United nations of tax incentives

Part I: Theoretical Background
accrue to the host country. Furthermore, tax holidays exempt profits 
with no regard to the level or amount of profits that are earned. For 
potential investments that investors believe will earn above market 
returns, tax holidays will result in a loss of tax revenue without any 
benefits. Because of the high return, investors would have undertaken 
these projects even without the availability of tax incentives.
 22 
Investment allowances and credits
As an alternative, or sometimes in addition, to tax holidays, some 
Governments provide investment allowances or credits. They are given 
in addition to the normal depreciation allowances, with the result 
that the investor may be able to write off an amount that is greater 
than the cost of the investment. An investment allowance reduces 
taxable income, whereas an investment tax credit is set against the tax 
payable, therefore, with a corporate income tax rate of 40 per cent, an 
investment allowance of 50 per cent of the amount invested equates to 
an investment credit of 20 per cent of that amount.
Investment allowances or credits may apply to all forms of 
capital investment, or they may be restricted to specific categories, such 
as machinery or technologically advanced equipment, or to capital 
investment in certain activities, such as research and development. 
Countries occasionally limit eligibility to contributions to the charter 
capital of the firm, an approach that may encourage investors to 
increase the relative amount of equity capital rather than related-party 
debt capital in the firm’s initial capital structure.
One objection to the use of investment allowances and credits 
is that they favour capital intensive investment and may be less 
favourable towards employment creation than would tax holidays. 
They may also distort the choice of capital assets, possibly creating a 
preference for short-lived assets so that a further allowance or credit 
may be claimed on their replacement.
Investment allowances and credits seem preferable to tax 
holidays in almost every respect: (a) they are not open-ended; (b) the 
22 
Vito Tanzi and Howell H. Zee, “Tax policy for emerging markets: developing 
countries” (Washington, D.C., International Monetary Fund, 2000).

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26
Design and Assessment of Tax Incentives
revenue cost is directly related to the amount of the investment, so 
there should be no need for a minimum threshold for eligibility; and 
(c) their maximum cost is more easily estimated. However, a recent 
study does find that investment credit and allowances are significantly 
less effective in attracting foreign investment than are tax holidays.