In part one, we considered issues on the costs and benefits of tax incentives and according to numerous research done, FDI tax incentives are not necessarily among the top factors influencing location decisions by foreign investors. 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. Here we must also not particularly forget the ability of foreign investor to repatriate dividends or profits without difficulty as a key determinant.
It has however been found that, in suitable economic environments, "targeted tax incentives” tend to be more effective and efficient, and therefore more likely to achieve specific socio-economic development objectives. These tax incentives can be used to target specific sectors of the economy, for example manufacturing, ICT, renewable energy and so on, to better align them with the national development agenda.
Targeted tax incentives identify the types of investment that the host governments seek to attract, and reduce the revenue cost side of incentives. Narrowly targeted incentive schemes have been found to be less difficult to enforce than broadly targeted ones. Furthermore, targeted tax incentives may also promote and encourage economic and social spill-overs, for example, tax incentives that foster linkages with local firms have proven very effective.
There is then what is termed efficiency seeking FDI. It has been found that efficiency-seeking FDI is more responsive to tax incentives than market and resource-seeking FDI. Efficiency-seeking FDI (as opposed to resource seeking FDI which targets natural resources) invests in countries where it can exploit cost advantages in production (cheaper local production costs) for the global market and thus gain a price competitive advantage. Investors therefore are attracted to the most cost-competitive locations where tax incentives can provide significant cost advantages.
From research done by the World Bank, it has been found that cost-based tax incentives are generally preferable to profit-based tax incentives in terms of both effectiveness and efficiency. Profit-based tax incentives, (e.g. income tax exemption and tax rate reduction) directly lower the tax amount, regardless of the actual investments made. The tax benefit to the company is a function of profit. On the other hand, cost-based tax incentives (e.g. accelerated depreciation, tax allowances and credits), deduct the investment costs from either taxable income or tax amount. Thus, the tax benefit to the company is directly related to the size of the investment undertaken.
According to further research done by the UN, cost-based tax incentives attract investments that would not otherwise have been made by making the project profitable. They tend to be less prone to tax evasion or avoidance. They also have advantages in targeting specific activities, such as SME linkages, skills development, and localized supply chain development by attaching those requirements to incentive provisions. However, they require higher tax administration capacity, which is often lacking in low-income countries.
What then are the key elements for effective and efficient use of tax incentives to attract FDI? How do we design appropriate incentives, manage them effectively and ensure proper governance? These are the questions that ought to occupy the minds of all, including Rwanda’s policy makers.
The design of tax incentives needs to be driven by the national development or transformation strategy. In the case of Rwanda, the National Strategy for Transformation (NST) must inform the design of tax incentives. Rwanda has established quite a comprehensive FDI promotion strategy in line with its long-term development plan as it seeks to achieve the objectives of Vision 2050. Any FDI promotion strategy should not only focus on tax incentives, but must also include non-tax measures.
Tax incentives should be provided and managed in a transparent manner for predictability by potential investors and the accountability of the government. This requires that comprehensive tax incentives inventories with up- to-date information be accessible and publicly available. Also the idea of a one stop investment centre, as is the case with Rwanda, is critical.
On the governance side, tax incentives should be law and there should be good coordination among government agencies. Tax regulations should be minimised to avoid mis-interpretation or abuse.
Well-designed tax incentives, managed properly under a supportive governance framework, can attract FDI, enhance spill-over benefits and reduce unnecessary revenue losses.
Systematic monitoring and transparent assessment are the key to a good tax incentive management system. The first and most important step to upgrade the management of tax incentives is to establish a comprehensive monitoring framework, which is a prerequisite for the proper assessment of tax incentives. The adoption/renewal/expiration of tax incentives is a prerequisite. Everlasting or automatically extended types of incentives should be avoided with a predetermined sunset clause.
Strong regional cooperation is also key especially to prevent cross-border tax evasions. Policy coordination to reduce tax competition among member economies within the EAC for example, will allow the members to attract more FDI at lower costs collectively.
In conclusion, from the above, it is therefore quite obvious that targeted cost (not profit) based efficiency seeking (not resource seeking) tax incentives can work effectively. Policymakers need to spend time designing most suitable FDI tax incentives, ensuring that there are institutional systems and capacity to manage them effectively, and also to ensure they are monitored regularly so that they remain in line with the long term development agenda, particularly the achievement of vision 2050 in the case of Rwanda.
Vince Musewe is an economist and you can contact him directly on vtmusewe@gmail.com