The value of using tax incentives as an investment promotion tool to attract multinational companies is increasingly being questioned, particularly in developing countries where profit-based incentives impose great costs on the tax revenue base. This column explores the opportunity provided by the OECD’s proposed global minimum tax for governments to rethink the use, type and mix of fiscal sweeteners on offer to foreign investors.
In many developing countries, tax incentives are viewed as a key tool to promote foreign investment – my home country Zimbabwe is no exception. However, tax incentives represent significant costs for the national economy, which makes the issue of personal interest to me.
In 2020 alone, the tax revenue forgone as a result of tax incentives has been estimated at US$ 346 million, while the total health budget was US$ 684 million. There has been little to show for it: across regions of Zimbabwe, tax incentives have not been accompanied by a comparable increase in foreign direct investment.
This and similar experiences elsewhere suggest that developing economies need to rethink their use of tax incentives. But reform of a country’s fiscal policy is difficult: these incentives are often locked into investment laws, treaties, contracts, and trade agreements that cannot be amended unilaterally. The building momentum around the OECD’s proposed global minimum tax provides an opportunity for governments to review their tax incentives.
What is the global minimum tax?
In October 2021, 137 members of the OECD/G20 Inclusive Framework agreed to a ‘two-pillar solution’ aimed at addressing the erosion of the tax base and profit-shifting by multinationals. This initiative was spurred by the need to address tax challenges arising from digitalization.
Pillar 1 seeks to expand the taxing rights of countries that host multinationals with no physical presence. Pillar 2 seeks to establish a global minimum tax that will be applicable on the profits of large multinational enterprises (MNEs) with a consolidated revenue of €750 billion or more.
The global minimum tax will be implemented primarily through a rule that will allow the home countries of MNEs to impose a top-up tax on these entities if they are liable for a tax rate of less than 15% in any jurisdiction.
Why does this matter to developing economies?
While many developing economies apply corporate headline tax rates that are above 15%, the use of tax incentives often serves to reduce the actual (effective) rate at which MNEs are taxed. Within this system, governments that forgo revenue through the extension of tax incentives will see that same revenue collected by another jurisdiction – rendering the incentives ineffective.
Countries will be affected by these rules whether they are members of the Inclusive Framework or not, as long as the home countries of MNEs apply the rules. The interaction between the global minimum tax and tax incentives should be of particular significance to developing economies. In general, these countries tend to offer more profit-based tax incentives such as tax holidays, which have been found to be more damaging to the tax base than expenditure-based incentives.
The upcoming implementation of these rules in 2024 should grant developing economies the negotiating leverage to reform their use of tax incentives. The fact that all MNEs will be subject to a minimum tax of 15% no matter where they operate should also change the importance that MNEs place on the availability of corporate income tax breaks when making investment decisions.
How will the global minimum tax affect the use of tax incentives?
The interaction between tax incentives and the global minimum tax will not be uniform. Each affected country will need to evaluate the impact of the particular tax incentives it provides on the MNEs that operate within its borders.
Governments will need to first identify the presence of in-scope MNEs within their jurisdictions and then determine the effective tax rate applied to them. Where in-scope companies are subject to an effective tax rate that is below 15%, a country may be at risk of revenue loss.
Broadly, profit-based incentives such as tax holidays will significantly reduce the effective tax rate to which an MNE is subject and are thus likely to trigger the payment of taxes under the global minimum tax. Other types of profit-based incentives, such as reduced rates or withholding tax relief, are less likely to result in significant top-up taxes.
Expenditure-based incentives, such as tax deferrals and extended carry forward periods, are even less likely to result in the payment of additional taxes, because they typically only create a timing difference in the payment of tax rather than resulting in a permanent reduction of tax. Other cost-based incentives – such as payroll taxes, property tax reductions, and exemptions from indirect taxes like VAT – have been excluded from the scope of the rules.
Tax incentives can be used effectively to promote investment. They can serve as a means for governments to attract mobile capital, enhance productivity, and offer sector-specific support in strategic industries.
For example, the Philippines and Malaysia have been able to harness the value of tax incentives by monitoring firms’ behavior in reaction to the granting of incentives and linking them to specific performance requirements. These countries have also prioritized payroll-related tax incentives and incentives that lower the costs of production.
Developing economies can take advantage of the adoption of the global minimum tax to revisit their use of tax incentives and boost domestic resource mobilization. They should discard tax incentives that are overly generous, poorly designed, unmonitored, and not linked to clear performance requirements.
Domestic reform and any necessary renegotiation with investors should be supported by an understanding that if tax revenue is not collected by countries hosting investment, it will remain payable in the home countries of MNEs.
Zimbabwe and other governments have the policy space under the global minimum tax framework to replace base-eroding tax incentives with other measures that will be less damaging to their revenue mobilization efforts and more effective at attracting investment. They should not miss this opportunity.
“The International Institute for Sustainable Development (IISD) together with the International Senior Lawyers Project (ISLP) have developed a Guide to assist developing countries adapt to and understand the global minimum tax which can be accessed here.“