Published by the IMF, this technical note sets out the essential elements to effectively manage tax incentives in developing countries, emphasizing the important role that revenue authorities must play in preventing abuses and revenue leakages. It presents considerations for a risk-based compliance program on tax incentives that combines various supportive, preventative, and corrective practices and approaches. It also delineates key enablers, such as a whole-of-government approach, robust transparency and accountability practices, and a modern compliance risk management framework.
This note aims to address the often-overlooked revenue administration aspects for managing tax incentives. Much of the attention on tax incentives has focused on their design and effectiveness to attract domestic and foreign investment and promote economic growth. However, tax incentives pose potential risks of revenue leakages particularly in developing countries, as well as additional compliance and administrative costs, which add to the sizable revenue foregone they represent. Tax incentives in developing countries intend to attract investment by reducing the tax burden of qualified investment projects and firms. They typically try to incentivize the economic development of certain sectors and regions, promote job creation (in labor-intensive industries), expand export-oriented activities, and transfer cutting-edge technologies, among other objectives. They are made available either to all qualified domestic and foreign investors or to those specifically approved on a project basis by a granting authorityat the executive branch.
In most cases, tax incentives in developing countries focus on corporate income tax, value-added tax, and excises and import tariffs and frequently take the following forms:
- Free zones (for example, free trade zones, export processing zones, special economic zones, development zones): free zones exempt business from some or all taxes and aim, in principle, at separating a qualified business activity from the domestic market
- Tax holidays: non-ring-fenced exemptions from some or all taxes for selected new firms or projects that might carry out activities inside or outside the domestic market.
- Lower-income taxation for small- to medium-sized enterprises.
- Full or partial exemption from income withholding taxes.
- Lower rates, and partial or full exemption from value-added tax and excises and import tariffs applicable to eligible goods purchased or imported by qualified firms or under qualified projects.
- Investment tax credits or equivalent allowances.
- Capital recovery schemes like accelerated depreciation or initial capital allowances.
Not all tax incentives in developing countries are well designed, and this has an impact on their administration. Some are well targeted and prescribed in a single law, whereas others are ill-designed (as it may be the case of some profit-based tax incentives) and scattered in various laws (not necessarily tax laws) or even approved by lower-rank instruments sometimes with nontransparent or discretionary clauses, which open opportunities for lobbying and rent seeking.