Question

( Graphically Illustrate) A positive incentive to work associated with a reduction in income taxes

Answer 1

There are arguments for and against “spending through the tax system.” On one hand tax incentives are relatively easy to implement; they don’t require an outlay of cash and they make use of information that revenue agencies already collect. But on the other, loading the tax system with too many policy objectives conflicts with the drive for a coherent, simple, transparent tax system. Tax expenditures are harder to assess than on-budget spending and are prone to special interest lobbying and corruption, and vulnerable to of abuse. Despite decades of advice from international organisations to curtail tax incentives, they remain a popular tool for governments.

While tax expenditures can have different goals (such as reducing VAT on basic goods to make the tax system more progressive), this blog post focuses on tax expenditures used as investment incentives.

One piece of evidence that suggests that tax incentives could be cut without harming investment is that a large proportion of respondents to investment surveys say that they would have invested even without the tax incentives received. For example, a World Bank survey in East Africa found that 93 percent of respondents said the company would have invested anyway. In surveys across many countries at least 70 percent of respondents say that the tax incentives they received.

One reason is that the tax incentives are most likely to be ineffective in the face of an unattractive investment environment. Policy instability create a triple-whammy against the effective use of tax incentives. Firstly it translates into immediate business costs such as unreliable electricity supply and lack of infrastructure, meaning that the gap to project viability is larger. Secondly the general perception of country-risk raises the investor’s hurdle rate for investment.