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10 Tax Concessions and Foreign Direct Investment in the Eastern Caribbean Currency Union

Author(s):
David Robinson, Paul Cashin, and Ratna Sahay
Published Date:
September 2006
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Author(s)
Jingqing Chai and Rishi Goyal 

Tax concessions—defined as preferential tax treatment for certain types of firms or entities—are commonplace in developed as well as developing countries. Concessions are granted to promote investment, in which case they may be termed tax incentives or investment incentives, or to achieve defined social objectives. For example, corporate income tax (CIT) holidays for five to 10 years may be granted to firms that export goods and services or that locate in designated areas or regions. Exemptions from import-related duties and taxes may also be given, which may be on capital imports to promote investment or on a wide range of other imported goods for statutory or civic bodies or nonprofit organizations.

Cross-country experience in the use of tax concessions is varied. The trend of using tax concessions to attract foreign direct investment (FDI) has continued, and some countries have granted increasingly generous concessions, for instance, by extending the duration of existing tax holidays. However, realizing that concessions can be very costly as a tool to promote investment, many countries have begun taking legal and administrative steps to restrict eligibility criteria and enforce compliance (UNCTAD, 1996; Easson, 2004).

Evidence on the effect of tax incentives in developing countries is limited. The emerging consensus from this research is that a country’s overall economic characteristics may be more important for attracting successful investments than any tax incentives; and even if tax incentives play a role in securing an investment, they are not generally cost effective (Zee, Stotsky, and Ley, 2002). In a recent survey of 159 multinational firms operating in the Caribbean, tax concessions were not among the top 15 of the 40 areas that firms considered critical for their investments (Foreign Investment Advisory Service, 2004; World Bank, 2005). Although there is some evidence that when all else is equal tax concessions can tilt the balance in favor of a particular location, it is generally considered much more effective for a country to attract investment by building genuine economic advantages and a conducive investment environment—including a stable, low, and transparent tax policy—rather than by simply offering incentives (UNCTAD, 2004). Based on individual country experience, Easson (2004) shows that competition often leads to overly generous terms, rendering the investments cost ineffective.

Another branch of research examines the effect of taxes on FDI, using various measures of the tax rate including the average effective tax rate, the marginal effective tax rate, or the statutory rate on investment (Zee, Stotsky, and Ley, 2002 ;Sosa, 2006). Few studies include tax incentives directly, largely because the data on the use of tax incentives are sparse.

This chapter adds to the literature on tax concessions in developing countries. It documents the use of concessions in six Eastern Caribbean Currency Union (ECCU) member countries,1 assesses the costs in terms of revenue forgone, and evaluates the effect of tax incentive regimes on FDI in a wide sample of countries. The chapter uses measures of FDI and tax incentive regimes as constructed in Wei (2000), who examines the effect of corruption on FDI. In a sample of 40 countries with mostly middle-and high-income economies, Wei found that FDI restrictions discourage and incentives encourage such investment. This chapter expands the sample to cover many developing and emerging market economies. The main finding is that the ECCU countries rely heavily on the use of tax concessions, and that reliance on these concessions has increased significantly in Antigua and Barbuda and in St. Kitts and Nevis over the past decade. In the region, tax revenues forgone are large, ranging from 9½ to 16 percent of GDP annually, while the effect of tax incentive regimes appears to be modest.

Previous work on tax concessions in the ECCU has analyzed costs in terms of revenues forgone and proposed administrative reforms. Bain (1995) assessed the costs in the early 1990s, while and rews and Williams (1999) suggested that the regime of administering concessions be streamlined. Lecraw (2003) made the case for a coordinated, harmonized approach to granting concessions. This chapter builds on this work, providing updated and additional calculations of revenue forgone, and analyzing benefits in terms of attracting FDI.

Tax Concessions in the ECCU

Tax concessions have been employed as a central component of the development strategy of ECCU member countries. The purposes for which concessions are granted can be broadly divided into two categories: tax concessions granted to induce investment (also called tax incentives), and concessions granted for regional, social, and welfare purposes. As will be shown below, contrary to the purported policy justification of stimulating investment, at least for import-related tax concessions, most revenue forgone from the granting of tax concessions was not investment related.

Concessions for investment in sectors such as tourism and light manufacturing have generally been provided through the member countries’ Fiscal Incentives Act, Aid to Pioneer Industries Act, Hotels Aid Act, and sector-specific acts (such as the Offshore Banking Act and the International Business Companies Act). Tax concessions granted for regional, social, and welfare purposes are provided in the Common External Tariff Act, in specific legislation covering statutory bodies, state enterprises, large individual institutions (such as utilities companies), or in special government arrangements with regional or international bodies regarding the tax treatment of diplomats and returning residents.

Concessions are typically granted in the form of import-related tax exemptions and CIT holidays, and there is some evidence that competition in the tourism market has led to more generous terms of concessions as provided in the Hotel Aid Act. Exemptions from import-related taxes (import duties and the general consumption tax) on the importation of capital goods (raw materials and equipment) are the most common forms of concessions. Such exemptions may be on 100 percent of taxes and duties owed, or for lesser amounts. They may also be granted for varying lengths of time. Similarly, holidays on CIT may be of varying amounts and lengths of time. While little data are available on how the terms of the concessions have evolved over time, increasingly generous concessions appear to have been given. For instance, tax holidays granted to certain tourism facilities have been extended from a maximum of five to 25 years.

While individual country experience in the region varies, the process of granting tax concessions generally involves considerable discretion and a lack of transparency and monitoring. The laws do not provide detailed procedural rules or specific criteria for granting concessions. Rather, the cabinet or the minister of finance is vested with the authority to grant concessions, and in practice they have close to absolute discretion in all aspects of a decision, including, for example, whether the legal requirements are fulfilled in an application and what the terms of the concessions should be for an application. Moreover, there is little public disclosure of information on the decision-making process and on awarded incentives, leaving many investors concerned over unequal treatment, market distortion, and favoritism. Finally, there is little monitoring of the beneficiaries of the incentives, and the conditions set out in the awarded incentives are often not enforced, potentially leading to abuses of the system. Based on the experience of many other developing countries, these issues together tend to provide scope for corruption and rent-seeking activities and negatively affect the investment environment.

The widespread use of tax concessions has been cited as justifiable because of increased competition in the tourism market in the wider Caribbean, and because of the reported threat by firms that they would leave if the concession were not granted. Indeed, the ECCU increasingly has faced tougher competition from other Caribbean countries (Figure 10.1).2 One reaction has been a divergence from the 1973 Caribbean Community Agreement to harmonize concessions (Lecraw, 2003). Moreover, multinationals and other large regional firms have tended to play one island off against another, thereby encouraging a race to the bottom (Box 10.1).

Figure 10.1.Regional Comparisons: GDP Growth and Tourism Receipts

Real GDP Growth (In percent)

Source: Country authorities. Note: ECCU denotes Eastern Caribbean Currency Union.

Revenue Costs of Concessions

The granting of tax concessions entails a number of costs: efficiency losses due to the preferential tax treatment to certain investors and consumers; revenue costs arising from forgone revenue; administrative costs; and social costs from corruption or rent-seeking associated with the abuse of tax concession provisions (Zee, Stotsky, and Ley, 2002).

While all these costs could be substantial, little data are available to quantify them. Data collected from the customs departments in the six ECCU countries allows for estimating the costs of tax concessions in terms of forgone revenue. Specifically, aggregated data were used to calculate revenue forgone from tax exemptions from import duties and consumption taxes for 2001—03 for each of the six ECCU countries. The customs departments compile some data on the revenue costs of concessions related to imports, as they verify the concessions vis-à-vis cabinet decisions and record the revenue forgone based on the reported import value.

The main finding is that overall revenue losses from concessions on import-related taxes and the CIT range between and 16 percent of GDP a year. As a percent of current revenues, the losses range between 30 and 70 percent.

Box 10.1.Use of Tax Concessions to Attract Foreign Direct Investment

There is a widespread perception in the Eastern Caribbean Currency Union that incentives are needed to secure investments. The authorities consider that they are competing for similar investments and feel compelled to offer generous incentive packages out of fear that potential investors will locate their investments in neighboring countries. They may also extend incentives on existing investments to keep investors from relocating.

Given the widespread use of incentives, the perceived need for them is self perpetuating. Potential investments are at a cost disadvantage vis-à-vis existing investments in similar activities that receive incentives. Potential investors could argue for, and the authorities may feel compelled to offer, incentives to induce the new investment.

One result is investments or firms that remain continually incentive-dependent. The investment regime becomes anchored around the granting of incentives not only for new investments but also for existing ones. Such incentives become quasi-permanent subsidies for the operation of firms.

A second result is that excessively generous incentives may be offered. As countries attempt to outbid one another for potential investments, the costs of incentives may outweigh the benefits. Such situations may result especially when there are political pressures to secure investments, while the costs are nontransparent or not well calculated.

Exemptions from Import Duties and Taxes

Revenue forgone from concessions on import duties or taxes has been large in the ECCU countries, exceeding 8 percent of GDP annually and increasing over the past decade.3 The data collected by customs and excise departments in each country provided an estimate of the revenue forgone in the ECCU. For a check of consistency, the estimates were compared to estimates derived from the difference between the statutory tax rate on imports and the effective tax rate on imports. The data show that, in the early 2000s, exemptions granted ranged from 4.3 percent of GDP in Dominica to 12.2 percent in St. Kitts and Nevis (Table 10.1). In the early 1990s, exemptions granted were about 6½ percent of GDP in the region, 1½ percent less than in the early 2000s.4

Table 10.1.Eastern Caribbean Currency Union (ECCU): Customs Revenue Losses From Concessions(In percent of GDP)
1991–932001–03
Antigua & Barbuda5.19.2
Dominica4.24.3
Grenada11.411.3
St. Kitts & Nevis5.812.2
St. Lucia5.95.9
St. Vincent & the Grenadines6.76.1
ECCU average6.58.2
Sources: Country authorities (customs and excise departments); and Bain (1995).
Sources: Country authorities (customs and excise departments); and Bain (1995).

The difference between the statutory tax rate on imports (excise and duties) and the effective tax rate on imports is exploited to estimate revenue losses.5 The statutory tax rate on imports is the sum of average import duties and consumption tax levied on imports. The effective tax rate is the ratio of revenues from international transactions to total imports. The difference in rates ranges from more than 8 percent in Dominica to more than 22 percent in Antigua and Barbuda. This difference in rates yields revenue losses similar to those shown by data from the customs and excise departments of each country (Figure 10.2). Average losses are nearly 8 percent of GDP for the region, with ranges from about 4 percent of GDP in Dominica to over 12 percent in St. Kitts and Nevis.

The increase in concessions since the early 1990s has been particularly evident in Antigua and Barbuda and in St. Kitts and Nevis. Customs revenue forgone in these two countries was about 5 percent of GDP a year higher in 2001–03 compared with the early 1990s (Table 10.1).

A detailed breakdown of the revenue forgone by purpose is not available except for Dominica and St. Vincent and the Grenadines, where revenue forgone by SRO 18 codes (2001) is used to calculate the share of the customs revenue forgone for investment purposes. Concessions granted under the Fiscal Incentives and Hotels Aid Acts, together with government agreements that deal with large special investors, account for less than 50 percent in value of the total customs duty concessions, whereas concessions granted by special cabinet decisions—mostly consumption-related decisions such as exemptions on personal vehicles—accounted for about 20 percent. Concessions related to government and statutory bodies (including public investment) are in the range of 9 to 14 percent of total concessions (Table 10.2).

Table 10.2.Customs Revenue Loss from Concessions, 2001–03(Percent of total)
DominicaSt. Vincent & the Grenadines
Fiscal incentives 130.29.5
Special cabinet decisions21.023.3
Government agreements 215.833.1
Government and statutory bodies9.213.7
Personal effects and vehicles7.01.5
Tourism3.90.3
Civil servants and parliamentarians 33.50.3
Primary industry2.50.7
Military and diplomat2.50.8
Other approved purposes2.01.2
Charities and churches1.40.3
Education, culture, and health0.90.8
Transportation0.6
Unclassified. . .
Sources: Country authorities; and authors’ calculations.Note: Based on SRO 18 codes of 2001.

Primarily concessions granted under the Fiscal Incentive Act and the Hotel Aid Act.

Special legislation involving such entities as Cable & Wireless, regional bodies, and large resorts.

For Dominica, the code shows “Consumption Tax Order,” which includes such items as concessions granted to civil servants to import cars free of duty.

Sources: Country authorities; and authors’ calculations.Note: Based on SRO 18 codes of 2001.

Primarily concessions granted under the Fiscal Incentive Act and the Hotel Aid Act.

Special legislation involving such entities as Cable & Wireless, regional bodies, and large resorts.

For Dominica, the code shows “Consumption Tax Order,” which includes such items as concessions granted to civil servants to import cars free of duty.

Figure 10.2.Eastern Caribbean Currency Union: Import-Related Taxes and Revenue Forgone from Concessions, 2003

Statutory and Effective Import-Related Tax Rates (In percent)

Sources: National customs and excise departments; and authors’ calculations.

1 Average for 2001–2003.

Two caveats need to be discussed. First, data are not available on the breakdown of the purposes for which the concessions were given for the early 1990s. Therefore, it is difficult to determine if changes in the revenue costs of concessions in a given country reflect the increasing use of tax concessions based on social and welfare considerations or in order to attract investments. For example, one possibility is that concessions were increased to facilitate reconstruction after the severe natural disasters of the 1990s. Second, data on the import prices are not available. It is possible that changes in the revenue costs of concessions in a given country are due to inflation in imports or in profits rather than the use of concessions. However, given the quasi-currency board arrangements and a stable dollar exchange rate, inflation in imports in the ECCU region has been broadly aligned with that in the U.S. goods market. Consumer price index inflation in the ECCU region—where most of the CPI basket is comprised of imports—has been low, at around 2 percent over the past decade. It can be concluded that the increase in forgone revenue in Antigua and Barbuda and St. Kitts and Nevis reflects a higher incidence or more generous terms of tax concessions, rather than inflation in imports and profits.

Corporate Income Tax Holidays

Revenue forgone from CIT holidays may have exceeded 4 percent of GDP annually. In the absence of data, forgone revenue is estimated from the difference between the statutory and the effective CIT rates. The effective CIT rates are calculated by dividing the CIT revenue by an estimated CIT base.6 Statutory rates range between 30 and 40 percent in the region, whereas effective rates are between 6 and 20 percent. Given the large differences, estimated forgone revenue is also substantial, ranging from 3 percent of GDP in Grenada to about 6 percent in Antigua and Barbuda (Figure 10.3).

Figure 10.3.Eastern Caribbean Currency Union: Corporate Income Taxes (CIT) and Revenue Forgone from Concessions, 2003

Statutory and Effective Corporate Income Tax Rates (In percent)

Sources: Country authorities; and authors’ calculations.

Table 10.3.Eastern Caribbean Currency Union (ECCU): Corporate Income Tax Collections(In percent of GDP)
1990–941999–2003
Antigua & Barbuda2.12.5
Dominica3.40.9
Grenada3.23.6
St. Kitts & Nevis2.7
St. Lucia4.24.0
St. Vincent & the Grenadines4.54.4
ECCU average3.53.0
Sources: Country authorities; and authors’ calculations.
Sources: Country authorities; and authors’ calculations.

CIT yields have declined since the early 1990s, which could reflect an expansion in concessions granted. The average yield fell moderately from 3.5 percent of GDP from 1990–94 to 3 percent from 1999–2003 (Table 10.3). Declines were observed in some countries, particularly Dominica, but increased somewhat in two countries, although from low bases.

The decline in yields came at a time when CIT collections had eroded across many developing countries. With capital market integration appearing to have strengthened, low tax rates could be expected to apply to internationally mobile capital, all else being equal. If low rates are not applied, capital could be moved to other lower tax rate destinations.

Two assumption were made to derive the estimates: perfect tax administration and an even distribution of the aggregate profits.7 Given relatively weak tax administration and a profit distribution skewed toward larger firms with excess profits in the ECCU, the biases go in opposite directions. Because of the considerable problems with tax administration, part of the estimate is due to leakages in tax administration rather than increasing use of CIT concessions. This tends to bias our estimates of the tax concessions upward. Very little data are available to quantify the distribution of profits in the region. However, discussions with inland revenue departments and banks suggest that a handful of large firms that currently enjoy tax holidays and other tax concessions have been very profitable, while many smaller firms have been struggling, especially in low tourism seasons. Therefore, the “actual” CIT tax base may be greater if this uneven distribution of profits is taken into account. This means that the effective CIT rate may be overestimated, biasing downward the estimate of tax concessions.

Revenue Collection from Removing Concessions: An Elasticities Approach

A common perception in the ECCU is that investment and revenue collection would decline in the absence of concessions. While there is agreement that revenue is forgone due to concessions, some consider that investments would not have taken place without the concessions. Hence, they argue that the employment and revenue resulting from the new investments that benefit from concessions are net gains.

However, calculations based on plausible demand elasticities suggest that revenue collections could increase substantially by removing concessions. Depending on demand elasticities, higher effective tax rates could offset declines in import volumes and corporate incomes were concessions to be removed. For instance, if demand were perfectly inelastic, then overall revenue collections would increase. But if demand were elastic, then overall revenue collections would decrease (Appendix 10.1).

Empirical studies have estimated relatively inelastic import price elasticities for developing countries, ranging between –1.0 and –0.4(Khan, 1974 ;Khan and Knight, 1988). Indeed, in small and highly open economies such as those in the ECCU that import the bulk of goods consumed and invested, and that depend mainly on high-income, relatively price-inelastic tourist clienteles, import demand is arguably inelastic.

Assuming a price elasticity of –0.7 both for import volumes and corporate incomes, the revenue gain from removing concessions is 9 percent of GDP on average, ranging from 7 percent of GDP for Dominica to 12 percent for St. Kitts and Nevis (Table 10.4).

Table 10.4.Revenue Gains from the Removal of Concessions: An Elasticities Approach(In percent of GDP)
Import-

Related Taxes
Corporate

Income Taxes
Total
Antigua & Barbuda6.24.210.4
Dominica3.14.17.2
Grenada7.82.410.2
St. Kitts & Nevis9.03.012.0
St. Lucia4.62.97.6
St. Vincent & the Grenadines4.13.27.3
Eastern Caribbean Currency Union average5.83.39.1
Source: Authors’ calculations.Note: Table assumes a price elasticity of –0.7.
Source: Authors’ calculations.Note: Table assumes a price elasticity of –0.7.

Benefits of Incentives: FDI Performance in the ECCU

The estimated revenue costs of tax concessions are large for the ECCU countries, begging the question of whether the costs can be justified by any benefits that may be derived from granting tax concessions. Possible benefits are delayed revenue benefits from induced investment and revenue from other type of taxes such as wage and hotel taxes. There are, also perceived spillover benefits flowing from FDI such as job creation, technology transfer, and improved efficiency of domestic industries.

As shown above, possibly more than half of the tax concessions are used for various social and welfare purposes in the ECCU. The quantification of the benefits that may derive from achieving such objectives is beyond the scope of this chapter. However, the conventional wisdom on social spending is that taxes and preferential tax treatments are not the best instruments to achieve social objectives. Moreover, the manner in which the tax concessions are administered in the region—discretionary, opaque, and arbitrary—provides scope for corruption and rent-seeking, which negatively affect the investment environment.

The second main policy motivation for tax concessions is to stimulate investment, both FDI and domestic investment, and to create employment. Despite the fact that concessions have increased over the past decade, the ECCU’s world ranking of FDI as a share of GDP has fallen (Table 10.5), and greater concessions do not seem to be reflected in changes in the FDI-to-GDP ratio (Figure 10.4). In an average ranking of the ratio of FDI to GDP of more than 150 countries, the ECCU countries fell from fifth to twentieth by 2002.8 The ECCU share of Caribbean FDI inflows also declined from 12.3 to 3.7 percent over the same period (World Bank, 2005).

Table 10.5.Foreign Direct Investment (FDI) Performance Index
1979–831984–881989–931994–951999–2003
Antigua & Barbuda24.112.311.43.52.6
Dominica2.58.010.9882.3
Grenada1.87.18.56.25.3
St. Kitts & Nevis12.316.419.27.08.4
St. Lucia37.410.812.14.92.3
St. Vincent & the Grenadines3.05.07.714.54.0
Eastern Caribbean Currency Union16.011.711.78.14.3
Small island economies 17.08.97.66.78.2
Latin America & the Caribbean1.81.51.42.01.6
Developing countries1.41.21.41.81.2
Sources: UNCTAD (2004); and authors’ calculations.Note: Performance index is the share of a country’s FDI inflow in the world’s FDI inflow, divided by the share of the country’s GDP in the world’s GDP.

Includes the six ECCU countries in the table plus The Bahamas, Bermuda, Cayman Islands, Cyprus, Dominican Republic, Guyana, Haiti, Jamaica, Malta, Mauritius, Papua New Guinea, Samoa, Seychelles, and Trinidad and Tobago.

Sources: UNCTAD (2004); and authors’ calculations.Note: Performance index is the share of a country’s FDI inflow in the world’s FDI inflow, divided by the share of the country’s GDP in the world’s GDP.

Includes the six ECCU countries in the table plus The Bahamas, Bermuda, Cayman Islands, Cyprus, Dominican Republic, Guyana, Haiti, Jamaica, Malta, Mauritius, Papua New Guinea, Samoa, Seychelles, and Trinidad and Tobago.

Measuring benefits in terms of employment is much more difficult, as no data are available on the employment generated by incremental investments or the other taxes derived from them. This data limitation precludes any cost-benefit analyses in terms of job creation or net revenue gain. Based on a sample of firms collected by the authors receiving concessions in the ECCU region in the second half of the 1990s, there is some evidence that the terms of the concessions are positively correlated with the size of the firms both in terms of capital and employment.

Tax incentives are often granted with the justification that future revenues may outweigh the present revenue forgone from granting these incentives. However, in the ECCU there is evidence that concessions are granted not only to newly-established enterprises but also to well-established firms. The sample of firms receiving concessions in the ECCU region in the second half of the 1990s showed that a large proportion of firms receiving concessions had been established for several years (Box 10.2).9

To more systematically analyze the effect of incentives on FDI, a broad cross-country study was conducted. Two indices were constructed—an FDI restrictions index and an FDI incentives index—using the methodology of Wei (2000) to relate differences in incentive regimes with FDI performance. Wei’s database was expanded to cover 80 countries (see Appendix 10.2 and Table A10.2.1). The ECCU countries have a generally pro-FDI policy, with incentives provided for select sectors (notably offshore financial services, tourism, and manufacturing) and exports.

Higher statutory CIT rates and import-related tax rates are negatively related to FDI (Figure 10.5 and 10.6) because they lower the after-tax return to capital and raise production costs, thereby hindering investment. The average CIT rate in the ECCU is 4 percentage points higher than in small island states, while the average import tariff rate is 2 percentage points higher (Table 10.6). Subject to fiscal constraints, there appears to be scope to reduce tax rates and broaden the tax base.

Figure 10.4.FDI/GDP and Tax Concessions, 1991–2003

(Change in percentage points)

Sources: Country authorities; Eastern Caribbean Central Bank; and authors’ calculations.

Note: FDI denotes foreign direct investment.

1 Measured as the difference in customs revenue forgone from concessions in 2001–03 relative to 1991–93.

2 Measured as the difference in FDI/GDP in 2001–03 relative to 1991–93.

Figure 10.5.FDI/GDP and Statutory Corporate Income Tax Rate

(In percent)

Sources: UNCTAD (2004); country authorities; and authors’ calculations.

Notes: *significant at 10 percent; FDI denotes foreign direct investment.

Figure 10.6.FDI/GDP and Statutory Import-Related Tax Rate

(In percent)

Sources: UNCTAD (2004); country authorities; and authors’ calculations.

Notes: ***significant at 1 percent; FDI denotes foreign direct investment.

Table 10.6.Average Statutory Tax Rates(In percent)
Corporate Income

Tax Rates
Import-Related

Tax Rates
Eastern Caribbean Currency Union35.016.2
Small island states31.114.3
Sources: Country authorities; and authors’ calculations.
Sources: Country authorities; and authors’ calculations.

A restrictive FDI regime is negatively associated with FDI, but there is little evidence that FDI incentives are associated with higher FDI (Figure 10.7 and Figure 10.8). These findings are consistent with past empirical studies of other regions, including surveys. The absence of a relationship between incentives and FDI is confirmed in cross-country regression analyses (Table 10.7 and Table 10.8). The incentives index is insignificant in all econometric specifications. The finding that FDI performance is positively related to a low CIT rate is fairly robust across specifications. There is also evidence that good governance and the lack of FDI restrictions are positively related to FDI.10

Figure 10.7.FDI/GDP and FDI Restrictions Index

(In percent)

Sources: UNCTAD (2004); Wei (2000); and authors’ calculations.

Notes: A higher value indicates a more restrictive foreign direct investment (FDI) policy.

*** significant at 1 percent.

Figure 10.8.FDI/GDP and FDI Incentives Index

(In percent)

Sources: UNCTAD (2004); Wei (2000); and authors’ calculations.

Note: A higher value indicates a broader foreign direct investment (FDI) incentives regime.

Table 10.7.Cross Country Ordinary Least Square Regressions(Dependent variable: Ln [FDI/GDP])
(1)(2)(3)(4)(5)(6)7)
FDI restrictions–0.220*

10.101)
–0.246*

(0.113)
–0.309*

(0.118)
–0.254*

(0.113)
–0.220*

(0.103)
–0.165

(0.102)
–0.164

(0.104)
FDI incentives–0.255

(0.178)
–0.142

(0.172)
–0.006

(0.156)
0.077

(0.154)
0.081

(0.159)
Average import tariff0.000

(0.017)
0.000

(0.017)
–0.002

(0.018)
Corporate income tax–0.047**

(0.014)
–0.044**

(0.014)
–0.009

(0.015)
–0.009

(0.015)
Quality of institutions0.041

(0.026)
0.053

(0.027)
0.041

(0.03)
0.044

(0.029)
0.041

(0.027)
0.033

(0.027)
0.032

(0.028)
Quality of infrastructure0.011

(0.007)
0.011

(0.007)
Eastern Caribbean Current Union fixed effect0.806

(0.437)
0.867

(0.496)
0.613

(0.518)
0.861

(0.497)
0.806

(0.440)
0.817

(10.423)
0.828

(0.444)
Observations77808080777575
R-squared0.190.290.200.300.190.240.24
Adjusted R-squared0.150.250.160.250.140.180.16
Notes: Standard errors in parentheses. * significant at 5 percent; ** significant at 1 percent. FDI denotes foreign direct investment.
Notes: Standard errors in parentheses. * significant at 5 percent; ** significant at 1 percent. FDI denotes foreign direct investment.
Table 10.8.Cross Country Ordinary Least Square Regressions(Dependent variable: Ln [FDI per capita])
(1)(2)(3)(4)(5)(6)(7)
FDI restrictions–0.193

(0.125)
–0.215

(0.138)
–0.293*

(0.143)
–0.229

(0.138)
0.197

(0.127)
–0.122

(0.120)
–0.100

(0.121)
FDI incentives–0.392

(0.215)
–0.261

(0.209)
–0.067

(0.193)
0.020

(0.181)
0.072

(0.185)
Average import tariff–0.019

(0.021)
–0.017

(0.021)
–0.027

(0.021)
Corporate income tax–0.056**

(0.017)
–0.051**

(0.017)
–0.014

(0.017)
–0.016

(0.017)
Quality of institutions0.264**

(0.032)
0.290**

(0.033)
0.271**

(0.037)
0.275**

(0.035)
0.261**

(0.033)
0.264**

(0.031)
0.253**

(0.032)
Quality of infrastructure0.016*

(0.008)
0.015

(0.008)
Eastern Caribbean Currency0.9090.8880.5890.8770.8990.8461.035*
Union fixed effect(0.539)(0.606)(0.626)(0.604)(0.543)(0.499)(0.518)
Observations77808080777575
R-squared0.600.590.560.600.600.660.67
Adjusted R-squared0.580.570.530.580.580.630.63
Notes: Standard errors in parentheses; * significant at 5 percent; **significant at 1 percent. FDI denotes foreign direct Investment.
Notes: Standard errors in parentheses; * significant at 5 percent; **significant at 1 percent. FDI denotes foreign direct Investment.

Summary and Policy Conclusions

Tax concessions have been employed as a key component of the investment and development strategy of ECCU member countries. Considerable discretion has been applied in the granting of concessions—mainly import-related tax concessions and corporate income tax holidays—for investment and social purposes. Incentives have been given not only for new investments but also for ones that have been in operation for several years. Larger firms have tended to receive more incentives and for longer periods of time.

Box 10.2.Firm-Level Analysis of Tax Concessions in the Eastern Caribbean Currency Union

Tax concessions in the ECCU are granted to a broad range of firms. In a sample collected by the authors of 145 firms receiving concessions from 1996 through 2000—covering such sectors as services, trade, and light manufacturing but excluding tourism facilities—all firms received exemptions from import-related taxes. About half also received exemptions from the corporate income tax (CIT). The size of the firms varied substantially, from as few as two employees to as many as 450, and from capital investment of about US$3,500 to US$5 million. Lack of ownership information on these firms precludes analysis of the question of whether foreign investors tend to receive more concessions than domestic investors.

Exemptions from import-related taxes are widely granted and holidays from CIT are also used frequently. On average, a firm in the sample received a tax holiday of 2.6 years, a 32 percent reduction in the effective CIT rate, and a 91 percent reduction in the effective import duty and consumption tax rate. One of 10 firms received an export allowance, and one out of four received either a tax holiday extension or expanded coverage in import duties and consumption tax exemptions.

Concessions are granted to newly-established firms as well as to existing firms. In 1996–97, about half of the firms receiving incentives had already been established, some several decades earlier. One of four existing firms had their concessions extended during 1996–97.

The size of firms matters. Large firms in terms of both employment and capital tended to receive longer tax holidays and face lower CIT rates. Firms with higher employment also received export allowances, while more capital-intensive firms received extensions on existing holidays and exemptions and concessions on business expansions.

Firm Size and Concessions: A Rank Correlation Analysis
Years of Tax HolidaysReduction in Effective CIT 1Reduction in Effective Tariff 2Export AllowanceConcession Extension 3
Employment0.337*0.320*0.0150.171*0.123
(No. of obs.)(161)(161)(163)(163(165)
Capital0.208*0.177*–0.0820.1100.197*
(No. of obs.)(138)(138)(140)(141)(141)
Source: Authors’ calculations.Note: * denotes significance at 5 percent.

Corporate income tax.

Import duties and consumption taxes.

Extensions of tax holidays and extensions and expansions in coverage of import duty and consumption tax exemptions.

Source: Authors’ calculations.Note: * denotes significance at 5 percent.

Corporate income tax.

Import duties and consumption taxes.

Extensions of tax holidays and extensions and expansions in coverage of import duty and consumption tax exemptions.

The benefits in terms of FDI appear to be limited, but the costs in terms of forgone revenue are substantial. A broad cross-country analysis shows that incentives are not related to FDI. Rather, in line with results from investor surveys and regression analyses in the economics literature, lower statutory tax rates, the absence of FDI restrictions, and better institutional and infrastructural quality are related to FDI. Estimates of forgone revenue range from 9½ and to 16 percent of GDP annually for the ECCU countries.

The strategy of using incentives to promote development should be reevaluated urgently, possibly within a regional context. A regional approach to harmonizing concessions would help limit each country’s large revenue losses, and avoid the tax competition that has produced a race to the bottom.

The development strategy should, therefore, focus on enhancing the investment climate. Some countries, such as Mexico and Hong Kong SAR, have attracted substantial investments without tax incentives. Mexico’s tourism industry attracted more than US$2.25 billion in new investments in 2003 without income tax holidays. In 2004, Mexico received a historic high of over 20 million international visitors and over US$10 billion in tourism receipts. Hong Kong SAR has been a top performer in attracting FDI, with a uniform 15 percent income tax rate and no tax incentives. Enhancing the investment climate entails addressing key investor concerns such as improving the regulatory environment, developing infrastructure, and raising labor productivity through skills acquisition and labor market reform.

Concessions should be reduced significantly or phased out and the tax base broadened, while statutory tax rates should be lowered. If tax rates were lowered but concessions not phased out, the fiscal and macroeconomic environment would deteriorate, which would deter investment and lower growth.

Meanwhile, concessions should be nondiscretionary, transparent, and limited in size, duration, and scope. Legislation on concession-related investment should be revised to be rule-based with clear specification of eligibility criteria. This would alleviate the administrative burden on the cabinet and line ministries and free them up to focus on other pressing matters. Ad hoc concessions for social and welfare purposes should be eliminated and any social spending should be incorporated in the budget process. As an example, in Dominica, the policy since mid-December 2003 has been to not grant ad hoc import concessions. Existing concessions should be reviewed, and the cost of all concessions granted should be published in a tax expenditure annex to the budget. There is an urgent need to strengthen data gathering on the costs and benefits of the tax concessions through routine monitoring and review, and to make available public information on the costs and benefits of each of the concessions granted.

When incentives are granted, careful consideration should be given to the choice of instrument. Incentives may be granted in a variety of forms, each with differing characteristics (Zee, Stotsky, and Ley, 2002; Sosa, 2006). CIT holidays are relatively easy to administer, but have several disadvantages. Since profits are exempted irrespective of amount, they tend to benefit investors with high profits who would likely have undertaken the investment even without the incentive. Moreover, they increase the potential of tax avoidance through transfer pricing. To encourage investment, tax credits for investment, accelerated depreciation, and loss-carrying-forward provisions could be considered. Indirect tax incentives such as exemptions from import-related taxes are prone to abuse, including by the diversion of qualified purchases to those not intended to receive the incentives. They should thus be avoided.

Appendix 10.1. What Is the Change in Revenue after Removing Import-Related Tax Concessions?

The current revenue intake from imports given existing tax concessions can be expressed as:vc*Pcif¯*te, where vc is the quantity of imports with the tax concessions, Pcif¯ is the average c.i.f value of the imports and is normalized to take the value of 1, and te is the average effective tax rate. The average effective after-tax import price is: paft = 1 + te.

The removal of tax concessions raises the average after-tax import price: Δpaft/paft = (tte), where t is the average statutory tax rate for imports and tte. The change in the average after-tax import price affects the quantity of imports: this relationship is measured by the import price elasticities:

where ε ≤ 0 generally. It follows that a change in quantity of imports is: Δv=vvc=vcε(tte)/(1+te).

The change in revenue from imports after the removal of tax concessions will then be:ΔR=vtvtvcte=vc[1+ɛ(tte)/(1+te)]tvcte. Adding and subtracting the term of vc[1+ε(tte)/(1+te)]te and rearranging the terms arrives at the following expression:ΔR=vc[1+ε(tte)/(1+te)](tte)+vcte[ε(tte)/(1+te)]. The first term captures the after-tax price effect of removing tax concessions, while the second term captures the volume effect of a higher after-tax import price.

From this expression, it is straightforward to show that:

Khan (1974) and Khan and Knight (1988) estimated that aggregate import price elasticities range from –0.4 to 1 for developing countries, with small open countries being more price inelastic with respect to imports. Given the average statutory and effective tax rates in the ECCU (about 41 and 26 percent, respectively), revenue will increase after removing tax concessions, and the increase is greater the more price inelastic the ECCU countries are to imports.

Appendix 10.2. Constructing Foreign Direct Investment Regime Indices

The FDI restrictions and incentives indices measure the government’s policies towards FDI and are constructed using the methodology of Wei (2000). Each index is a sum of four variables, each of which takes a value of either 0 or 1. Publicly available sources, including PricewaterhouseCooper’s Investment Guides and various investment agency reports, were used in compiling the indices.

The FDI restrictions index measures whether (1) there are controls on foreign exchange that interfere with the ability of foreign firms to import intermediate inputs or repatriate profits; (2) there is a ban on foreign investments in strategic sectors (in particular, national defense and the mass media); (3) there is a ban on foreign investments in other sector where their presence would be considered harmless in most developed countries; and (4) there are limits on ownership share.

The FDI incentives index measures whether (1) there are special incentives to invest in certain industries or geographical areas; (2) exports are specially promoted, including through export processing zones and special economic zones; (3) there are tax concessions specific to foreign firms, excluding those designed specifically for export promotion; and (4) there are cash grants, subsidized loans, reduced rent for land use, or other nontax concessions specific to foreign firms.

For additional details on FDI restrictions and FDI incentive indices, as well as on country-specific values of the indices, see Chai and Goyal (forthcoming).

Table A10.2.1.Summary Statistics of Key Variables
VariableMeanStandard

Deviation
MinimumMaximumNo. of

Observations
FDI restrictions 1
Overall sample1.31.24.080
ECCU6
Small island states0.40.72.020
FDI incentives 2
Overall sample1.90.83.080
ECCU2.02.02.06
Small island states2.30.61.03.019
Statutory corporate income tax rate
Overall sample32.09.060.0123
ECCU35.04.030.040.06
Small island states31.111.645.022
Average import tariff
Overall sample11.86.937.2140
ECCU16.22.114.119.66
Small island states14.36.76.534.020
Quality of institutions
Overall sample1.05.4–12.411.7143
ECCU3.10.82.34.16
Small island states2.63.6–6.68.522
Quality of infrastructure
Overall sample9.514.90.1100.0138
ECCU24.214.58.143.46
Small island states20.724.60.6100.019
Source: Authors’ calculations.Note: ECCU denotes Eastern Caribbean Currency Union.

A higher value indicates a more restrictive FDI policy.

A higher value indicates a broader foreign direct investment incentives regime.

Source: Authors’ calculations.Note: ECCU denotes Eastern Caribbean Currency Union.

A higher value indicates a more restrictive FDI policy.

A higher value indicates a broader foreign direct investment incentives regime.

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1This chapter studies the six ECCU countries that are also members of the IMF: Antigua and Barbuda, Dominica, Grenada, St. Kitts and Nevis, St. Lucia, and St. Vincent and the Grenadines.
2Hotel room capacity increased sharply in the wider Caribbean, while hurricane-related damage to hotel capacity in ECCU countries such as Antigua and Barbuda was significant.
3Although data on revenue forgone in other countries are generally not known, a recent study on the Philippines estimated revenue forgone at 1 to 2 percent of GDP annually (Easson, 2004).
4Data for the early 1990s are provided in Bain (1995).
5Note that the revenue losses are due not only to concessions granted but also to leakages from administrative weaknesses.
6National accounts data on the income side are not available for ECCU member countries. The corporate income tax base is assumed to be 25 percent of GDP, in line with the number for Jamaica.
7Distribution of profits and losses matters. For example, assume there are 20 companies and the sum of their profits is EC$100 (Eastern Caribbean dollars). If the statutory tax rate is 30 percent, then statutory revenue would be EC$30. However, if the distribution of profit is such that 15 companies make losses of EC$300 and five make profits of EC$400, then true statutory revenues are EC$120.
8See World Bank (2005). Even though the relative ranking of the ECCU region has fallen over time, the share of FDI in GDP has remained high, reflecting the region’s natural endowment as a prime tourist destination and the small size of its economies.
9Data are not available on the costs of each concession granted or on the receiving firms’ financial conditions, precluding any cost-benefit analyses at the firm level.
10The statistical significance of the CIT rate is driven by three “tax haven” countries. When these countries are excluded from the estimation, the CIT has the correct sign, but is statistically insignificant. Instead, the FDI restrictions index and the ECCU fixed effect become statistically more significant.

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