United nations of tax incentives

Part I: Theoretical Background
third parties or related “contract manufacturers”) some or all of their 
production. With improvements in transportation and communication, 
component parts are often produced in multiple countries, which 
results in increased competition for production among several 
countries. In addition, distribution arrangements have evolved, where 
the functions and risks within a related group of corporations are 
allocated to reduce tax liability through so-called commissionaire 
arrangements. Finally, there has been substantial growth in common 
markets, customs unions and free trade areas. Firms can now supply 
several national markets from a single location. This will likely 
encourage competition among countries within a common area to 
serve as the host country for firms servicing the entire area.
While tax incentives can make investing in a particular country 
more attractive, they cannot compensate for deficiencies in the design 
of the tax system or inadequate physical, financial, legal or institutional 
infrastructure. In some countries, tax incentives have been justified 
because the general tax system places investments in those countries at a 
competitive disadvantage compared with other countries. It makes little 
sense, however, to use tax incentives to compensate for high corporate 
tax rates, inadequate depreciation allowances or the failure to allow 
companies that incur losses in early years to use those losses to reduce 
taxes in later years. The better approach is to bring the corporate tax 
regime closer to international practice, rather than grant favourable 
tax treatment to specific investors. Similarly, tax incentives are a poor 
response to the economic or political problems that may exist in a 
country. If a country has inadequate protection of property rights, rigid 
employment laws or a poorly functioning legal system, it is necessary 
to engage in the difficult and lengthy process of correcting these 
deficiencies rather than provide investors with additional tax benefits.
The effectiveness of tax incentives is directly related to the 
investment climate (including investor confidence that a revenue 
authority will actually honour tax incentives without controversy) in 
a particular country.
 9 
While two countries could provide identical tax 
9 
See Stefan Van Parys and Sebastian James, “Why Tax Incentives May be an 
Ineffective Tool to Encouraging Investment?—The Role of Investment Climate”, 
International Monetary Fund, World Bank Group (Washington, D.C., IMF; World 
Bank Group, 2009), available from http://ssrn.com/abstract=1568296.

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8
Design and Assessment of Tax Incentives
incentives (for example, a 10-year holiday for corporate income taxes), 
the relative effectiveness of the incentive in attracting foreign direct 
investment is substantially greater for the country with the better 
investment climate.