Notwithstanding the growing body of evidence questioning their effectiveness (for instance: Masiya et al., 2024), most governments offer their taxpayers multiple tax expenditures, meaning preferential tax treatment resulting in reduced tax revenues being collected. Such measures include tax exclusions, exemptions, deductions, credits, deferrals, as well as preferential tax rates, and are aimed at supporting various policy goals including attracting foreign direct investment (FDI).
The exact relationship (or absence thereof) between tax incentives and FDI is not easy to grasp, especially given that often countries simultaneously use multiple policy measures to support investment, effects of which can be very challenging, if not impossible, to disentangle. Nevertheless, there are good reasons to believe that many investments would still happen in the absence of related tax incentives (Holland and Vann, 1998; IMF et al., 2015). Where this is the case, tax revenues are lost for no good reason, also meaning the loss of an opportunity to use them for improving other aspects of a country’s investment climate (Masiya et al., 2024). Tax incentives’ effectiveness in attracting FDI also depends significantly on the industry in question: while the tax factor is relatively more important for MNEs and companies heavily relying on intangibles, where location-specific factors are involved, for example in the extractives sector, tax policies are less of a concern for investors (Hanappi et al., 2023; IMF et al., 2015).
Multiple studies demonstrated that tax is only one of the factors considered by companies when making investment decisions, and not the most important one (for instance: Bird, 2000; Klemm & Van Parys, 2011). Both the UN Handbook on Protecting the Tax Base and the 2019/2020 Global Investment Competitiveness Report support this argument, with the latter claiming that “the legal and regulatory conditions of the host countries rank behind only political and macroeconomic stability, and ahead of considerations such as low taxes and low input costs”, being especially important for larger corporations (United Nations, 2017; World Bank Group, 2020). Moreover, where the investment climate is not favourable in general, tax incentives do not make it significantly more appealing to investors (James and Van Parys, 2010).
The – rather generous but not always effective – use of tax expenditures in extractive industries has been a special concern for academics and policy makers alike. Mineral resources are finite, non-renewable and owned by the state on behalf of its citizens, and many would argue that the government has a responsibility to transform its mineral wealth into lasting development outcomes (Readhead, 2018). It also needs to be kept in mind that the impact of FDI on developing countries’ economies is not purely positive: it can include crowding out of local businesses, increase in environmental hazards, and distortion of local currency stability due to mass repatriation of profits by foreign investors (Nyeadi, Davies and Abor, 2024). Besides, an increase in FDI in the extractive sector also does not always result in an increase of fixed assets in the jurisdiction providing them (Klemm & Van Parys, 2011). Some researchers believe that tax exemptions provided to mining companies, especially in resource-rich low-income economies, have been unnecessary generous, especially when base erosion and profit shifting (BEPS) and weak institutional capacity are taken into account, causing significant detrimental impact on countries’ ability to generate domestic revenue, the most sustainable source of financing (Darimani and Lambrechts, 2009).
Tax expenditures are the Achilles heel of many governments around the world. While resulting in significant fiscal costs (up to 14.5% of GDP in Russia[1]), they are not subject to the same level of scrutiny as direct spending or other elements of the tax system, and it’s quite rare that a proper cost-and-benefit analysis is run to properly assess their impact (CBO, 2012; CRS, 2019). It is not uncommon for tax expenditures to be provided not just in the general tax legislation but through investment treaties, exploration or extraction contracts, which reduces transparency of such measures and complicates their analysis and revision (Burman and Phaup, 2011). Often, tax expenditures’ policy goals are formulated vaguely or not formulated at all, making assessing their effectiveness practically impossible. Implementing tax expenditures can also have unforeseen impact on the economy, including increasing inequality or negatively impacting the environment (De la Feria and Redonda, 2020; OECD, 2021), and potentially enabling or facilitating illicit financial flows (Von Haldenwang, Narotzky, Mosquera Valderrama and Redonda, 2024).
It is also not uncommon for the exploration or extraction contracts providing tax incentives for foreign investors to contain a stabilization clause, a provision limiting the government’s flexibility of changing the contract’s conditions. While increasing predictability and stability for investors, such clauses also make redesigning or removing tax expenditures provided earlier extremely challenging and sometimes impossible, also causing distortions between different investors. Removing or even reducing the size of tax expenditures is challenging in any case: taking back the privileges that were promised before is not popular politically. However, if we are aiming to better a country’s outcomes in the long-term, often it is the only responsible thing to do.
Improving design and management of tax expenditures can play a crucial role in enhancing domestic revenue mobilisation, financing the Sustainable Development Goals, and aligning tax systems with governments’ policy objectives (Redonda and Neubig, 2018, von Haldenwang et al., 2021). Government must aim to make well-informed decisions on if and when tax incentives are truly necessary to attract investment into the extractive industries, and design them carefully in a way that optimizes their impact given the revenue foregone. The realities of the extractive industries must be taken into account when (re) designing tax expenditures applicable to the sector (Readhead, 2018). The economic environment in which tax expenditures will be implemented, as well as their interaction with other policies in place, should also be accounted for, as they impact tax expenditures’ effectiveness significantly (Redonda, 2016).
Potential behavioural responses of investors to a reform of tax expenditures also matters, as some of such reforms, especially tax incentives offered in the form of income tax holidays, export processing zones (EPZ), royalty-based incentives, withholding tax reliefs on interest services, cost-based incentives and fiscal stabilization guarantees, might incentivize base erosion and profit shifting. For example, if a subsidiary of a mining corporation is set up in an export processing zone that offers reduced tax rates, the mining company (subject to the standard tax rate) might be tempted to underprice its minerals in order to reduce its taxable income and shift profits to the subsidiary in the EPZ (Readhead, 2018).
To minimize the risks associated with tax expenditures’ provision while maximizing their effectiveness, information on tax expenditures being provided should be available publicly to allow for independent analysis and evaluation (Mosquera Valderrama, 2015) and ensure transparency, accountability and good governance. Their policy goals should be stated clearly as otherwise assessing their effectiveness becomes impossible, and ideally, tax expenditures should be time-bound to guarantee that the government is in a position to reconsider tax expenditures’ provision if necessarily. Tax expenditures’ analysis should be carried out periodically following a comprehensive approach, focusing not only on the direct revenue foregone and their general effectiveness (ideally, taking behavioural responses into account), but also on the broader consequences of such measures, including their impact on socio-economic equity, environment and climate change, which should be minimized to secure long-term wellbeing of local societies.
This research belongs to The Sustainable Trade and Investment Law Initiative (STILI), by researcher Natalia Pushkareva
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