The Use of Corporate Tax Incentives : A Guidance Note and Experience from Poland, Hungary and Latvia

Targeted reductions in corporate income tax rates may in some cases increase investment by firms, which can increase employment and the incomes of employees and suppliers, improve the availability of goods to their customers, and increase access to new technology. However, tax incentives also face significant problems. It can be hard to determine if an incentive results in a rise in investment, or if firms would have made the investment even without the incentive. In the latter case, the government loses revenues for no purpose. Corporate income tax reductions that are tied to the level of investment expenditures (for example, accelerated depreciation) tend to have a greater impact on investment per dollar of revenue lost than do reductions based on the level of profit (for example, profit exemptions or a targeted reduction in the tax rate). Rigorous monitoring is necessary to ensure that deductions are declared only for eligible expenditures, which can lead to high administrative costs. Tax incentives also may help firms to reduce their tax liability, in ways unintended by policy makers, for example by using accounting techniques that shift profits to low-tax jurisdictions. Tax incentives may replace domestic with foreign investment rather than increasing total investment. And the targeting of tax relief to businesses can create a perception of unfairness that erodes tax compliance. This paper summarizes the results of case studies of the impact of targeted corporate income tax reductions on investment in Hungary, Latvia and Poland. In Hungary, a change in EU policy resulted in significant changes across regions in the maximum amount of EU and state aid, including a development tax credit, that could be allocated. This change affected the relative attractiveness to investment of the regions affected. In Latvia, the government permitted firms to increase their deduction for depreciation, with even more generous deductions allowed for some kinds of new equipment and for investment in less developed areas. In Poland, small firms were allowed to deduct the full cost of machinery and equipment purchases in the first year.