The political economy of tax incentives in low-income countries
The ICTD Annual Centre Meeting on tax exemptions concluded with a presentation by Professor Richard Bird.
Drawing on his vast experience, Professor Bird summarised key practical messages about tax exemptions, while challenging the audience to move beyond the stale debates that have been repeated for almost four decades.
His key message on systems of tax exemptions in low-income countries?
They are overwhelmingly political, shaped not only – or even primarily – by the efficiency concerns of economists, but by the desire to deliver important benefits to key political constituencies. This line of reasoning signifies that tax exemptions will persist, despite economists’ equally persistent demonstrations of exemptions’ distortionary economic effects.
This conclusion seems to offer little in terms of policy reform prescriptions; however, Professor Bird highlighted where there may be policy space for reform – namely, in the identification of strategies for overcoming political resistance to reform and in the design of transparent and nonpermanent tax exemption regimes.
New studies, same conclusions
Tax incentive regimes in low income countries are ostensibly intended to attract foreign investment and to increase the international competitiveness of resident firms. While the rationale is clear, there is no evidence in practice that tax exemptions are effective in achieving this goal. Studies have shown time and again that tax exemptions lead to inefficiency costs, while the associated lack of transparency has negative implications for development and good governance.
Tax incentives have been widely condemned by economists, tax experts, and, more recently, the IMF for a few primary reasons that are repeated, rephrased, and repeated again. First, tax incentives may be a particularly destructive form of tax competition, leading to a “race to the bottom” that undermines tax revenue potential across the developing world. Second, incentive regimes tend to be poorly targeted, with many of the benefits accruing to firms that would have invested or been equally competitive in the absence of the incentive. Third, the granting of incentives may create economic distortions, drawing resources toward less efficient activities and undermining long-term growth.
It’s all politics
From an economist’s perspective, the persistence of tax incentive regimes in low-income countries thus seems inexplicable. It is clear, however, that there are powerful political reasons why tax exemptions are given, and why they persist despite weak economic rationale. They may be politically attractive as a means of delivering patronage benefits to key interest groups, as well as a low-effort means of signaling commitment to private sector development. Once in place, they are notoriously difficult to reform or repeal.
Essentially, tax exemptions are inefficient policies given for political reasons.
Tax exemptions are a fairly basic political instrument, and one that is unrealistic to expect governments to surrender. Mired in politics, they will persist in low-income countries for the foreseeable future. So is there even any point in pursuing the issue further?
With a touch of optimism, we can assume that there is some degree of policy space for reform, which leads us from defeatism to pragmatically consider less harmful ways of designing and implementing tax incentive programs. What follows are a few basic principles for reform that may reduce the incidence and adverse impact of tax exemptions.
Transparency, transparency, transparency
(1) Keep tax exemptions simple and transparent. It is often a challenge simply to get a clear sense of the structure and costs of a tax incentive regime. Despite general support for a rationalisation and significant reduction in incentives and exemptions, initiating constructive discussion of reform options in low-income countries has long been hampered by the absence of simple monitoring data that quantifies the associated direct revenue losses. At the same time, the continued absence of transparency has served to reinforce the assumption that politically powerful interests have misused these policies. Greater transparency would allow for empirical technical analysis, while also shifting the political debate by opening up existing policies to public scrutiny.
(2) Record exemptions through standard processes – and again, keep them transparent. The best way to provide incentives is to have investors file taxes through standard processes and to grant exemptions at the end of the tax return, rather than providing exemptions or tax holidays that obviate interaction with the tax administration. By keeping exemptions on record with the tax administration, transparency would be strengthened, as it would quickly be obvious which actors benefit from exemptions and to what degree. Evidently, this is the same reason why governments generally have no independent incentive to process exemptions through standard tax filing procedures.
(3) Never give an incentive without an end – and seriously, keep them transparent. If sunset provisions are not included in agreements, political incentives will ensure the staying power of inefficient policies. To mitigate these political incentives, negotiated agreements should require the renewal of tax exemptions to ensure that they are not, in effect, permanent policies.
The way forward: Transparency as the basis for reform-minded political leadership
Without greater transparency supported by local and regional civil society organisations, little can be done to address the underlying issue – that the incentives to introduce and maintain tax incentives are inherently political and thus resistant to independent reform. Grounded in research that brings to light details of existing incentive systems and shares strategies for overcoming the political obstacles to reform, greater transparency is the foundation for reform-minded political leadership and civil society engagement.