Using and Misusing Investment Incentives

1. Using and Misusing Investment Incentives James Alm and David L. Sjoquist March 2008

2. Investment incentives are widely used in countries around the world. • What should Puerto Rico policy be toward their use?

3. Purpose of Presentation To examine and evaluate the practice of investment incentives – world-wide and in Puerto Rico To suggest some general policies that Puerto Rico should consider

4. Why Give Investment Incentives? Main Types of Investment Incentives Some Worldwide Trends in Taxing Companies Other Factors in Attracting Investment: The Investment Climate in Puerto Rico Evaluating the Benefits and Costs of Incentives “Best Practices”

5. Why Give Investment Incentives? Investment incentives are part of a broader strategy that encourages overall economic development. They are given: • Because there are thought to be benefits (as well as costs) from giving them – see the discussion below. • Because a country believes that it must offer incentives to compete with rival countries for foreign investment. • Because a country is pressured by large domestic (and foreign) firms to offer incentives.

6. Main Types of Investment Incentives • Investment tax credits and deductions • Accelerated depreciation allowances • Tax holidays • Investment grants • Miscellaneous incentives • Reduced corporate tax rates • Reduced tax rates on some activities • Exempt purchases

7. Some Worldwide Trendsin Taxing Companies Statutory corporate tax rates have fallen significantly since 1982 for most of the 19 (OECD) countries examined, and continue to decline today. In 1982, 15 of the 19 countries had statutory tax rates above 40 percent; by 2004, no country had a tax rate above 40 percent. Overall, the (unweighted) mean statutory tax rate fell from 48 percent to 32 percent over this period. The tax bases of most countries were broadened over much of this period, at least as measured by the (reduced) generosity of depreciation allowances. The effective tax rate on corporate income, measured by the “marginal effective tax rate” and the “average effective tax rates”, tended to fall over time. These measures of effective tax rates are discussed in more detail later.

8. Other Factors in Attracting Investment:The Investment Climate in Puerto Rico

9. Doing Business 2008 The World Bank, working with Pricewaterhouse Coopers, has conducted a survey on the ease or difficulty of doing business in 178 countries. The survey uses a “case study company” approach, in which a standardized, common company is constructed, and then the specific institutional features of each country are applied to this identical company along various dimensions of doing business.

10. Puerto Rico’s Rankings in Doing Business 2008(out of 178 countries) Starting a business (7th) Dealing with licenses (135th) Employing workers (32nd) Registering property (117th) Getting credit (26th) Protecting investors (12th) Trading across borders (95th) Enforcing contracts (88th) Closing a business (28st) Paying taxes (39th)

11. Paying taxesPuerto Rico - 39th out of 178 countries • Payments (number per year): 16 (39th) • Corporate income tax payments (number): 5 • Labor tax payments (number): 6 • Other taxes payments (number): 5 • Time (hours per year): 140 (39th) • Corporate income tax time (hours): 80 • Labor tax time (hours): 60 • Consumption tax time (hours): 0 • Total tax rate (percent of profit): 44.3 (92nd) • Corporate income tax rate (percent): 12.4 • Labor tax rate (percent): 12.6 • Other taxes rate (percent): 19.3

12. Overall Ranking of Puerto Rico in “Ease of Doing Business”: 28th out of 178 countries

13. World Economic Forum’sGlobal Competitiveness Report 2007-2008 The World Economic Forum provides rankings of 131 countries in 12 “pillars” of competitiveness, based on publicly available information and on the Executive Opinion Survey of several thousand business leaders across the countries. The result is the “Global Competitiveness Index” (GCI).

14. Puerto Rico’s Rankings inGlobal Competitiveness Index 2007-2008 (out of 131 countries) Puerto Rico Ranking Subindex A: Basic Requirements 45th 1st Pillar: Institutions 40th 2nd Pillar: Infrastructure 40th 3rd Pillar: Macroeconomic Stability 69th 4th Pillar: Health and Primary Education 93rd Subindex B: Efficiency Enhancers 32nd 5th Pillar: Higher Education and Training 48th 6th Pillar: Goods Market Efficiency 29th 7th Pillar: Labor Market Efficiency 27th 8th Pillar: Financial Market Sophistication 30th 9th Pillar: Technological Readiness 26th 10th Pillar: Market Size 66th Subindex C: Innovation and Sophistication Factors 27th 11th Pillar: Business Sophistication 25th 12th Pillar: Innovation 29th Global Competiveness Index, 2007-2008 36th

15. Evaluating the Benefits and Costs of Investment Incentives Benefits to Country • Increases in investment • Industrialization • Job creation • “Infant industry” • Increases in tax revenues • Technology transfer • Correction of “distortion”

16. Costs to Country • Loss of tax revenues • Distortions in investment and other types of behavior • Discrimination against firms that lack the resources/influence to apply for incentives • Complexity • Political discord • Corruption • Unfairness

17. On balance, the evidence is that the benefits seldom exceed the costs. And there is also little convincing evidence that incentives actually change behavior: they simply subsidize behavior that would occur even without the incentives, or they lead to purely accounting changes (e.g., transfer pricing) that reduce taxes without generating any real, new economic activity.

18. “Best Practices” Basic tradeoff: Reduce the statutory tax rate for all investments versus Extend tax incentives to targeted and selected investments

19. “Best Practices” • Avoid the use of tax incentives, unless… • And resist the temptation to industrialize through the tax system. • Instead, reduce the overall corporate tax rate, keeping tax rates in line with those of neighboring countries and with those of capital-exporting countries.

20. But, if incentives are to be used, then: • Quantify their benefits and costs. • Simplify the tax incentives system. • “Rationalize” tax incentives. • Define clearly the types of activities that will receive incentives and then grant these incentives automatically. • Permit unrestricted entry of foreign investment. • Do not favor foreign over domestic investors. • Permit unrestricted transfers of capital income abroad.