According to Barbour (2005: 9), it is a complicated task to identify which incentives may successfully work for an economy and which kind may not work. He explains that each tax relief measure has its own benefits and shortcomings and therefore it depends on the circumstances of the economy. Klemm (2009: 5) expounds the view that tax incentives may work if they are well designed and certain conditions are met, but he also casts doubt on their benefits while pointing to the resultant costs. Several scholars and economists of note agree that despite all the uncertainty and controversy surrounding tax incentives, these instruments are still widely used in different parts of the world (Bird 2008: 9, James 2013: 36, Calitz et al 2013: 3,Zolt2014: 3). The arguments that follow, present a discussion of the advantages and disadvantages of tax incentives.
3.5.1 Advantages of tax incentives
The Nathan-MSI Group (2004: 3-1) indicates that tax incentives can lead to higher profits on the side of investors. They argue that relief which allows the reduction of imposed tax on income results in a higher return on the investors’ investments. James (2013: 41) identifies that businesses could greatly benefit from tax holidays and become more profitable. The IMF et al (2015: 16) agree with James (2013: 41) on tax holidays leading to higher profits for investors. They argue that tax holidays would benefit companies that could start making profits sooner in the holiday period rather than long term investments that could start being profitable in the long run.
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Calitz et al (2013: 8) argue that tax incentives play a part in compensating for other shortages in the investment climate. They explain that authorities may consider attracting investment; however, they could be finding it difficult to deal with the main issues that could be discouraging investors. Babatunde (2012: 6) agrees that tax incentives are being used to compensate for other shortcomings in the investment climate. Klemm (2009: 19) also believes that tax incentives can be utilised in compensating for deficiencies in the investment climate. He explains his view with an example that for a country with low investment rates as a result of poor tax administration, the ultimate solution would be to reform the tax department. Klemm also argues that in a case where such reform would be politically impossible, a consideration would be made for the introduction of a special economic zone or a tax holiday.
Furthermore, James (2013: 35 – 37) argues that tax incentives are less complicated to provide than improving the investment climate, infrastructure, or skills. The OECD (2007: 5) argues that in attracting investments, governments could find it easier to provide tax incentives than to correct deficiencies such as the lack of infrastructure and skills shortages. Tax concessions do not involve actual expenditure or cash subsidies to investors and therefore this makes it easier to provide (OECD 2007: 5). In addition, Jordaan (2012: 6) believes that fiscal incentives respond to government failures as much as they do to market inadequacies. He is also convinced that it is harder and takes a longer period to engage investment impediments than using tax incentives to counterbalance the market deficiencies.
According to Klemm (2009: 10 - 11), an incentive-laden system has the potential to reduce the harmfulness of across the border tax competition as it lessens the downward pressure on tax rates. This is contrary to the argument put forward by the Nathan-MSI Group (2004: 3-2) that tax incentives lead to tax competition when several countries wish to attract a similar investment. Klemm (2009: 10) seems to have been aware of the contradiction in his argument that tax incentives could reduce the harmfulness of tax competition hence he denoted it as being paradoxical.
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Klemm (2009: 5) argues further that, while there are possibilities of finding circumstances under which tax incentives are worthwhile, the case for most incentives remains doubtful. The Nathan-MSI Group (2004: 3-3) agrees with Klemm (2009: 5); they warn that certain arguments and opinions could be impressive in justifying the use of tax incentives, however, a well-documented analysis needs to be done to balance those considerations. This, therefore, requires an examination of the other side of the story which relates to the disadvantages or arguments and opinions against tax incentives.
3.5.2 Disadvantages of tax incentives
The Nathan-MSI Group (2004: 3-5) identifies loss of revenue by the government as one of the major disadvantages of tax incentives. Indeed a few scholars such as James (2013: 36) and Zolt (2014: 10 -12) have also lamented the costs and loss of revenue associated with tax incentives. The main purpose of tax policy should be revenue mobilisation but instead, tax incentives lead to loss of revenue. The loss of revenue occurs when tax incentives do not significantly affect the investment decision or when they are more generous than necessary (Nathan-MSI Group 2004: 3-5). Zolt (2014: 17) explains that tax incentives lead to loss of revenue by creating opportunities for businesses to engage in tax avoidance. He particularly blames tax holidays for being susceptible to this unscrupulous practice.
The additional investment caused by tax incentives in certain sectors and regions may cause the allocation of resources that may result in too much focus and investment in certain activities and at the same time too little or nothing in other non- prioritised areas. This inequality and imbalance could be brought about by tax incentives attracting investments to certain prioritised areas or sectors (Easson and Zolt2002: 11). Barbour (2005: 3) shares similar sentiments in his argument that providing tax incentives to one group of investors rather than the other, creates inequality in the investment climate surrounding potential investors and leads to an inefficient allocation of capital. Such an ‘unlevelled playing field’ for potential investors violates the principle of horizontal equity, which is one of the main pillars of a good tax system. Bird (2008: 10) points to the inequity of tax incentives alongside
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inefficiency and believes that the two symbols of tax incentives could prevent a tax system from achieving its main objective of funding essential public sector activities.
According to Klemm (2009: 12), tax incentives lead to high administrative costs incurred in preventing fraudulent use of incentive schemes. This is a view that is also echoed by Bird (2008: 10) in his warning against the excessive use of tax incentives. Bird noted that tax incentives complicate tax administration as they facilitate evasion and encourage corruption. Calitz et al (2013: 7) believe that the non-transparent nature of tax incentives promotes tax evasion, complicates tax administration, and encourages corrupt behaviour. Tax incentives pose management problems for tax administration while they also require a well-developed accountability system (Babatunde 2012: 2).
Tax incentives lead to erosion of the revenue base when taxpayers abuse the tax incentive regimes to avoid paying tax on non-qualifying income or activities (Zolt 2014: 11). Zolt adds that a closely linked scenario could be a situation where tax incentives are used by taxpayers to reduce the tax liability on non-qualifying activities and income. A similar view had earlier been echoed by the Nathan-MSI Group (2004: 3-7) when they pointed out that tax incentives lead to revenue leakage through tax avoidance and evasion. The group argues that tax incentives create opportunities for taxpayers to engage in aggressive tax planning, which in essence the Group calls tax avoidance. Calitz et al (2013: 7) also mention in their argument from a fiscal point of view that the real cost of tax incentives is hidden and that they lead to erosion of the tax base.
James (2013: 41) warns that entities could take advantage of loopholes in the tax holiday dispensation to increase their profits. He argues that entities could channel high profits through transfer pricing from a profitable company to another which is covered by the tax holiday scheme and thereby avoid paying tax on either of the two. This would pose a challenge on the side of the policy implementers. Klemm (2009: 10) also identified that a system with tax incentives would lead to many problems such as increased complexity and reduced transparency. Tax holidays also have the potential to increase tax competition among countries. Nathan-MSI Group (2004: 3-
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2) are of the opinion that countries end up being pushed into offering tax breaks of their own to match those offered by their neighbours such that they too do not miss out on attracting investments. This is echoed in the views of Zolt (2014: 15) that there is fierce competition among countries in relation to export promotion and the attraction of export-oriented investments particularly among developing countries.
Tax incentives can be capitalised over time and they lose their purpose. Gwartney and Stroup (1986: 119 - 120) argue that when the real incentive benefits are linked to the ownership of the asset, the market value of the asset increases to reflect the present value of the expected income stream. In their assessment of agricultural price support programmes, in relation to the adverse effects of capitalisation of the incentives, Gwartney and Stroup (1986: 119) conclude that the real beneficiaries are the landowners and not the farmers. In this scenario, it could be understood that the incentive should have been meant to provide support to the farmers such that they would increase on their produce. In addition, Coetzee (1995: 59) is of the opinion that tax incentives are rent-generating restrictions because the tax saving that comes along with them is capitalised and thus their only purpose is to expand the consumption of a particular commodity. In essence, the gains of tax incentives are only transitional and after the capitalisation, the original recipients are left in no better position than they were in, before the tax privileges.
Klemm (2009: 5) suitably sums the arguments in favour and against tax incentives in his argument that it could be possible to find circumstances under which certain tax incentives are justifiable, although the case for most incentives remains doubtful. Based on the different views and opinions, both in favour and against tax incentives, it is clear that tax incentives are widely criticised by different scholars and researchers. The fact that proponents of tax concessions exist cannot be ignored. Those in favour of tax incentives gather courage from the reality that tax incentive regimes are still widely used across the world (Calitz et al 2013: 3) to drive much of the tax policy in developed and developing countries. The design of tax incentives could be crucial in determining their success or failure as indeed Zolt (2014: 9) recognises that well-designed tax incentives have achieved success in increasing
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investments. The study, therefore, looks at the design of tax incentives in the following paragraphs, together with the requisite monitoring and administration.
3.6 THE DESIGN, MONITORING, AND ADMINISTRATION OF TAX