Review of corporate tax incentives for investment in low- and middle-income countries

Corporate income tax is an important source of revenue for many low- and middle-income countries. At the same time, many such countries lose much needed revenues by providing corporate tax (and non-tax) incentives in the hope of attracting mobile business investments, incentivising specific geographic areas and industrial sectors, or addressing market failures. Many countries thus face a difficult trade-off between raising vital revenues and maintaining an attractive corporate tax environment in a world of increasingly footloose capital and international tax competition that can lead to a race to the bottom.

Against this background, there is scarce evidence about the cost and benefits of tax incentives in developing countries, which hinders evidence-based policy-making. This paper, written collaboratively by IFS researchers and policy-makers from Ethiopia and Ghana, has multiple and interlinked objectives: (i) to provide an overview of tax incentives and best practices for their design grounded in economic principles, and assess how these apply to the case studies of Ethiopia and Ghana; and (ii) to understand more broadly the causal impacts of tax incentives on economic outcomes in developing countries by reviewing the relevant methodologies to conduct rigorous quantitative analysis  and the existing empirical literature. Finally, we discuss the policy implications and avenues for research given the existing literature on the causal impact of tax incentives.

Key points

• Corporate income tax is an important source of revenues in low- and middle-income countries (LMICs). At the same time, many LMICs provide corporate tax incentives hoping to attract mobile business investments, promote specific geographic areas and industrial sectors, or address market failures. It is unclear whether these policies are effective in reaching their goals, while the associated costs are likely very significant.

• Best practices for tax design provide valuable information for the economic rationale of tax incentives. The economic case is stronger for some incentives, e.g., tax incentives for export-oriented and footloose investments that are likely to be sensitive to cost factors, including tax. However, many LMICs provide wide-ranging incentives, sometimes with a high degree of variation across narrowly defined industrial sectors and geographical areas. These types of non-neutralities generate costs beyond foregone revenues, by creating economic distortions and complexities; putting non-targeted firms at a disadvantage; inducing avoidance and rent-seeking behaviour associated with corruption; and increasing compliance, administration and enforcement costs.

• Evidence on costs and benefits of tax incentives in LMICs is scarce but increasing. Existing studies on the causal impact of tax incentives are inconclusive and the results are mostly context-specific.

• More empirical evidence is needed to assess the costs and benefits to the tax system and the economy more broadly. Measuring the causal impact of tax incentives is complex and data intensive. Due to better data and new econometric techniques, there is increasing scope for new and better impact evaluation.

• Given current evidence and economic principles, it is better to avoid tax incentives unless there is a very strong economic rationale, while opportunities for abuse and cost of implementing and monitoring are low.