Cost-benefit of investment incentives

 

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2.6 What mechanisms has the government established for the evaluation of the costs and benefits of investment incentives, their appropriate duration, their transparency, and their impact on the economic interests of other countries?


Rationale for the question

Offering financial and other incentives to attract foreign investors is not a substitute for pursuing policy measures that create a sound investment environment for domestic and foreign investors. Without a solid investment environment, competition among countries for FDI might simply divert public resources away from more productive uses with no effect on investment. In some circumstances, however, incentives may complement an already attractive enabling environment for investment or serve as a partial rectification for market imperfections that cannot be addressed by direct policy reforms. Each individual incentive granted may make sense at the time, but the cumulative effect of all the incentives offered might, with time, become unaffordable or counter-productive by giving investors an incentive to delay investments until they can obtain concessions.

As a result, authorities offering incentives to attract investment must periodically evaluate their relevance, appropriateness and economic benefits against their budgetary and other costs, including the long-term impact on resource allocation. In doing so, authorities also need to consider their commitments under international agreements, since investment incentives can have international repercussions, including bidding contests leading to a waste of resources. Many governments, including all OECD member countries, consider it inappropriate to encourage investment by lowering health, safety or environmental standards or relaxing core labour standards.

Related PFI questions:

Chapter 5 on tax policies, particularly Question 5.7 on tax incentives

All Chapters address the issue of periodic review in specific areas, e.g. Question 3.4

 

Key considerations

Measuring full costs – The IPA needs to understand the full costs of investment incentives. This should include an assessment – albeit subjective – of whether a given incentive was a critical element in the subsequent investment decision. Some incentives, such as a waiver of environmental regulations or responsibility for mine cleanups, can have enormous long-term consequences that need to be considered carefully.

Time limits – It is considered good practice to grant concessions, particularly tax holidays, for a finite period of time to help a new firm become profitable or direct its limited capital into productive assets that promise greater tax revenues in the future when profits grow. To offer one firm a lower level of taxation in perpetuity would run counter to the principle of equal treatment, which is an important component of a sound investment climate. Time limits also help prevent countries from having to engage in a bidding war. Particularly for developing nations, such concessions can limit the nation’s revenues and indirectly force higher taxes onto existing businesses or consumers, which can harm growth.

Broadly beneficial versus narrow concessions – In considering what if any form of incentive to use, it is important to consider the broader impact. A direct tax concession to one firm may have very limited impact because it does not necessarily stimulate related industries. However, some concessions can tip the balance for a given investor but also bring much broader benefits to the economy. For example, providing a specialised training programme at a university, extending or upgrading infrastructure or creating a risk insurance programme can have broad positive effects beyond the first investor to whom they are promised.

Incentives should also be weighed against the alternative uses of such funding, how scarce government resources are and the possibility of over-spending to court particular investors creating a political or social backlash where other important sectors are denied funds. Overly generous incentives, particularly for foreign investors, can undermine political support for ongoing efforts to create an attractive investment climate and can also entice investments that are not viable without the implicit subsidies that incentives represent. Incentives can also be an inducement to corruption, which can have highly adverse effects on the national image and investment climate.

 

Policy practices to scrutinise

  • What incentives exist for foreign investors?
  • What are the objectives and criteria for offering incentives? At what level of government are they established, and who is responsible for their implementation?
  • Have proposed incentives been thoroughly examined to determine their full financial cost?
  • Are there circumstances under which the expected cost of incentives would grow larger than is affordable, such as offering price supports or guaranteed prices for production when market prices are falling?
  • Do incentives have an expiry period after which industry is expected to follow the general fiscal rules governing other investors?
  • Do provincial or sub-national governments have the power to offer incentives beyond those specified in investment laws? If yes, are these incentives designed with due consideration of those offered by other provinces?
  • Do laws or investment contracts make sufficient provision for industries to pay for environmental cleanup, particularly for mining and chemical industries?
  • Has the government (national or sub-national) ever lowered health, safety or environmental standards or relaxed core labour standards to attract investment projects?
  • Do incentives to foreign investors have the effect of asking domestic industry to subsidise foreign businesses through higher domestic corporate tax rates?
  • Do incentives take into account the number of jobs likely to be created?

 

Resources

See the investment promotion and facilitation resource library.

 

 

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