Implications of tax incentives on foreign direct investment decisions

Ekundayo Abdurahman

Taxaide Professional Services, Lagos State

e.abdulrahman@taxaide.com.ng

Bidemi Olumide

Taxaide Professional Services, Lagos State

b.olumide@taxaide.com.ng

Lateef Omoyemi Akangbe

Sofunde, Osakwe, Ogundipe & Belgore, Lagos

loakangbe@sooblaw.com

Africa has been urged to boost its infrastructure development by attracting significant inflows of foreign direct investment (FDIs), which:

• contribute to job creation and economic growth;
• improve productive resources;
• advance information communication technology; and
• benefit the economy in general.

Developing countries, especially in Africa, have improved their strategies for attracting FDI inflows. Some recent market data highlights the recent FDI trends in Africa (see Table 1):

1. The Democratic Republic of Congo saw a 140 per cent increase in projects from 2019 to 2020. A 95 per cent increase in capital investment saw the country's gross domestic product (GDP) increase from $566m for 2019 to $1.1bn for 2020;
2. An estimated 100 projects in South Africa attracted FDIs in 2020, a decrease of 21 per cent from 2019 levels. Between the same period, capital investment increased from $3.5bn to $3.8bn;
3. In 2020, Egypt saw a substantial decline in FDIs. Capital investment amounted to $12.2bn in 2019 but only $1.3bn in 2020. Over the same period, FDI-funded projects into the country dropped by 70 per cent while jobs created by FDI also decreased by 76 per cent; and
4. Nigeria saw a 30 per cent decrease in FDI-related projects between 2019 and 2020.

Table 1: FDI-related projects in 2020 [1]​​​​​​​

There are several benefits attributed to FDIs which explain the increasing efforts to attract them. These include:

• productivity gains;
• technology transfers;
• the introduction of new processes;
• managerial and technological expertise within the domestic market;
• employee training;
• international production networks; and
• market access.

Most governments have been actively promoting their countries as investment locations to help meet their development goals by attracting private capital and technology. A growing number are taking measures to facilitate FDIs, including:

• law reforms;
• providing guarantees for the repatriation of profits and investments; and
• creating mechanisms for the settlement of investment disputes and the provision of tax incentives.

A tax incentive reduces corporate or individual tax burdens to induce investment in specific projects or sectors. Tax incentives include:

• reduced tax rates on profits;
• tax holidays;
• accounting rules that permit accelerated depreciation;
• tariff reductions on imported equipment, raw materials and components; and
• increased tariffs to protect domestic markets in the event of import substitutions. 

To attract FDIs, attention must also be paid to more fundamental factors, such as market size, access to raw materials and the availability of skilled labour. A typical investor's evaluation of a country as an investment location usually involves more than one consideration. The fundamentals of a country's development may take priority, with other factors such as tax rates, grants and other incentives taking a back seat. Investment incentives, including tax incentives, are only moderately important for attracting FDI.

However, FDI tax incentives come with costs. Countries are forced into bidding wars to attract FDIs due to intense competition. This favours multinational companies at the expense of states and citizens. Governments have been forced to harmonise their tax laws under regional and international agreements to avoid this risk. Furthermore, tax incentives are likely to reduce tax revenue, as well as creating opportunities for business and tax administrators to engage in illicit behaviour. These issues have become critical in developing countries, where budgetary constraints and corruption are far more severe than in industrialised countries.

Aside from their obvious costs, tax incentives also have many less obvious costs. For example, they can distort resource allocation because they influence investment by private companies. They can attract investors that focus exclusively on short-term profits, which can be a significant issue for countries with deteriorating political and macroeconomic fundamentals.

Tax incentives generally impose enormous administrative burdens, so they must be more than marginally worthwhile to offset their implementation costs and generate net benefits. Particularly difficult are the discretionary regimes that require case-by-case evaluations. These regimes can cause delays and uncertainty for investors, which increases investment costs. In addition, widespread corruption has effectively ‘screened out’ desirable investments, and undermined sound policy making and competitive markets.

For developing countries to benefit from tax incentives for national development, tax policies must be structured to attract foreign investment without hindering domestic growth. The objective is to prevent them from becoming tax competitors with other countries.