 (Rodrik, 1993).
Additional resource costs arise for the government in administering tax incentives and forbusinesses in complying with the associated requirements. Of course, any tax comes along withsuch costs. However, they generally increase with the complexity of the assessment processes of tax
incentives, and with the opportunities for rent seeking and corruption they might create (asdiscussed further in the next section). The additional administrative costs are a particular concern in
LICs, where administrative capacity is often limited. Indeed, scarce resources might be diverted awayfrom core aspects of a country’s tax administration, undermining other efforts to mobilize revenues.
In Papua New Guinea (PNG), the taxation review committee recently evaluated its tax incentive
policies and concluded that one significant concern is the additional complexity they create,placing greater demands on already limited tax administration resources. In particular, PNG’sexperience with the research and development incentive and the infrastructure tax credit havehighlighted the challenges of implementing or effectively monitoring these incentives in theabsence of sufficient administrative or technical capacity (PNG Tax Committee, 2014).
A first step to understanding the public revenue forgone as a consequence of tax incentives is
to calculate the implied ‘tax expenditure’ (see background document). Investment tax incentives
are only one form of tax expenditure, by which is meant a provision in the tax code that deviatesfrom some benchmark tax system in a direction favorable to the taxpayer. A tax expenditure review
quantifies the revenue forgone for each provision, including for investment tax incentives analyzed
in this paper.16 Conceptual complexities arise when performing a tax-expenditure review, including
in defining the relevant benchmark to which tax incentives are to be compared. Importantly, a tax
expenditure review does not take into account either any effect of the incentive on investment or
the leakage and abuse to which it can give rise to. The former may imply an overstatement of actual
revenue cost, since elimination of the incentive might lead to a reduction in the tax base and hence
to less additional revenue (if the rate would still be positive) than a ‘static’ calculation implies. The
latter implies an understatement. As methodologies differ, international comparisons of tax
expenditures are usually difficult.
Tax expenditure analyses are increasingly being used by developing countries, with strong
encouragement by and support from the IOs (see e.g. IMF, OECD, UN and World Bank, 2011),
including through technical assistance. The International Budget Partnership’s Open Budget Survey
indicates that tax expenditure reporting is undertaken by the following middle and low-income
countries: Argentina, Chile, Columbia, Dominican Republic, Guatemala, India, Jamaica, Jordan,
Kenya, Lebanon, Malaysia, Morocco, Nepal, Pakistan, Peru, Philippines, Russia, Serbia South Africa,

16

For assessing the revenue forgone from investment tax incentives, corporate micro simulation models can play animportant role, as the background document explains further.
17

TAX INCENTIVES FOR INVESTMENT—OPTIONS FOR LICS

Sri Lanka, Tanzania, Trinidad and Tobago. Some other countries carry out such analyses, but theirscore is low, indicating weak methodological frameworks.
In the Philippines, tax incentives are provided to a large number of firms producing for thedomestic market. The cost of fiscal incentives granted by the Board of Investments (which is only
one of the authorities that can do this) in 2004 was estimated to exceed 1 percent of GDP (Reside,2006). The background document discusses recent progress in the Philippines, with the Tax
Incentives Management and Transparency Act.
For purposes of policy evaluation, each dollar of public revenue forgone should be inflated byan indicator reflecting the scarcity of public funds: the ‘marginal cost of public funds’. Taxes
generally reduce labor supply, saving and investment, thereby imposing an additional cost tosociety. The marginal cost of public funds (social cost of a dollar of tax revenue) in advanced
economies is generally estimated around $1.20 to $1.30 due to these distortions. Estimates fordeveloping countries are scarce, but constraints on the instruments for domestic revenue
mobilization available to them likely mean that in LICS too, the marginal cost of public funds
substantially exceeds unity. For instance, Auriol and Walters (2012) estimate it at an average of $1.20
for a group of 38 African countries. Intuitively, spending a marginal dollar on tax incentives by thegovernment to attract FDI competes directly with other uses of funds, such as tax rate cuts acrossthe board or increases in expenditure on infrastructure or education. High returns to such public
investments in LICs due to a scarcity of public funds raise the opportunity cost of tax incentives by(on these estimates) an extra 20 cents per dollar revenue forgone, and thus call for a 20 percent
higher payoff to justify them.
Calculations of ‘dollar cost per job created’ are a popular metric for measuring the costeffectiveness of tax incentives. Number of jobs can be measured either for all investors enjoying
the incentive, or only for those that are ‘marginal’, in the sense that they would not have invested
without the incentive. Dollar costs can either be based on total revenue forgone from the taxexpenditure review, or only those from the non-marginal investors. Clearly, calculations of this kind
are simplistic and suffer from several pitfalls, implying they should be interpreted with caution. Still,
however calculated, the dollar cost per job provides a quick ballpark figure that can inform
policymakers on the relative cost-effectiveness of a particular incentive—which can also becompared with the costs of creating jobs by direct spending measures. Sometimes, the numbers
calculated are striking.
A 2008 Investment climate advisory study found that the government of Yemen spent about$6,000 per worker each year for 8,000 jobs that investment incentives helped create—more thansix times the country’s per capita income. In Thailand, a 1999 study by the Foreign Investment
Advisory Service found that investment incentives each year cost the government about 16 times
the average annual wage of an industrial worker. In Tunisia, it was found that the cost of tax
incentives for each job created was three and a half times the per-capita income. The governmentof India granted over US$200,000 per job in incentives. Investments by General Motors in Hungary
cost US$ 300,000 per job created. (James, 2014; Kenneth, 2011)18

TAX INCENTIVES FOR INVESTMENT—OPTIONS FOR LICS

Inefficiencies also arise from distorted resource allocations. By definition, tax incentives place
non-incentivized investments at a competitive disadvantage. The risk is that, in seeking to pickwinners, there will be inefficiently high investment in incentivized activities and inefficiently low
investment in others. Incentivized firms may also be able to attract workers from non-incentivizedfirms by offering higher wages, just because they enjoy an artificial competitive advantage. Diversionof labor and capital to the incentivized firms in response to discriminatory tax treatment will distort
the allocation of resources and can hurt economic growth.
The World Bank Group finds that a few politically connected firms have captured tax incentives in
Egypt and Tunisia. This selective access caused a dual economy with large differences in
profitability between insiders and outsiders, undermining a level playing field and reducing
competition, significantly reducing job growth (Shiffbauer et al., 2015).
In principle, efficiency may require taxing activities that are more mobile across countries lessheavily than those less mobile…. This is in line with the standard principle of efficient tax designthat items with less tax-sensitive bases should be taxed more heavily—because the tax then has alesser impact on real decisions. Such an outcome would effectively be one in which incentives areoffered to the most mobile activities—which in practice has clearly been a major concern for many
LICs and others. Differential tax rates across sectors may also serve as a pragmatic device forimposing higher burdens where rents (that is, profits in excess of the minimum required byinvestors) are more substantial.
…but this can bring its own difficulties, and be inferior to more cooperative outcomes.
Applying different rates to different sectors, for instance, creates opportunities for profit shifting
between the two (as elaborated on above). And since tax bases are less mobile from a collective
perspective (that of a trading bloc, for instance) than between individual countries, low tax rates set
in pursuit of national objectives may forego opportunities for efficient taxation from a collective
perspective. Where there is reason to suppose substantial rents are being earned, targeted taxes
may be the better way to approach them rather than by differential rates—hence the distinct
resource rent taxes often found in, and recommended for, resource-rich countries.

GUIDANCE IN THE USE OF TAX INCENTIVESAs the analysis above makes clear, how tax incentives are designed and governed is critical to theireffectiveness and efficiency. This section discusses principles and good practices in these areas, andelaborates on issues of reform of tax incentives.

A. Design
Tax incentive policies involve three core design issues:

Choice of tax instrument to incentivize investment;Eligibility criteria used in the selection of qualified investments;
19

TAX INCENTIVES FOR INVESTMENT—OPTIONS FOR LICS

Reporting and monitoring requirements during different stages of the tax incentive’s life cycle,
as well as sunset and recapture provisions.

Instrument choice
Incentives can cover a wide range of taxes, including corporate income tax (CIT), VAT, tariffs,
property taxes, personal income taxes and social contributions. Incentives in each of these areas
require distinct economic analysis. For instance, a reduction in tariffs for capital goods is usually on
solid economic ground in that it eliminates production distortions that create large welfare costs. On
the other hand, VAT exemptions on investment may be entirely redundant, since full operation of
the tax means that VAT charged on inputs does not ‘stick’ with the purchaser, but is fully recovered
as a credit against VAT charged on sales;17 but VAT exemptions can become beneficial for firms if
VAT implementation is problematic, for instance, due to imperfect VAT refund procedures.
Corporate income tax incentives are probably the most contentious and widely criticized byobservers. Much of the focus below will consequently be on them.
Tax incentives that lower the cost of investment are often to be preferred over profit-based
tax incentives:


Cost-based tax incentives involve specific allowances linked to investment expenses, such as
accelerated depreciation schemes and special tax deductions and credits. They are targeted atlowering the cost of capital and so make a greater number of investment projects more
profitable at the margin—that is, may generate investments that would not otherwise have been
made.



Profit-based tax incentives generally reduce the tax rate applicable to taxable income;examples include tax holidays, preferential tax rates or income exemptions. One effect is thus toforego government revenue in order to make even more profitable investment projects thatwould be profitable, and hence undertaken, even without the incentive.

The difference between the two types of instruments is critical. For instance, profit-based incentives
will be less effective in encouraging investment compared to incentives that reduce the capital cost
if profitability is low. When profits are earned due to the presence of location-specific factors, suchas natural resources, agglomerations, or local markets, profit-based incentives tend to be associatedwith high redundancy rates and are again ineffective in raising investment. But international
considerations are important here. Profitable investments that are highly mobile across national
borders—because, for instance, rents are associated with intangible assets, such as patents ortrademarks, that are easy to move between jurisdictions—may be sensitive to both cost-based andprofit-based tax incentives.
Tax holidays tend to favor readily mobile (‘footloose’) activities rather than long-term
investment. By offering temporary tax relief for profitable firms, tax holidays benefit industries that17

Indeed VAT exemption on investments (and intermediate purchases more generally) can be worse than redundant,
because of its cascading effect through the production chain: see for instance Ebril et al. (2001).

20

TAX INCENTIVES FOR INVESTMENT—OPTIONS FOR LICS

start making profits soon in the holiday period. This introduces a bias towards short-term projects
with low upfront investment costs, which may be those least likely to generate spillover effects on
the wider economy (of the kinds described above). Such investment projects are known to “packand go”, fleeing the host country as soon as the preferential treatment is removed. For industries
with significant long-term capital needs, and for which spillover benefits may be greater, tax
holidays could actually discourage investment: little otherwise taxable profit might be expectedduring the holiday period, and, to utilize depreciation allowances, a firm might be encouraged topostpone investment until after the holiday period in order to claim full deductions for its costs (seebackground document).

Eligibility criteria
Tax incentives need to be well-targeted and based on clear eligibility criteria. Targeting serves
two related purposes: (i) identifying the types of investment that a government seeks to attract; and(ii) reducing the fiscal cost of incentives. The following criteria are commonly used—often in
combination:
Special size. Tax incentives are sometimes restricted to new investments (or investors) thatexceed some stipulated value of assets or those that create at least some stipulated number of
new jobs. This of course has significant appeal, for instance where investments can betransformational for a country or region or where financing and technical constraints hold up
investment. Limiting incentives to large investments can also reduce administrative costs forgovernment. However, discrimination in favor of large foreign investments can also lead tomanipulation, abuse and distortion. For instance, size conditions are relatively easy to meet on
paper, but extremely difficult to monitor and verify ex-post. If an investor increases the size of
their planned investment or the number of new jobs simply to obtain a tax privilege, this implies
an inefficient use of resources, so that marginal productivity increases can be very low or evennegative. Discrimination can also distort competition and restrict the growth of smaller domestic
enterprises that do not enjoy incentives, even when they are more productive.18

Special sectors. Many countries grant preferential tax treatment to certain sectors of theeconomy, which policy makers consider as most desirable and which are most likely to be
influenced by tax. Among the activities commonly preferred are tourism, “offshore” financial
centers, film production and manufacturing activities, with the idea that they bring more sociallyvaluable spillover effects. Incentives are also sometimes restricted to so-called “pioneer”
industries, which can be defined in various ways, but are always viewed as of strategic value for18

Many countries also offer special tax incentives for small and medium-sized (usually domestic) enterprises(perhaps to address their difficulties in raising external finance), for example through lower tax rates or special
allowances. There is no clear evidence, however, that targeted tax relief for small firms is more cost-effective than
general tax relief for businesses (IMF, 2012). On the contrary, special relief may hurt economic growth by creating asmall-business trap, preventing small firms from growing larger to maintain their preferential tax treatment.

21

TAX INCENTIVES FOR INVESTMENT—OPTIONS FOR LICS

the national economy.19 There is always a question, however, whether serving special interestsaligns with serving the general public interest. For instance, investments in other economic
sectors are placed at a competitive disadvantage and may under develop, even though they are
more productive.
Special regions/zones. Tax incentives are sometimes targeted to special regions in the form of‘zones’, for example to address geospatial inequality. Economic zones (EZs)—which exist undervarious names and definitions20—have rapidly gained popularity over the last couple of decades.
For instance, the International Labour Organization (ILO) estimated in 2007 that 3,500 EZs wereoperational in 130 countries, compared to only 176 in 46 countries 20 years earlier. Successful
economic developments in Hong Kong SAR, Singapore, and Korea have often been attributed toEZs. In China, SEZs were used as test beds for the gradual liberalization of the economy andexport-oriented industrialization. There is evidence that these Chinese SEZs, on average, boosted
the growth rate of FDI by almost 7 percent per year (Wang, 2013) and regional economic growthby 12 percent per year (Alder et al., 2013). These successes in East Asia have inspired many otherdeveloping countries to adopt EZs of various kinds, including in sub-Saharan Africa and Asia.
Experience on their effectiveness, however, is mixed at best. Zeng (2015) recently concluded, forexample, that the experiences have been disappointing in most African countries, which heexplains by poor institutions, weak governance and inadequate infrastructure (among others). In
India too, there is evidence that the number of EZs per region has had no discernible impact onregional economic growth (Leong, 2013). In such circumstances there is evident risk ofsignificant revenue loss through redundancy, and many observers also stress sizable risks fromtax planning between the free-zone and affiliates outside the zone (similar to those shown in the
India example above).
“Performance data are elusive because the effects of zones are hard to disentangle from othereconomic forces. But anecdotal evidence suggests that they fall into three broad categories: a few
runaway successes, a larger number that come out marginally positive in cost-benefit assessments,
and a long tail of failed zones that either never got going, were poorly run, or where investors
gladly took tax breaks without producing substantial employment or export earnings” (The
Economist, April 4th 2015).

19

Investment incentives are also frequently targeted at export-oriented production. However, such incentives may becontrary to WTO rules—although there is a LIC exemption provided under the WTO Subsidies and Countervailing
Measures Agreement, under which 33 LIC WTO members (as well as 12 accession LICs) are granted special relief.

20

Export processing zones (EPZs), for example, are enclaves where foreign companies engaged in the manufacturingof products for exports enjoy preferential (tax) treatment compared to the rest of the economy. Special economic
zones (SEZs) offer locational flexibility and have a wider application than EPZs by granting such treatments also todomestic sectors. Several other zone types exist, each with particular features. Incentives in those EZs generally
involve non-tax benefits, such as good infrastructure and cheap utilities, as well as reductions in customs duties,
income taxes and other (local) taxes and fees.

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TAX INCENTIVES FOR INVESTMENT—OPTIONS FOR LICS

A recent IDB study uses micro data to evaluate Export Free Zones in Costa Rica, El Salvador andDominican Republic, including the specific role of tax holidays. It finds that (i) the Zones generally
favor high profitability projects that would likely have gone ahead also without the incentives;(ii) projects are readjusted to keep incentives over time; and (iii) global tax avoidance is facilitatedthrough the use of transfer prices vis-à-vis subsidiaries in the Zones (Artana, 2015).

Life-cycle stages
After approval, the tax administration should continue monitoring firms. This is an often
neglected stage in many countries. Even when granted a tax holiday, taxpayers should still be
required to file a tax return so that the authorities can assess the revenue cost of the incentive (as acentral element of its tax expenditure review). Tax authorities should also periodically carry out
audits to ensure that tax incentives are not abused. Conditions attached to incentives often requireongoing monitoring—for example, requirements that a given number of jobs be maintained, or thata certain percentage of production be exported (which may call for specialized tax forms for firms
enjoying such incentives). Where non-compliance or abuse is detected, a penalty should be imposed
and, ultimately, tax privileges denied.
Making tax incentives temporary rather than permanent can have some attraction. One major
attraction of a temporary tax incentive is that its expiry provides for a natural point of evaluation,
feeding into a periodic reconsideration of whether the incentive should be continued, reformed orrepealed. Temporariness of a tax incentive can also be used as a counter-cyclical policy. Indeed,
when foreseen to be phased out in the near future, the investment effects of an incentive tend to bebigger than of permanent incentives (US Department of Treasury, 2010). Sunset provisions should
be built into the law. In the absence of such a provision, firms may seek to roll-over a tax holiday,
either by negotiating a new holiday period or by incorporating a new firm that may qualify for it. Tax
holidays then become de facto permanent tax exemptions—a practice that should be avoided.

B. GovernanceGood governance requires that the government’s decision-making process, its policies andthe administration be transparent and subject to scrutiny and evaluation, to ensure that
authorities can be held accountable for their actions and remedial action taken when necessary. This
limits the scope for corruption, strengthens the trust of investors in government, and enhances
confidence of the public that the tax system is fair in design and implementation. Transparency is anecessary but not a sufficient condition for good governance (see Box 3). IOs have developed avariety of practical tools to assess the transparency and wider governance performance of countries
with respect to tax incentives.21 The background document presents templates that can be used asassessment tools. In general, the key requirements for good governance are that:21
See for instance the IMF Fiscal Transparency Code (2014), including pillar IV on resource revenue management;
IMF Manual on Fiscal Transparency (2007); OECD Best Practices for Budget Transparency (2002). The backgrounddocument presents recent templates developed by the OECD and the World Bank.

23

TAX INCENTIVES FOR INVESTMENT—OPTIONS FOR LICSThe award and monitoring of incentives be guided by the rule of law, with clarity about eligibility
criteria;Authority to grant national-level tax incentives (related to national taxes) rest solely with the
Ministry of Finance; decisions drawing, as need be, on the views of stakeholders acrossgovernment;

There be effective and transparent administration and evaluation.
Box 3. Transparency

Transparency is fundamental to empowering all stakeholders—the legislature, businesses, civilsociety and the public at large—with information about tax incentive policies, so that they canhold government accountable for its decisions. Transparency also generates information required
for evaluation. Transparency should be created along three dimensions:

Legal: tax incentives should have a statutory basis in relevant tax laws.



Economic: the rationale for tax incentives should be clearly spelled out to enable a publicdebate on the country’s policy priorities. The costs and benefits of an incentive scheme should
be assessed ex-ante and ex-post, based on clearly stated assumptions and methodologies,
and the assessments published.

Administrative: qualifying criteria should be clear, simple, specific and objective, so as toreduce the discretion afforded to officials that grant the incentives. The decision-making
process should be open and a list of incentives granted should be published.

Because the revenue costs of tax incentives are usually not obvious, governments tend to face
limited scrutiny when granting them, in contrast to the case of direct expenditures. Budgeting theamount of revenue forgone from tax incentives by the Ministry of Finance and revealing it to the
public supports good governance, enables informed budget making and improves accountability.
Transparency in the benefits they receive should also be required from multinational corporations.
This can strengthen corporate social responsibility as employees, customers and local communities
can hold corporations accountable for their decisions, including their tax treatment.

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TAX INCENTIVES FOR INVESTMENT—OPTIONS FOR LICS

Rule of law
Tax incentives should be clearly prescribed in the law… This ensures that the legal basis
governing the tax incentive has been approved by the legislature and has passed appropriate
parliamentary and public scrutiny. If, on the other hand, tax incentives are negotiable and provided
through decrees, agreements, regulations and the like, they escape oversight and can become prone
to undue influence.
Tax incentives in Nigeria can be introduced through laws, budget speeches, government
notices/directives, executed agreements, as well as Memoranda of Understanding between thegovernment and businesses (Nlerum, 2011).
…and preferably consolidated in the tax law. The transparency and accessibility of tax incentives
are compromised when embedded in multiple pieces of legislation applying, for instance, todifferent sectors. Tax incentives are for this reason best consolidated into the main body of the tax
law. This reduces the likelihood of conflicting or overlapping provisions, which could create
unintended distortions and uncertainty, as well as revenue losses. In practice, however, more thanhalf of all LICs provide tax incentives outside the tax law (Figure 4).
Figure 4. Governance of tax incentives by income group/1
80%
70%
60%
50%
40%
30%
20%
10%
0%
Low Income (32)

Low Middle (37)Discretionary process available

Upper Middle (43)High Income (42)

Incentives outside Tax Laws

/1 Percentage of countries in four income groups that have discretion/provide incentives outside the tax law. Discretion isdefined as processes under which the taxpayer can negotiate special incentives, or where approval of a tax incentive can be
granted outside of the tax/customs agency.
Source: Calculations based on James (2014)25

TAX INCENTIVES FOR INVESTMENT—OPTIONS FOR LICSIn December 2012, special tax measures in as many as 17 laws and legislative acts were
either abolished or consolidated into the General Tax Code in Senegal, significantly
improving transparency of the tax system. The comprehensive tax reform, along with tighter
administrative measures, streamlined the tax system and represented a significant rollback of
tax incentives and exemptions. (Journal Officiel de la République du Sénégal, 2012)
Eligibility criteria for granting tax incentives should be clearly defined and readily verifiable
to allow for a rules-based approach. The law (and its accompanying regulations) should specify
the conditions that the taxpayer needs to satisfy in order to qualify for a tax incentive, with as little
room as possible for subjective interpretation or negotiation. Granting incentives can then be largely
automatic by verification of stipulated criteria. Yet, not all tax incentives can be granted
automatically, for instance because the law cannot always prescribe eligibility under all possible
circumstances. This often introduces some elements of discretion. The extent of discretion, however,should be kept to a minimum as it introduces the risk of rent-seeking behavior on the part of theinvestors and corrupt behavior on the part of the public officials—a major concern in many
countries.22 Excessive discretion can also serve as a signal of poor governance and thus alarm newinvestors. Figure 4 shows that, troublingly, close to 70 percent of LICs allow for granting processes
that are largely discretionary in nature.
There are several examples of considerable discretionary interpretation. For instance, therecently promulgated Foreign Investment Law of Myanmar loosely defines eligibility for tax
exemptions over a “suitable period” for businesses that are “beneficial for the State.”(Myanmar
Foreign Investment Law, 2012). The Gambia’s investment promotion authority confers a
special status on investors, which are then awarded special investment certificates entitling
them to benefit from incentive packages; the investment promotion authority states that,“Apart from these specific incentive packages, others can be negotiated with the Agency
depending on the strategic nature of the investment.” (James, 2014). Tanzania’s ‘Strategic
Investor Status’ allows companies investing over US$ 20 million to negotiate individual tax
breaks. These “special concessions to individual companies … have never formally been madepublic” (Tax Justice Network, 2012). Haiti’s Investment Code covers virtually any economic
activity and provides no selection criteria to be applied by the inter-ministerial committee incharge of granting discretionary incentives, which include both a 15-year CIT holiday andaccelerated depreciation (Investment law of Haiti, 1989).
There is reason for optimism too, as increased public awareness and civil society activism haveurged governments to bring some previously secret deals into daylight. In 2012, thegovernment of Sierra Leone established an online database for mining contracts, to makeinformation on natural resource extraction contracts publicly accessible. Similarly, dozens of

22
The World Bank defines corruption as the abuse of public office for private gain; rent seeking reflects the use ofcompanies’ resources to obtain economic benefit without wealth creation. Both can hamper development, see e.g.
Abed and Gupta (2002).

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TAX INCENTIVES FOR INVESTMENT—OPTIONS FOR LICS

previously secret extractive industry contracts were placed online by the government of Guinea(Africa Progress Panel, 2013).

Authority to grant
It is critical that ministries and agencies involved in the granting of tax incentives coordinate
their activities. Several government agencies are often involved in the foreign investment process,such as the Investment Promotion Agency, the Ministry of Economy and Ministries responsible for
specific sectors, such as Agriculture, Tourism or Mining. These different players often bring specificexpertise, which can be useful in the design of tax incentives or required in the evaluation ofeligibility criteria. But they usually also have different objectives. For instance, investment promotion
agencies often support tax incentives in order to attract investors, having little direct concern for therevenue consequences. The Ministry of Finance, in contrast, will emphasize that revenue needs to beraised to provide public goods, including key pillars of a business-enabling environment such as
infrastructure. Where various Ministries do not properly coordinate and responsibilities are notcentralized, incentives may overlap, be inconsistent, or even work at cross-purposes. Effective
coordination is a daunting but critically important task.
The ultimate and sole authority to enact tax incentives at the national level should be with the
Minister of Finance. Countries that have been successful in attracting investment have generally
adopted a holistic approach that places tax policy in the context of a broader national development
strategy. It is common practice to have an interdepartmental adjudication committee with combined
expertise that makes recommendations to the Minister of Finance about tax incentives. The lattershould take the final decision to enact tax incentives and be responsible for their implementation
through, or working closely with, the tax administration. Indeed, the Minister of Finance is best able
to weigh different priorities while also keeping an eye on the cost of incentives. Where authority isoutside the Ministry of Finance, special interests can easily dominate the general public interest.
As many as 10 organizations/agencies have the authority to grant tax incentives andexemptions in Ghana, including the Parliament, Ministry of Finance & Economic Planning,
Revenue Agencies, Minerals Commission, Environmental Protection Agency, Food and Drugs
Board, Ghana Free Zones Board, Ghana Investment Promotion Council, and Ghana National
Petroleum Company (Amegashie, 2011).
The Solomon Islands recently implemented a comprehensive statutory regime, prescribing
the process of granting tax exemptions for import duties, excise, Goods and Services Tax(GST), income tax, sales tax and stamp duties. If a request is received for a tax exemption, aformal “Exemption Committee” provides advice to the Minister for Treasury and Finance.
The Committee consists of representatives of the revenue administration, the Ministry ofDevelopment and Planning and the Ministry of Commerce. The law also prescribes clear andpublic criteria for the award of tax incentives and demands publication of both theapplication and the decision regarding the incentive. (Revenue and Customs Exemption
Committee Solomon Islands, 2013).
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TAX INCENTIVES FOR INVESTMENT—OPTIONS FOR LICS

Administration
The revenue administration should be in charge of the implementation and enforcement oftax incentive schemes, as it has the unique authority, expertise and experience necessary for the
execution of the tax law of which incentives should be part. Where tax incentives are simple andunambiguous, they might be self-assessed by the taxpayer and subject to ordinary control andauditing procedures. Many incentive provisions, however, require some form of approval by the tax
administration. When verifying facts, information or certification may be needed from otherspecialized government agencies or ministries. For the tax administration, documentation andpublication of the decisions is a prerequisite to ensure transparency. This enables it to be held
accountable by government and taxpayers. It also enables government (preferably the Ministry of
Finance) and other organizations to evaluate the costs and benefits of tax incentives.

C. Reform
IOs have frequently advised countries to remove, or radically adjust, their tax incentives, as
they have often been found to be ineffective or inefficient, or governance structures were illperforming. Yet, reform of tax incentive regimes has proven difficult. This is because tax incentives
are usually not only driven only or even mainly by well-articulated economic concerns—aimed at
improving the wellbeing of citizens—but also by political motivations. For instance, politicians may
find it attractive to introduce new tax incentives to reveal their proactive stance in addressing weakeconomic performance, or to favor particular regions. The fiscal costs of granting those incentives,moreover, are usually not transparent and only arise as forgone revenue in the future. Tax incentives
also create vested interests among businesses and within government, making them difficult torepeal, even if they are ineffective. Indeed, economic elites are sometimes able to influence thegovernance and design of tax incentives and shape public opinion where it suits their objectives.
When successful, they become powerful lobbyists who can capture the political process to resist
change (Moe, 2005). Yet, successful reforms have been achieved:
In 2013, Jamaica undertook a major tax reform, eliminating many of its generous anddiscretionary tax incentives. The Minister of Justice said: “The Jamaican economy has not been
well served by the existing regime of sector based incentives. The consensus is that suchincentives may have been partly responsible for Jamaica’s lackluster record of growth byencouraging the misallocation of limited economic resources in our country.” (James, 2013)
In 2009, India’s Ministry of Finance released a draft Direct Taxes Code and a discussion paperon the bill, which recommended that India should move away from profit-based tax incentives
in favor of expenditure-based tax incentives. A final bill was sent to Parliament in 2010, andpassed to a Standing Committee on Finance (SCF), which released its report in March 2012.
The SCF report concurred with the Ministry of Finance that profit-based incentives facilitate
artificial tax planning, and that this form of incentive should no longer be granted (while
existing tax holidays previously granted for firms in special economic zones would continue tobe respected) (Standing Committee on Finance 2011-12).
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TAX INCENTIVES FOR INVESTMENT—OPTIONS FOR LICS

Egypt passed a new income tax law in mid-2005 that provided for the phasing out of tax
holidays while grandfathering current beneficiaries. Between 2005 and 2006, FDI into Egypt
doubled. (Keen and Mansour, 2010)
In 2006, Mauritius normalized the taxation of its export processing zone companies with thatin other sectors and removed all provisions relating to tax credits and tax holidays (except for a
four-year income tax holiday for small business). At the same time, the corporate tax rate was
gradually reduced from 25 to 15 percent in 2008. (Keen and Mansour, 2010)
In his latest budget speech, the Finance Minister of India proposed to reduce the corporate tax
rate from 30 to 25 percent over the next 4 years, accompanied by rationalization and removal
of various tax incentives and exemptions, which, he argues, have led to pressure groups,
litigation and loss of revenue. The Minister expects base broadening and rate reduction to leadto higher levels of investment and growth and more jobs (Government of India, Ministry of
Finance, February 28, 2015).
When reforming tax incentives, governments should seek a balance between tax stability forincumbents and equal treatment of entrants to the market. Sunset provisions are often provided
when incentives are scaled back due to policy reform. For instance, in the case of repeal of a tax
holiday, the expectation can be that existing privileges will continue for incumbent firms. Investment
laws sometimes even contain stability clauses for investors against adverse legislative changes, as asign of government’s commitment. Such stability provisions, however, create an uneven playing field
between old and new investors and can lead to significant distortions. Such situations should notlast for too long. Government might therefore need to renegotiate existing incentive provisions orprovide reasonable, time-bound incentives to new investors.

INTERNATIONAL COORDINATION
Tax incentives are often instances of tax competition, with the risk that ultimately all
countries will lose from their use.23 By attracting investment that would otherwise have goneelsewhere, tax incentives can have adverse cross-border spillover effects on the welfare of othercountries. To the extent that the allocation of investment is driven by tax rather than commercial
considerations, the result is an inefficient global allocation of capital, and a consequent collective
loss of output. Moreover, tax incentives in one country might evoke strategic reactions that leadthem to offer similar policies (IMF, 2014). This process of tax competition can cause a race to thebottom, with all countries ultimately ending up with lower tax revenue and with no discernible
impact on the allocation of investment. ,23

Tax competition might not be bad per se. For instance, some see tax competition as welcome in counteracting apolitical bias towards excessive public expenditure. Such arguments are less pervasive in LICs, however, which
generally face an urgent need for higher domestic revenues to finance projects for development.
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TAX INCENTIVES FOR INVESTMENT—OPTIONS FOR LICS

Examining data for 40 countries in Latin America, the Caribbean and Africa, it appears that thelength of a country’s tax holidays responds positively to that of its neighbors (Klemm and Van
Parys, 2012).
A race to the bottom is evident among special regimes in Africa, where effective tax rates havefallen to almost zero in industries where special regimes are in place (Abbas and Klemm, 2013).
Grenada announced in 2012 that, in order to encourage the resort group Sandals to invest
in his country, the government agreed to waive the company’s payment of corporate taxes
for 25 years, place a cap on Sandals’ property taxes for 25 years and waive all import duties
for 25 years. The minister announced that the benefits to the economy were an injection of
US$100 million and the creation of 425 jobs. This reflects the aggressive nature of tax
competition in the hotel industry in the Caribbean (James, 2013).
Tax coordination offers opportunities to address spillovers—but also involves the risk of
inducing other harmful responses. In principle, a coordinated response can prevent mutuallyharmful outcomes induced by uncoordinated tax design, for instance by agreeing to a ban on theuse of certain tax incentives. Most forms of international coordination, however, are only of limited
scope and scale. This raises two fundamental issues that require careful consideration whenassessing the impact of tax coordination:
Coordination with respect to some tax incentives can intensify tax competition in otherprovisions. Suppose for instance that countries agreed not to offer special treatment to mobile
activities (which, as discussed above, they might wish to do) but could otherwise compete on
the general rate of tax they apply. The outcome could then be worse for all than if differential
treatment were allowed, since they will then compete more aggressively on the rules covering allindustries, including those with immobile capital (see e.g. Keen, 2002). Against this, of course,
must be weighed the disadvantages of differential treatment across sectors discussed above.



Coordination among a subset of countries can intensify tax competition with outsiders—with the latter the major beneficiaries. Coordination is best achieved among the countries
that most directly compete for mobile capital. If too limited in regional scope, the tax base of theparticipating countries can become more vulnerable to pressures from outside jurisdictions withlower taxes: they are in effect setting themselves up for increased competition from nonparticipants, who may consequently be the major beneficiaries. The scope of coordinationagreements should thus be sufficiently broad in terms of country coverage,24 the difficulty beingthat of overcoming the incentive to benefit by staying outside the agreement.

International tax coordination can take different forms. For instance, countries can agree on a
non-binding code of conduct not to use certain tax incentives, such as tax holidays—as for instancehas been done with the Code of Conduct for business taxation in the European Union. Something
24

Or other relevant characteristics. Similar arguments apply, for instance, to cooperation between producers of somenatural resource, whatever their geographical location.

30

TAX INCENTIVES FOR INVESTMENT—OPTIONS FOR LICS

more binding would be a common legislative framework, akin to the state-aid rules in the European
Union. Yet, tax coordination has proven difficult in practice in many regional groupings. Negotiating
and implementing an agreement is a substantial effort, and will require an effective supranational
monitoring framework and powerful institutions to enforce it—something that is lacking in many
regions. More realistic in these circumstances might be to start with a more modest form ofcooperation. For instance, countries could agree on a common framework for reporting tax
incentives and information exchange to encourage mutual learning. This could also enhancetransparency and governance practices, and enable ex-post assessment of tax incentives.
The Southern African Development Community (SADC) aims to reduce and ultimately to eliminate
tax competition that damages the region’s revenue mobilization efforts. The SADC Protocol on
Finance and Investment provides for co-operation and coordination on tax incentives in the region.
The “Guidelines for the application and treatment of tax incentives in the SADC region” seeks
endeavors by the Member States to avoid harmful tax competition or introducing tax legislationthat prejudices another Member State’s economic policies or activities (SADC, 2012).
The members of the East African Community (EAC) have recently made progress towards
coordination of their tax incentive regime through the use of a ‘Code of Conduct’, though this is yet
to be adopted. This aims to formalize an existing arrangement under which each year the EAC
finance ministers meet before their budget speeches are made and discuss their budget proposals.
This provides the opportunity for Finance Ministers to dissuade other members if they propose any
new tax incentive that puts other countries at a disadvantage (Tax Justice Network, 2012).
In the West African Economic and Monetary Union (WEAMU), considerable efforts have been madeto set-up a structure to tackle the problem of tax competition by issuing directives that limit theapplicable tax rates that countries can use. The coordination framework has led to someconvergence of countries’ tax systems, and in turn to positive revenue effects in WAEMU member
states. However, there are large gaps between de jure and de facto coordination, as WAEMU has
failed to provide its regional institutions with the necessary resources to undertake effective
surveillance, which has led to ineffective enforcement and undermined the credibility of
coordination. In fact, the framework allows for unfettered tax competition as long as this is done
outside the countries’ main tax laws. This has made their tax systems opaque, increased complexity
and contributed to a culture of tax negotiation (Mansour and Rota-Graziosi, 2013).
In Central America, coordination of tax incentives has some history. Between 1962 and 1984, four
countries (Costa Rica, El Salvador, Guatemala and Nicaragua) were parties to a convention on tax
incentives, which mandated uniform tax incentives and prohibited the introduction of new ones. In
2012, the Committee of Ministers of Finance of Central America, Panama, and the Dominican
Republic (COSEFIN) discussed the adoption of a “Declaration of Good Practices” for investment tax
incentives, which was preceded by a wide-ranging exercise to quantify the cost of existing tax
incentives to make a stronger case for their removal. Discussions on a mandatory code of goodpractices remain ongoing (Cebotari et al., 2013).

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TAX INCENTIVES FOR INVESTMENT—OPTIONS FOR LICS

International tax rules adopted by advanced and emerging economies may affect theintensity of tax competition among LICs. The benefits of tax incentives to investors are larger, forinstance, if parent companies reside in countries with territorial taxation and/or weak CFC regimes,
since (as discussed above), because the exemption of qualified foreign-earned income in theresidence country preserves the benefit of tax advantages in the host country. Advanced andemerging countries with worldwide taxation, however, sometimes offer tax sparing clauses, as
discussed in footnote 14. This too increases the potential effectiveness of tax incentives. This in itself,
however, is likely to intensify tax competition among LICs to attract FDI. Ultimately, territoriality andtax sparing may therefore not make LICs collectively better off.
Tax incentives as part of bilateral or multi-party investment agreements vary widely in form
and there is no standard template for them. There are often exceptions providing that tax
matters are not covered by such agreements. This might refer to tax matters generally, thoseconfined to double tax treaties (not extending to indirect taxes such as VAT), or those related to
specific investment treaty obligations, such as the "most favored nation" provision. Where a tax
incentive is provided, it is important to consider whether the relevant investment treaties might
unintentionally be automatically accorded to other taxpayers, not originally intended to benefit fromthe tax incentive (such as under a most favored nation clause). Moreover, protections under theinvestment treaty (such as stabilization clauses) may make it hard to withdraw the tax incentive
when it no longer serves the original purpose, or may require compensation not otherwise payable.
Also important is which dispute settlement procedure would apply if tax issues fall under theinvestment treaty (usually there is a binding arbitration clause), and what should be done to prepare
for such a possibility. These issues are best considered in collaboration with those responsible fornegotiating the investment treaties.

CONCLUSIONSThis paper finds that many LICs have considerable scope to improve the effectiveness andefficiency of their investment tax incentives. The paper has set out options for improvement indesign and governance, at both national and international levels. At the national level, there is
generally scope to improve the design of tax incentives (for example by placing greater emphasis on
cost-based incentives rather than profit-based ones; and by targeting tax incentives better),strengthen their governance (for instance through more transparency, better tax laws and a stronger
role of the Minister of Finance) and by undertaking more systematic evaluations. At the international
level, countries may gain by coordinating their tax incentive policies regionally, so as to mitigate thenegative spillovers from tax competition.
Making progress requires concerted action from many stakeholders. National reform andinternational coordination of investment tax incentives have often proven difficult to achieve for avariety of reasons. Making better progress requires that political decisions about tax incentives bebased on proper analysis of their effectiveness and efficiency, which requires transparency alongwith systematic information gathering and evaluation. Stakeholders need to accept their various
responsibilities if progress is to be made:32

TAX INCENTIVES FOR INVESTMENT—OPTIONS FOR LICSGovernments in LICs bear the prime responsibility for the design and governance of tax
incentives. It is critical that they can be held accountable by parliament, businesses, donors,
relevant regional and international bodies, and the public at large. This requires transparency, as
well as a properly functioning legal system. Also important is that governments be equippedwith the necessary skills, tools and data to undertake evaluations, to enable informed decision
making. Publishing an annual tax expenditure review as part of the budgetary process is an
important step in this direction.

Society at large, including civil society organizations (CSOs) and media, play a vital role inscrutinizing government decisions, detecting malfunctioning practices, and mobilizing voice.
They can, for instance, draw attention to and publicize the revenue foregone from tax incentives
that is reducing the resources available for development.



Corporations, including foreign-owned multinationals that enjoy tax incentives bear
corporate social responsibility, including towards (local) communities, governments, employees,
consumers and other stakeholders. This means, for instance, that they should comply not onlywith the letter but also the spirit of the tax law. Going further, the business sector might develop
and subscribe to a code of conduct under which incentive packages that fail to meet certain
minimum transparency standards are not accepted or sought.

Supranational regional bodies have delegated responsibility from national governments toenforce commitments agreed upon in the cooperation. Their powers will be as strong as themembers want them to be. Supranational bodies can support transparency by developing
common standards for reporting, data collection and evaluation of tax incentives.



Governments in donor countries, including those in the G20, have a responsibility in: (i) the
design of their own corporate tax policies, to avoid harmful spillovers onto LICs (for example,
through treaty abuse; (ii) the provision of donor aid, which itself in many cases enjoys thebenefits of tax incentives offered by LICs (a practice for which the rationale is increasingly
unclear, and which is being revisited by several donors);25 (iii) imposing conditionality regarding
tax incentives when providing donor aid, such as meeting minimum transparency standards.

International organizations, such as those co-authoring this document, need to build on theirestablished experience to support their LIC members in building more efficient and effective tax
system. This includes support in developing their capacity to employ tools to better analyze tax
incentives (such as micro simulation models and effective tax rate models), and evaluations that
help inform the debate (such as tax expenditure reviews, governance assessment and morecomprehensive cost-benefit assessments)—as discussed in detail in the background document.

25

See e.g. International Tax Dialogue (2006).

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TAX INCENTIVES FOR INVESTMENT—OPTIONS FOR LICS

Realizing improvements in effectiveness and efficiency in the use of tax incentives is important for
LICs to achieve better development outcomes. Higher investment can then be reconciled with moreabundant domestic revenue mobilization, much-needed for public spending programs andestablished as a development priority in the Addis Ababa Action Agenda.26

26

Draft Resolution by the General Assembly endorsing the Addis Abeba Action Agenda A/69/L.82.

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TAX INCENTIVES FOR INVESTMENT—OPTIONS FOR LICS

Appendix I. Consultations
This paper draws on the extensive technical assistance provided by the IMF and World Bank on tax
incentive issues in developing LICs over many years, and their continuing dialogue with them on tax
matters. In preparing this paper, the IOs also held several discussions during public consultation
meetings with representatives from developing countries, civil society organizations, businesses andacademics. Events were organized during March and April 2015 in Paris, Washington DC and New
York. In response to an online invitation for comments on a draft version of the paper during Julyand August 2015, several submissions were received. A short review of key issues raised is listed
below.
Developing country officials showed great interest in deepening their analysis of tax incentives
with the tools described in the paper, including for the analysis of tax holidays and economic zones.
Most officials noted that their countries have not carried out any in-depth analysis of the costs andbenefits of tax incentives, yet are frequently confronted with pressures from businesses to grant
them. For the fear of losing investments, generous tax incentives are then offered with ample tax
receipts foregone. In some regions in Africa, countries are coordinating efforts to assess the revenue
costs of tax incentives—sometimes showing very large numbers. However, methodologies are notharmonized, which hampers comparison between studies.
Civil society expressed the view that tax incentives are often ineffective and inefficient. They alsoemphasized the importance of ‘spillover effects’ of tax policies in one country on other countries
and therefore the need for international cooperation. They argue that developing countries are
particularly vulnerable to tax incentives, reducing the domestic resources for their own development.
Organizations also noted the inherent difficulties of performing a proper cost-benefit assessment,
yet urged the IOs to support such exercises in LICs so as to improve information in the decisionmaking process. Finally, the importance of transparency—from both governments and businesses—
was emphasized. It was argued that G20 countries need to work together with LICs to develop a
global coordinated approach, with developing counties having an equal say at the negotiation table.
Business argued that tax incentives can be effective instruments to stimulate investment, but only
when used as part of a well-conceived and well-implemented strategy. Thus, tax incentives require
clear pre-established objectives, should be based in the law and efficiently managed. Theyemphasized that it is essential for investment that the tax regime be predictable, efficient and stable.
Business also argued that tax incentives cannot compensate for an otherwise poor tax structure orfor an unfavorable investment climate, such as significant administrative barriers, limitations tocompetition, no independent legal system, or failing property rights protection. Finally, they findthat countries should be able to set their own tax policies and allocate their own tax incentives, since
there is no one-size-fits all. Regional coordination is not considered to be helpful.
Independent contributors offered important information and ideas. One contribution offeredinsight into tax incentives in ten ASEAN countries. It shows that, while 10 countries grant tax
holidays, 6 of them also allow for their renewal upon expiration. Contributors also warned against
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TAX INCENTIVES FOR INVESTMENT—OPTIONS FOR LICS

the outcomes from investor surveys, which may give a biased view regarding the actual behavior ofinvestors. An important point raised was the lack of relevant data and the need for more systematic
data gathering by tax administrations. This will require them to monitor firms, even if they havebeen granted tax exemptions. Also emphasized was the need to explore the effectiveness of tax
incentives under the unique circumstances of every country. Others noted that tax incentives are not
only prevalent in LICs, but are widespread in advanced countries. Several contributors emphasized
the importance of tax expenditure budgeting for enhancing transparency.

36

TAX INCENTIVES FOR INVESTMENT—OPTIONS FOR LICS

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