United nations of tax incentives

Part I: Theoretical Background
Although a general description can be provided of the possible 
types of benefits from the additional investment that results from tax 
incentives, it is difficult to quantify them with any degree of certainty 
and, at times, benefits accrue to persons other than the firm receiving 
the tax benefits.
B . 
Costs of tax incentives
In considering the costs of a tax incentive regime, it may be useful to 
examine four different types of costs: (a) revenue costs; (b) resource 
allocation costs; (c) enforcement and compliance costs; and (d) the 
costs associated with corruption and lack of transparency.
 18 
Revenue costs
The tax revenue losses from tax incentives come from two primary 
sources: forgone revenue from projects that would have been undertaken 
even if the investor did not receive any tax incentives and lost revenue 
from investors and activities that improperly claim incentives or shift 
income from related taxable firms to those qualifying for favourable 
tax treatment.
Policymakers seek to target tax incentives to achieve the 
greatest possible benefits for the lowest cost. The ideal scenario 
would be to offer tax incentives only to those investors at the margin 
who would invest elsewhere but for the tax incentives. Offering tax 
incentives to those investors whose decisions to invest are not affected 
by the proposed tax benefit merely results in a transfer to the investor 
from the host Government without any gain. It is very difficult to 
determine on a project-by-project basis which ones were undertaken 
solely due to tax incentives, much as it is difficult to estimate for an 
economy as a whole what the levels of investment would be with or 
without a tax incentive regime.
For those projects that would not have been undertaken 
without tax incentives, there is no real loss of tax revenue from those 
18 
Howell H. Zee, Janet Gale Stotsky and Eduardo Ley, “Tax incentives for busi-
ness investment: a primer for policymakers in developing countries”, 
World Develop-
ment
, vol. 30, No. 9 (2002).

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16
Design and Assessment of Tax Incentives
firms. To the extent that the firms become regular taxpayers or that 
their operations generate other tax revenue, such as increased profits 
from suppliers or increased wage taxes from employees, there are 
revenue gains from those projects.
An additional revenue cost of tax incentives results from the 
erosion of the revenue base due to taxpayers abusing the tax incentive 
regimes to avoid paying taxes on non-qualifying activities or income. 
This can take many forms. Revenue losses can result when taxpay-
ers disguise their operations to qualify for tax benefits. For example, 
if tax incentives are available only to foreign investors, local firms or 
individuals can route their local investments through foreign corpo-
rations; or if tax benefits are available only to new firms, taxpayers can 
reincorporate or set up many new related corporations to be treated as 
a new taxpayer under the tax incentive regime.
Other leakages occur when taxpayers use tax incentives to 
reduce their tax liability from non-qualified activities. For example, 
when a firm qualifies for a tax holiday because it is engaged in a type of 
activity that the Government believes merits tax incentives, it is likely 
quite difficult to monitor the firm’s operation to ensure that it does not 
engage in additional non-qualifying activities. Even for cases in which 
the activities are separated, it is very difficult to monitor related-party 
transactions to make sure that income is not shifted from a taxable 
firm to a related one that qualifies for a tax holiday.