Effectiveness of Investment Incentives in Developing countries Evidence and Policy Implications Investment Policy Workshop Vienna May 14, 2012

Plan of the Presentation The Incentives Framework The econometric evidence – Current literature – Investment Climate Department research The survey evidence – Previous surveys – Investment Climate Advisory’s surveys Incentives for Public Goods Cost of Incentives Political Economy Policy advice 2

The Incentives Framework The econometric evidence – Current literature – Investment Climate Department research The survey evidence – Previous surveys – Investment Climate Advisory’s surveys Incentives for Public Goods Cost of Incentives Political Economy Policy advice 3 Plan of the Presentation

Typical Incentives Non-Tax Incentives Grants (Training) Loan Guarantees Free Land/Electricity, etc Pricing (Feed-in-Tariffs) 4 Tax Incentives Tax holidays Special zones Investment tax credit Investment allowance Accelerated depreciation Reduced tax rates Exemptions from various taxes Financing incentives

The Benefits and Costs of an Incentive Policy Revenue rise due to increased investment Social benefits from increased investment Indirect cost of incentives Lost revenue from investments that would have been made anyway > + + Benefits 5 Social Benefits include cleaner environment, better skills, better health, etc. Costs

The Incentives Framework The econometric evidence – Current literature – Investment Climate Department research The survey evidence – Previous surveys – Investment Climate Advisory’s surveys Incentives for Public Goods Cost of Incentives Political Economy Policy advice 6 Plan of the Presentation

7 The Effectiveness of Tax incentives in West/Central Africa

Source: James and Van Parys, Impact of Investment Code on FDI

Finding in UMEOA/CEMAC Case Study General Tax Holiday  Investment  Export Tax Holiday  Investment   Complexity Incentives  Investment  Legal Guarantees  Investment  9

10 The Effectiveness of Tax incentives for Tourism Investment in the Caribbean Organization of Eastern Caribbean Countries

Finding in OECS Case Study Tourism Incentives  Tourism Investment  Tourism FDI ( Thousand Eastern Caribbean dollars) Antigua ECCU6 11 Source: James and Van Parys, 2009

Almost no impact of lowering Effective Tax Rates on FDI in low IC countries 12 Source: James and Van Parys, 2009

The Incentives Framework The econometric evidence – Current literature – Investment Climate Department research The survey evidence – Previous surveys – Investment Climate Advisory’s surveys Incentives for Public Goods Cost of Incentives Political Economy Policy advice 13 Plan of the Presentation

Tax incentives are one of the least important factors in investment decisions

Results from Surveys AuthorFocus of surveyRedundancy ratio for incentives Did Incentives influence Investment level Investment Climate Advisory (FIAS)—Investor motivation surveys and incentives Jordan (2009)70%28% Mozambique (2009)78%13% Nicaragua (2009)15% (51% for non- exporting firms outside free zones) 17% Serbia (2009)71%6% Thailand (1999)81% Ghana (Agriculture, 2010)69% Tanzania (2012)91.2%30% Rwanda (2012)97.7% Burundi (2012)77.4% Uganda (2012)92.7% Phu et. Al. (2004)Vietnam85% 15

Investor responses do not depend on foreign ownership or size Would your company have invested without tax incentives?

Tanzania: Marginal investors only created 16% of all new, national permanent jobs CategoryConventionsComm. Telecom TransportWater suppliesIndustry/Ma nifact Other sectors cumulative Total jobs created – selected sectors Total jobs created – All sectors MI (Raw count) 1, ,0963,0925,188 MI (Percentage) 62%14%43%100%6%11%21%16% NMI (Raw Count) 7164, ,80317,19011,61728,807 NMI (Percentage) 38%86%57%0%94%89%79%84% Total1,9164,9101, ,17419,28614,70933,996 *Sectors are selected based on the highest number of representation in the survey  Investors who said “would not have invested without incentives” created more jobs in sectors of conventions, exhibitions and water supply than investors who said that they did not need incentives to invest.

The Incentives Framework The econometric evidence – Current literature – Investment Climate Department research The survey evidence – Previous surveys – Investment Climate Advisory’s surveys Incentives and Public Goods Cost of Incentives Political Economy Policy advice 18 Plan of the Presentation

Incentives and Public Goods Investment incentives are recommended when – Investment assets available to general public (eg road, school) This is just another way to pay for public goods – Investments generate positive externalities Encouraging Green Technologies Upgrading skills of workers Anchor investments (but have to be justified) Infrastructure 19 *: First best is to tackle the tax competition issue

Tax competition Race to the bottom – Evidence shows that countries compete by lowering tax rates by providing more attractive tax holidays (Klemm and Van Parys, 2009) – Thought this cannot be extended to other kinds of tax incentives – Fighting off one country with the other is part of a strategy followed by some private sector However, in many cases the final choice is already made – ‘Winning’ countries in many cases suffer from the winners curse/buyers remorse, having given up too much – Only a coordinated response could avoid such a race to the bottom (Ex. agree on common minimum criteria) There is also evidence of a race to the top ! 20

The Incentives Framework The econometric evidence – Current literature – Investment Climate Department research The survey evidence – Previous surveys – Investment Climate Advisory’s surveys Incentives and Public Goods Cost of Incentives Political Economy Policy advice 21 Plan of the Presentation

Cost of Incentives 22 Distortion costs Time and money spent by businesses to lobby the government for incentives Time and money spent by businesses to qualify for and receive tax incentives Revenue lost to illegal activity Additional costs for tax authorities responsible for administering tax incentives

Percent Mozambique (60 respondents) Jordan (61 respondents) Serbia (50 respondents) Nicaragua (71 respondents)  Did obtaining incentives delay project implementation? 20% by 2–12 months 1% by more than 1 year  Did obtaining incentives add to project costs?  What were the main additional costs? Additional senior management time: 18% Loss of business: 15% Not an issueAdditional senior management time : 6% Additional consulting fees: 12% Additional senior management time: 26% Legal fees: 24% Loss of business: 17% 23 10% by 1–3 months 8% by 3–6 months 2% by 18 months or more Costs of obtaining incentives

The Incentives Framework The econometric evidence – Current literature – Investment Climate Department research The survey evidence – Previous surveys – Investment Climate Advisory’s surveys Incentives and Public Goods Cost of Incentives Political Economy Policy advice 24 Plan of the Presentation

Political Economy of Incentives 25 Discretionary Incentives popular with politicians Incentives have non- transparent costs Role of Governance Bargaining for Incentives

The Incentives Framework The econometric evidence – Current literature – Investment Climate Department research The survey evidence – Previous surveys – Investment Climate Advisory’s surveys Incentives and Public Goods Cost of Incentives Political Economy Policy advice 26 Plan of the Presentation

27 Tax Policy Generous Tax HolidaysPartial Tax Holidays Investment linked Tax Incentives (Investment Credits, Investment Allowances, etc) Only indirect tax incentives for capital inputs Tax Incentives only for Anchor Investments Uniform low tax rate over a broad base Tax Administration Discretionary/Non-Transparent Tax Incentives Tax Incentives in Individual Agreements Improve Transparency (Publish list of investors benefiting from incentives) Tax Incentives in Tax Laws Tax Incentives are available without additional permission No Tax IncentivesNon Fiscal IncentivesDefine Investment PolicyInvestor AftercareRemoving Regulatory BarriersInvest in InfrastructurePolicy Coordination Reform Path for Investment Incentives Policy

Key Reforms Increase Transparency – Measure the cost of Incentives (Tax Expenditure Statements) – This allows the costs to be scrutinized by the public – Place a budget on tax incentives Reduce Discretion – Replace discretionary Incentives with those that flows out of the Tax Code – This ensures the role of the legislature – Even if a ‘big’ deal has to be given tax incentives ensure that criteria is defined Tighten administration – Reduce leakage on the usage of Tax Incentives Periodically study the effectiveness – This allow the public to see for themselves if incentives work 28

Typical Reform Program Compile an Inventory of Incentives Determine how they are administered Measure their Costs (Tax Expenditures) Conduct Investor Motivation Survey – Look at the Investment side - Political Economy Do a Cost-Benefit analysis Advise on Policy to improve transparency – Define an Investment Policy to drive Incentive Policy – On Tax Policy – On Tax Administration

Questions 30

Fiscal Policy and Investment Climate (Western Europe and North America excluded) 31

Thank You.

Policy questions to ask Would the Investment come in anyway ? Does the country have any special advantages that are important to the investor ? Does the Investment provide benefits beyond the direct investment (positive externalities) ? Will the Investment generate additional tax revenue ? Would Incentives put existing investments at a disadvantage? Does it cause leakage in tax revenue ? Does it undermine the investment environment by encouraging other investors to ask for similar incentives ? 33

Incentives and Tax - Project scope This project studies incentives in 38 countries across 5 continents using, -Econometric studies -Survey of Investors 34

Investor Motivations to Invest 35 *: Grading from 1 to 5 in order of importance for 25 different factors, with 5 defined as “critical”; **: Number of businesses surveyed in respective countries Source: Investment Climate Department, 2009 Survey asked how critical were several factors to the investment decisions* (Answers in Percent )

Finding of India Case Study Export Tax Incentive  Investment  Export Tax Incentive  Reported Profits  Source: James,

37

(1)(2)(3)(4)(5)(6)(7)(8)(9)(10)(12) VARIABLESFDI as % of GDP FDI as % of GDP FDI as % of GDP ic_startic_licic_emwoic_propic_gecric_protic_tax_norateic_tradeic_focoic_clobuic_dbrank08 METR _ **-0.142**-0.184*** **-0.174**-0.138** ***-0.397*** (-1.18)(-2.62)(-2.18)(-2.79)(-0.50)(-2.28)(-2.64)(-2.07)(-1.00)(-2.95)(-3.38) IC3.068*** *1.992* *** (3.54)(-1.02)(0.37)(1.51)(1.61)(0.75)(1.02)(1.98)(1.90)(0.95)(-2.74) metr_IC-0.087*** ** **-0.077* ** (-3.04)(0.58)(0.24)(-1.00)(-2.10)(-0.77)(-0.94)(-2.25)(-1.95)(0.02)(2.55) L._GDPpc_cUSD (-1.07)(0.19)(-0.46)(-0.35)(0.06)(0.02)(-0.18)(-0.11)(-0.35)(-0.18)(-0.63) L.openness20.420**0.589***0.544**0.541***0.532***0.443*0.527***0.466**0.389*0.528***0.402** (2.32)(3.00)(2.43)(2.85)(2.81)(1.76)(2.70)(2.43)(1.83)(2.80)(2.11) inflation (-0.66)(-0.68)(-0.51)(-0.41)(-0.29)(-0.54)(-0.22)(-0.18)(-0.42)(-0.68)(-0.34) L._GDP_cbnUSD (-0.90)(-1.55)(-1.65)(-1.07)(-1.00)(-0.66)(-1.22)(-0.82)(-0.74)(-1.26)(-0.49) Constant7.330***10.121***9.791***10.144***7.060**9.595***9.667***8.575***7.672***10.731***16.340*** (3.06)(3.92)(4.01)(4.08)(2.55)(3.82)(3.88)(3.44)(2.89)(4.35)(4.86) Observations69 R-squared *** p<0.01, ** p<0.05, * p<0.1 t statistics in parentheses 38

Econometric Analysis ResearchConclusionPolicy implication Mooij and Enderveen (2003), Desai, Foley, and Hines (2004) Investments in developed countries respond strongly to incentives Tax incentives are likely to work in developed countries Klemm and Van Parys (2009)Investments in some developing countries did respond to incentives, but the elasticity was lower than that seen for developed countries. Incentives have a small impact on investments in developing countries Grubert and Mutti (2003), Rolfe and White (1991), Wells (1986) Export-oriented investments are more sensitive to tax incentives Targeted incentives are more cost effective for such businesses Investment Climate Advisory research Investments are poorly influenced by lower tax rates in countries with weak investment climates Incentive policy should take into account the readiness of the environment to encourage business 40

Would your company have invested without tax incentives? (by capital ownership)

Would your company have invested without tax incentives? (by investment amount in $US)

43

Would your company have invested without duty relief? (by country)

Investor Motivations to Invest 45 *: Open-ended question, multiple answers possible **: Number of businesses surveyed in respective countries; ***: Includes ease of import/export, employing labor, etc. Source: Investment Climate Department, 2009 Survey asked about three most critical factors for investment decisions* (Answer in Percent)