A Guide on Using Tax Incentives for Optimal Investment Returns

By Selcuk Caner & Sandeep Bhattacharya

This blog was first published in Development Asia.

Countries worldwide provide tax incentives to stimulate domestic and foreign investment. These incentives are designed as special provisions within the tax code, favoring specific types of investments, investors, or products. They are particularly prevalent among developing countries, including those in Asia and the Pacific.

An up-to-date examination of tax incentives is crucial, especially as countries in the region prepare to implement the key features of the global minimum corporate income tax.

Adapted from a governance brief on tax incentives and investments published by the Asian Development Bank (ADB), this article emphasizes the importance for countries to use tax incentives sparingly, integrate them into law, and strengthen their overall investment environment.

Impact and Deployment of Tax Expenditures

Tax incentives can play a crucial role in attracting socially beneficial investments, particularly in countries grappling with weaknesses in their investment environment and limited capacity to address these challenges. However, they come with trade-offs, such as forgone revenues, increased administrative costs and complexity, unwanted distortions in investment behavior, and the potential to foster corruption and rent-seeking. Therefore, it is essential to strike the right balance in utilizing tax incentives to ensure that the benefits outweigh the costs associated with these incentives.

Tax incentives can be integrated into any part of the tax code, including corporate income tax, personal income tax, value-added and excise taxes, customs tariffs, and investment and related laws or decrees. Advanced countries typically deploy these incentives sparingly, often in the form of enhanced cost recovery of investments within the corporate income tax framework. In contrast, developing countries tend to employ tax incentives more extensively, particularly in the corporate income tax, including measures like tax holidays, and across various tax instruments.

There is a growing global consensus regarding a set of good practices concerning the use of tax incentives, drawing on evidence derived from decades of studying the impact of this approach on investment (e.g., International Monetary Fund et al., 2015Organization for Economic Cooperation and Development, 2022Asian Development Bank, 2023; and Stotsky, 2024). These practices emphasize a few key points: a well-structured and well-administered tax system is more important than tax incentives. A tax system should feature broad bases for major taxes and internationally competitive rates, especially for the corporate income tax (Stotsky and Bhattacharya, 2022).

Studies reveal that numerous non-tax-related factors influence investment decisions. One critical factor is whether countries maintain stable macroeconomic policies and effectively manage key macroeconomic variables, such as inflation, interest rates, and exchange rates. Sound macroeconomic management significantly contributes to an investment-friendly environment.

There is a growing body of empirical evidence on the impact of tax incentives on investment, including foreign direct investment (International Monetary Fund et al., 2015 and Kusek et al., 2020). Several studies, particularly those focused on Asia and Pacific countries, align with findings from other regions, emphasizing that tax incentives are inefficient and do not compare favorably to the establishment of a properly structured and administered tax system.  Cost-based incentives under the corporate income tax are preferable over income- or profit-based incentives, especially tax holidays, which are still widespread throughout the region. Excessively generous tax holidays and export processing zones can be particularly damaging to countries striving to align growth in tax revenues with economic growth.

Policy Implications

  • Tax incentives should be used sparingly. It is more advantageous for countries to address weaknesses in the investment environment than to rely extensively on a wide array of tax incentives to encourage higher levels or a particular composition of investment. Key components of a conducive investment environment include stable macroeconomic and political systems, sound regulatory and judicial frameworks, adequate investment in market-supporting infrastructure, and well-trained workforces. Taxes are not the foremost consideration and typically cannot compensate for deficiencies in these more fundamental characteristics.
  • Tax incentives can play a valuable role in addressing challenging weaknesses and promoting industries with positive spillover effects on the broader business environment and society.  This is particularly true for sectors involved in research and development or innovative technologies. Additionally, tax incentives can facilitate investment in critical assets vital for fostering competitive industries. However, under these circumstances, tax incentives should only be granted when there is a clear economic rationale, and their design should prioritize cost-effectiveness. Regular assessments of the benefits versus the costs of tax incentives are essential.
  • Tax incentives come with various drawbacks. They contribute to the erosion of the tax base, limiting governments’ ability to fully benefit from the potential growth of tax revenues associated with economic expansion. Also, they increase administrative costs, especially when incentives are widespread and have a complex structure. Furthermore, tax incentives may introduce significant inefficiencies by distorting investments, especially when applied to endeavors that do not serve socially beneficial purposes. In some cases, tax incentives can foster corruption and rent-seeking, particularly when awarded in a discretionary or nontransparent manner, significantly affecting the rate of return.
  • There are certain types of tax incentives better suited to meeting economic objectives. In the case of income tax, incentives based on cost recovery, rather than income exemptions, are more effective in targeting desired investments. Regarding indirect taxes, zero rating should primarily be applied to exports, while exemptions should be minimized and primarily used for administrative reasons or essential consumer goods. Export processing zones and related special zones are susceptible to abuse. Therefore, countries should ensure the implementation of a streamlined and tightly controlled approach for managing eligibility and benefits within these zones.
  • Tax incentives should be embedded in tax law. Likewise, their implementation should be supervised by the ministry of finance and tax and customs administrations, even in countries where boards of investment play a role. The criteria for eligibility and application should be clear and transparent, with discretion minimized. Beneficiaries should be made public, and regional cooperation should be emphasized to mitigate competitive pressures.
  • The annual (or medium term) budget should regularly account for taxes forgone due to tax incentives, using a sound methodology. Tax incentives should not be granted indefinitely. They should have clearly defined limits and be reviewed periodically.


  1. Asian Development Bank. 2023. Cross-Border Investment. Asian Economic Integration Report: Trade Investment and Climate Change in Asia and the Pacific. pp. 57–88. Manila.
  2. International Monetary Fund, et al. 2015. Options for Low Income Countries’ Effective and Efficient Use of Tax Incentives for Investment: A Report to the G-20 Development Working Group. Washington, DC: International Monetary Fund.
  3. J. Stotsky. 2024. Tax Incentives and Investment. Manila.
  4. J. Stotsky and S. Bhattacharya. 2022. A Tax Primer: With Applications to Asia-Pacific Countries (Background Note to the Asian Development Outlook, Asian Development Bank). Manila.
  5. Organization for Economic Co-operation and Development. 2022. Tax Incentives and the Global Minimum Corporate Tax: Reconsidering Tax Incentives After the GloBE Rules. Paris: OECD Publishing.
  6. P. Kusek, A. Saurav, and R. Kuo. 2020. Outlook and Priorities for Foreign Investors in Developing Countries: Findings from the 2019 Global Investment Competitiveness Survey in 10 Middle-Income Countries. Global Investment Competitiveness Report 2019/2020: Rebuilding Investor Confidence in Times of Uncertainty. Washington, DC: World Bank.