We read about and participate in many of these initiatives at international, regional, national and local levels taking various forms like “indabas”, seminars, conferences you name it, and a lot of corporate and professional time is going into these.
There is also talk of plans to introduce major reforms in the income tax legislation in Zimbabwe.
One of the major issues discussed at such initiatives to attract investment is taxation and in particular how “competitive” our tax laws are regionally. There is a lot of justification put to tax competition in traditional economics essentially saying it improves competition among nations, promotes investment among a host of other advantages advanced. This orthodox thinking which is abundantly covered in many text books will not be commented on further.
Discussion will be on the other side of the coin of tax competition, the intention being to provoke thought.
Tax competition involves governments lowering their tax rates and offering various tax incentives in order to attract investment against their neighbours or competitors.
The tax incentives take various forms and can be based on various factors like; profit/income, capital investment, labour, sales, value added imports, exports or other expenses.
One country starts the process by lowering its taxes and offering tax incentives in order to gain an advantage over its rival countries.
The other countries in turn lower their taxes in retaliation and thus a “race to the bottom” starts. At the end of the race all the participants end up losing and in an overally less favourable economic position than they would otherwise have been.
They end up with less tax revenue. This race is common in a number of regions globally and is evidenced by tax legislators and planners in a country trying to match or beat their neighbours in terms of “tax attractiveness” during national budget preparations or in crafting national tax legislation.
We have heard on various occasions, voices crying out that Zimbabwe has the most unattractive tax regime in the region. The cries are designed to coax Zimbabwe to participate in or initiate a tax competition –– which may lead to a race to the bottom for the region.
What is often not realised is the fact that some of these countries may be using tax competition to attract investment because of lack of natural and other resources and therefore the only way they can attract investment is through tax competition.
Others may have other negatives, social or otherwise which they would like to counter by tax competition.
In Europe this race has degenerated in the establishment of tax havens like islands of Guernsey, Jersey, the Isle of Man, and Channel Islands with some of these offering zero tax rates to companies, both resident and non-resident.
It is important to note that current studies on tax inducements in China, Brazil, Mexico and India, (all successful economies in their own right) have concluded that tax inducements might have had negative impacts and unintended results in these countries.
The conclusion was arrived at after realising that the tax incentives, subsidised financing, and free land offered to investors did not significantly increase volume of investment but lowered the values of those investments that would have been made anyway even without the incentives.
Currently empirical evidence is also showing that non-tax related factors like good physical infrastructure, transport, water supply, enablers like electricity supply, telecommunications; an educated workforce with good work ethics, stable social, economic and political conditions, good governance, transparency, accountability and the like are more important in investment decision than perceived impact of tax regimes on the same.
When considering applying tax reduction initiatives to attract investment, it is important to take them as part of a total package which includes all the other factors mentioned above.
It’s no good going for massive tax competition initiatives but at the same time ignoring all or some of the other more important factors mentioned above.
It’s a misdirected effort and will lead the country to greater heights of poverty because the tax base will have been eroded but no investment attracted at all.
Despite the realities mentioned above, governments still engage in tax competition and this is to a large extent a result of these governments being under pressure especially from advisors and consultants to offer tax incentives to attract investment.
Additionally multinational companies do at times exert their influence and power to secure preferential treatment and can influence the formation of laws, regulations and state policies to their own advantage at the expense of the general public. This becomes a form of “state capture” and can lead to corruption and lack of transparency.
Some of the incentives commonly used relate to export processing zones, specific exemptions for certain sectors, subsidised infrastructure costs such as energy, water charges, tax holidays, and free land.
Tax holidays tend to be granted blindly without regard to the nature of business like profit patterns and life of business.
Tax competition to the bottom has several negative effects on economies. They distort market forces by being discriminatory in giving significant financial advantages to external investors and put local business at a disadvantage in cases where they are structured that way.
This advantage to inward investors is compounded by the ability of multinationals through complex global tax planning to engage in tax evasion through any of the following means, “transfer pricing”, “off-shoring of profits” to tax havens otherwise known as “profit-laundering” which is a massive problem on its own.
The other negative result of tax competition is that it shifts tax charges from capital, which is a very mobile factor of production towards less mobile factors like labour (through Pay as you earn (Paye) and other employment taxes) and consumers (through Value added tax Vat). This leads to high levels of Paye and Vat. The high levels of Paye and Vat impact negatively on labour and consumers and are very regressive on personal wealth and income distribution.
The reduced tax revenues caused by tax competition lead to governments failing to fulfill their mandate on public expenditure, schools, health, social welfare and lead to a general reduction in the standard of living of the citizens further leading to greater dependence on foreign aid which has proved not to be effective in improving the welfare of recipient country citizens on a sustainable basis.
Generally tax measures which give a significantly lower level of tax than levels generally applicable in a region have a potential of creating tax competition and eventually lead to all participating nations loosing out through reduced tax revenue which impact negatively on the development of the country and the well being of its people.
Extreme caution is therefore needed in the process of drafting tax legislation meant to attract investment to avoid undesired negative consequences.
Country specific realities have to be considered in the process and more importantly that process must be part of a broad package that addresses all the other factors that affect investment decisions and not taken in isolation.
Mabheju is the CEO for the Institute of Chartered Accountants Zimbabwe. He can be contacted on firstname.lastname@example.org