As an economist, I find it very important to continually consider the effectiveness of economic policies, especially their social impact. Many a time in Africa, we blindly copy economic policies and models from elsewhere because they sound good without us really considering whether they will have the intended social impact or not. In my opinion, the problems we face in Africa need a new approach which takes into account our unique needs and environment and then blends that with our own new ideas relevant in our time and space.

The question that has been on my mind for some time is whether tax incentives, commonly given to foreign investors, and unfortunately not local investors, really work to attract foreign investment which creates sustainable and inclusive economic growth in the long term? In other words do foreign investors invest in developing or low income economies because of tax incentives?

Tax incentives are extensively used to attract investments, although their effectiveness remains controversial. Rwanda has adopted a wide range of investment promotion measures to nurture specific sectors (such as ICT industry), encourage specific activities (such as exports), and develop specific regions (such as Special Economic Zones). This is of course necessary and commendable, but we must continually evaluate their social impact and their contribution towards achieving the national developmental agenda and specifically the achievement of Vision 2050 underpinned by inclusive growth.

Despite their wide use, however, the effectiveness of tax incentives in attracting FDI has been found to be uncertain. Many empirical studies argue that, at an aggregate level, the effectiveness of tax incentives is inconclusive or, at best marginal. It is therefore important for us to have this debate and learn how best we can attract new investments for the sake of inclusive long term socio-economic development without unnecessarily losing fiscal revenues.

For the avoidance of doubt, tax incentive instruments can be categorized by the stage and way that the instrument affects the tax amount. The instrument may reduce the actual tax amount by affecting either tax base, tax rate, or tax liability, directly or indirectly. These include;

· Tax exemption: this is exclusion from the tax base. For example income tax exemption for the first five years or Trade tax (VAT and customs duty) exemption for strategic imported goods

· Tax rate reduction; this is a reduced tax rate. For example reduced income tax rate for the businesses in the Special Economic Zone or reduced VAT rate in the mining sector.

· Tax allowance; this is a deduction of certain expenses to arrive at taxable income. For example deduction of R&D costs from taxable income or the deduction of capital investment from taxable income.

· Tax credits; this is deduction of certain expenses from tax liability. For example the deduction of training expenses from tax liability.

· Tax deferral; this is depreciation of fixed assets at a faster rate. For example a delay in recognition of taxable income.

There is no debate that FDI is a critical source of external capital for promoting economic development, especially in economies where there are very little domestic savings. FDI can indeed attract more foreign investment while indirectly contributing to economic development. However, tax incentives incur various costs these being: revenue costs, administrative costs, and distortion in resource allocation and it is important to always weigh out the costs and benefits. Unfortunately very few governments consider the costs because of the overwhelming assumption that tax incentives are necessarily good as long as more tax revenues are flowing in. In other words, we are at most times blind to the actual cost of tax incentives.

Let us consider the benefits side of the equation.

Firstly, FDI can result in the creation of new supply chain backward and forward linkages and thus create new business and employment opportunities. It can also increase productivity of an economy through adoption of advanced technologies, new skills transfers, new knowledge, and production processes. This can in turn increase competition and stimulate innovation in the economy.

Second, increased production, employment, and incomes can raise domestic aggregate demand due to increased domestic purchasing power, resulting in higher consumption levels. FDI can also increase international trade through the exports.

Third, FDI can fundamentally influence the economic structure of a country. This occurs where FDI targets specific sectors of the economy. The host country can pursue economic diversification and inclusive regional development.

Lastly, tax revenue collection can improve in the long-term after the tax incentives expire. Tax revenues collection can also increase from new supply chains, employees, and consumers.

On the costs side;

Evidently tax incentives reduce tax payable meaning that less tax than normal is collected until and if such incentives expire. This also includes the forgone revenue from projects that would have been undertaken even without any tax incentives.

Additional revenue loss may arise due to the increased complexity of the tax system. In response to tax incentives, (tax avoidance) or illegal (tax evasion), tend to increase tax non-compliance, thereby reducing government revenue collection. Overall, tax holidays and preferential income tax rates lower the effective tax burden but tend to encourage individual tax avoidance strategies. In addition, where there is discretionary and non-transparent implementation of tax incentives, particularly granting of tax incentives, this exacerbates the rent-seeking behaviour of investors and corruption of public officials, reducing tax compliance and government revenue collection.

Another issue that is normally forgotten is that there are costs related to the government’s administration and enforcement of tax incentives and taxpayers’ compliance. Costs to administer complex tax clauses include granting incentives, monitoring taxpayers’ compliance with the requirements, and enforcing termination or renewal of incentives. Administration costs tend to increase with the complexity of the tax incentive regime and the whole tax system, which also increases the compliance cost of taxpayers.

Tax incentives also lead to distortions in resource allocation by affecting investment choices among sectors and activities. More investment and labour will naturally flow into the incentivized sectors and activities which could crowd out other productive sectors and activities with insufficient investment and labour. This may distort resource allocation and thereby lower the overall productivity and efficiency of an economy.

It has generally been found that tax incentives are more effective when combined with better infrastructure and investment climates. According to surveys conducted for investors (UNIDO, 2011; World Bank, 2017), tax incentives are not among the top factors influencing location decisions. Instead, economic and political stability, transparency of regulations and legal framework, and ease of doing business matter more to investors. Studies from international organizations demonstrate that countries are most likely to benefit from tax incentives with a strong investment climate, including infrastructure, availability of skills, macroeconomic stability, market access, and clear intellectual property rights. We must not also forget the ability to repatriate profits as a key determinant.

In conclusion, it has however been found that only targeted tax incentives are more effective and efficient, and more likely to achieve specific socio-economic development objectives. These tax incentives can be used to target specific sectors (manufacturing, pioneer industries), activities (R&D, technology transfer, exports), and regions (less developed, SEZ) to better align with the national development plan. Rwanda is implementing a mix of these and the question we must ask is whether we are optimising FDI tax incentives.

I shall share some ideas on this in my next instalment.

Vince Musewe is an economist and you may contact him on vtmusewe@gmail.com