Fiscal decentralization and tax incentives in the developing world

Many developing countries use tax incentives to attract foreign direct investment, sacrificing immediate revenue from foreign capital, even though the effects of tax incentives on investment, growth, and revenue are empirically dubious. This leads to the puzzle of why states adopt tax incentives. Extant studies of tax incentive adoption overlook the fact that many countries have decentralized fiscal authority, allowing subnational governments to offer tax incentives. Public finance scholars argue that fiscal federalism intensifies tax competition among regions. Hence, drawing on the public finance scholarship, one may ask: Does fiscal decentralization lead to a race to the top among subnational governments and an oversupply of tax incentives in a country? This article argues that fiscal decentralization affects tax incentives in complex ways. When subnational governments are authorized to set tax policies, their politicians have economic and political incentives to engage in tax competition for mobile capital, providing more tax incentives in a country. However, the politicians are less likely to do so if they are held accountable and have to fund most expenditures through own-source tax revenues. An empirical analysis of over 50 developing countries in early 2000s produces robust supporting evidence. This research challenges both the view that fiscal decentralization is always beneficial and the view that horizontal competition invariably produces inefficiently low tax rates. The impact of fiscal decentralization on tax incentives and by implication, revenue mobilization depends on the design of the central–local government relations.