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CHAPTER 3: Tax Incentives and Foreign Direct Investment: Policy Implications for the Caribbean

Author(s):
Sanjaya Panth, Paul Cashin, and W. Bauer
Published Date:
October 2008
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Author(s)
Luis Cubeddu, Andreas Bauer, Pelin Berkmen, Magda Kandil, Koffie Nassar and Peter Mullins 

Policymakers across the Caribbean have long recognized the benefits of foreign direct investments (FDI) and actively sought for levers to attract them. As a consequence, special incentives for foreign investors have proliferated throughout the region, mainly in the form of tax holidays, which exempt qualified investors from paying corporate income taxes and import duties for periods that can be as long as 25 years.

However, several developments suggest that a reassessment of existing policies to promote FDI is in order. Sharply higher debt levels throughout the region are forcing governments to consider steps to achieve fiscal consolidation, including the scaling back of tax incentives. In addition, the existing literature is, on balance, striking a cautious tone about the merits of these incentives. Studies for developing countries mostly suggest that benefits of investment incentives in terms of increased FDI are limited, particularly if they are put in relation to their estimated costs.

Governments have so far been reluctant to move ahead decisively with the reform of tax incentives. Foreign investment is deemed necessary to generate jobs and promote economic development, particularly as countries in the region struggle to adjust to the gradual dismantling of trade preferences and export-processing zones.1 In addition, the perception of increased capital mobility and competition for FDI has put pressure on governments to maintain incentives, particularly in light of the emergence of extraregional free trade agreements such as CAFTA-DR (Central America–Dominican Republic–United States Free Trade Agreement). Against this background, policymakers have found it difficult to dismantle their investment incentive schemes unilaterally, out of fear that other regional and extraregional competitors will not follow suit and thus obtain an advantage in attracting FDI. Past efforts to overcome this problem through a common regional investment policy for the Caribbean Community (CARICOM) have proved largely ineffective, as member countries adopted incentive schemes that deviated from the agreed harmonized framework.

This chapter seeks to contribute to the policy debate in the Caribbean about the appropriate use and scale of tax incentives to stimulate FDI. To set the stage, we briefly review recent fiscal developments and take stock of the main tax incentives that are being offered in the region (Section A). We then investigate whether tax systems and tax incentives are important determinants for attracting FDI. For this, the chapter reviews FDI trends in the Caribbean over the past 15 years, takes stock of the existing empirical evidence in the literature, and provides further econometric evidence regarding the role that tax systems have played in attracting FDI in the region and in developing countries more broadly (Section B). Even if taxes play a role in attracting FDI, decisions about tax incentives should be based on whether the benefits to the economy and society from the higher investment levels outweigh their costs. This issue is discussed in Section C, where we investigate the revenue losses from existing tax incentives and assess the comparative merits in terms of cost-effectiveness of alternative tax incentives. On the basis of this analysis, Section D derives policy implications for a more rational and efficient use of tax incentives in the Caribbean, and discusses how regional coordination could help overcome collective action problems. Section E summarizes our conclusions.

A. Background

Fiscal authorities in many countries of the Caribbean are facing difficult policy choices.2 A sharp accumulation of public debt in recent years (Table 3.1) has forced many countries to enter a phase of fiscal consolidation to address looming debt sustainability problems. Because of limited scope for expenditure cuts, attention is focusing on raising revenues as the main avenue for improving fiscal outcomes. Cutting back on tax incentives, which are widespread in the region, is one option to consider in this regard. However, there are concerns that such a step could also reduce competitiveness and the capacity to attract investments, and thus ultimately hurt growth prospects.

Table 3.1.Summary of Fiscal Indicators in Caribbean Countries, 2004–061,2(In percent of GDP, unless otherwise stated)
VariableAntigua & BarbudaThe BahamasBarbadosBelizeDominicaDominican RepublicGrenadaGuyanaHaitiJamaicaSt. Kitts & NevisSt. LuciaSt. Vincent & the Grens.SurinameTrinidad & TobagoAve.
Revenues22.718.234.024.033.017.636.037.39.530.036.125.432.826.131.527.6
Tax revenue19.816.432.921.229.516.324.931.89.226.427.723.826.621.929.723.9
Direct taxes3.40.813.16.06.93.94.314.82.010.88.35.47.810.723.88.1
Corporate income tax2.00.05.9n/a2.32.22.76.70.92.25.22.53.95.717.74.3
Personal income tax1.40.05.0n/a3.81.21.27.51.18.502.73.64.44.53.2
Property tax revenue0.40.82.20.20.90.40.40.60.00.00.50.20.20.00.10.5
Royalties (oil/mining)0.00.00.00.50.0n/a00.930.00.10.00.00.00.11.40.2
Indirect taxes16.215.619.815.222.512.420.616.97.215.619.417.619.011.26.015.7
Of which: custom duties43.09.73.07.85.11.86.52.32.72.46.48.75.03.41.64.6
Overall balance-7.2-2.71.1-5.01.2-4.7-3.2-9.85-1.3-5.2-4.5-4.5-8.0-1.55.0-3.3
Primary balance-2.6-0.64.72.15.60.20.6-0.1-0.510.33.6-1.4-3.70.57.71.8
Public debt121.748.573.895.7108.947.6126.8151.535.2135.8189.660.181.335.438.990.0
Corporate income tax yield60.066n/a0.157n/a0.0760.0880.0890.1470.0260.0660.1490.0750.0990.150n/a0.099
Source: Fund staff estimates.

Central government, except for Guyana (Nonfinancial Public Sector), and Dominican Republic (Combined Public Sector: NFPS and central bank).

Average 2004–06. The Bahamas: FY 2003/04–2005/06.

Average of 2004–05. Paid directly to the decentralized agencies (Guyana Forestry Commission & Guyana Geology and Mines Commission). Not included in NFPS tax revenue.

Includes service charges.

After grants.

The ratio of Corporate Income Tax Revenues/Corporate Income Tax Rate, in percent of GDP.

Source: Fund staff estimates.

Central government, except for Guyana (Nonfinancial Public Sector), and Dominican Republic (Combined Public Sector: NFPS and central bank).

Average 2004–06. The Bahamas: FY 2003/04–2005/06.

Average of 2004–05. Paid directly to the decentralized agencies (Guyana Forestry Commission & Guyana Geology and Mines Commission). Not included in NFPS tax revenue.

Includes service charges.

After grants.

The ratio of Corporate Income Tax Revenues/Corporate Income Tax Rate, in percent of GDP.

Recent fiscal developments

Public indebtedness has risen sharply over the past 15 years, and debt sustainability has become a concern in a number of countries. Public debt as a share of GDP (Table 3.2) has steadily increased from an average of 56 percent of GDP in 1990–94, to about 90 percent of GDP in 2004–06. As a consequence, debt service costs now weigh heavily on the budgets of many countries in the region.

Table 3.2.Fiscal Indicators in Caribbean Region, 1990–20061
1990–941995–992000–042004–06
Public debt (in percent of GDP)56.058.289.290.0
Public debt (share of revenues)2.62.53.63.3
Revenues (in percent of GDP)21.823.524.727.6
Corporate income tax (in percent of GDP)3.03.33.94.3
CIT rate (in percent)35.233.132.231.8
Average tariff (in percent)14.514.214.7
Sources: Authorities data; and authors’ calculations.

Simple average of sample of 15 Caribbean countries.

Sources: Authorities data; and authors’ calculations.

Simple average of sample of 15 Caribbean countries.

Governments confronted rising debt pressures by reducing their fiscal deficits, though these efforts have waned in recent years. The average overall central government deficit in the Caribbean fell from about 4.2 percent of GDP in 1990 to about 3.3 percent of GDP in 2004–06. More recently, however, the fiscal picture has become more mixed, driven mainly by increased spending including on the Cricket World Cup.

  • The observed fiscal adjustment was primarily achieved through a larger revenue effort. Central government revenues in the region have risen from an average of 22 percent of GDP in 1990–94 to more than 27 percent in 2004–06, reflecting in part the adoption of the VAT by some countries (Table 3.3). Corporate income tax (CIT) revenues also contributed, rising from an average of about 3 percent of GDP in 1991–94 to more than 4 percent of GDP in 2004–06, notwithstanding a decline in statutory rates.3 However, despite this improvement, corporate income taxes still contribute a relatively modest share to total tax revenues in most countries, especially in the ECCU.

Table 3.3.General Features of the Tax System in Caribbean Countries1
VariableAntigua & BarbudaThe BahamasBarbadosBelizeDominicaDominican RepublicGrenadaGuyanaHaitiJamaicaSt. Kitts & NevisSt. LuciaSt. Vincent & the Grens.SurinameTrinidad & Tobago
Direct taxes
Corporate income tax rates235.037.525.030.025.0 330.035.45 435.0 533.335.033.340.036.025.0 14
Personal income tax rates255.037.525.025.040.030.033.335.0 525.030.040.038.025.0
Personal income tax threshold (share of per capita GDP)0.72.82.31.45.41.31.01.01.41.20.3
Final withholding rate on payments to non-residents
Interests20.015.025.0–33.32010–25
Rents20.015.020.0–25.025.0–33.3101020.0–30.0
Dividends20.015.015.025.0 3152025102510.0–25.0
Royalties20.015.025.025.0–33.31025205.0–30.0
Management fees20.015.025.025.0–33.310252020.0–30.0
Covenants0.020.025.020102020.0–30.0
Entertainers0.025.030.0251020.0–30.0
Depreciation scheduleDecl. bal.n/aDecl. bal.Decl. bal.Straight lineStraight lineStraight lineDecl. bal. 6Straight lineDecl. bal.Decl. bal.Decl. bal.Decl. bal. 7Decl. bal.Decl. bal.
Initial allowance (in percent)n/an/a30.020.020.020.020.020.0
Loss carryforward period6 yrs.89 yrs.95 yrs.5 yrs.85 yrsNo5 yrs.86 yrs.86 yrs. 83 yrs 10
Indirect taxes
VAT 1115.015.0 1212.0 310.012.515.0
Sales tax8,127.55,78,10,25
Consumption/Excise tax15205,8,10,150–1284–175–355–405–25
Simple Average Tariffs1319.634.013.112.312.910.515.012.19.012.315.413.913.813.19.2
Sources: Country authorities; and Fund staff.

Based on tax code for 2003–05.

Highest marginal rate.

In 2005, the DR increased the CIT rate from 25 to 30 percent and the VAT rate from 12 to 16 percent. Starting in 2007, the CIT rate is set to decline gradually to 25 percent by 2009.

Manufacturing noncommercial corporations pay 35 percent on net profit, Non-manufacturing commerical corporations pay 45 percent on net profit.

The rate was lowered to 30 percent as of October 2006.

Some assets are subject to accelerated depreciation or straight line depreciation rules. Initial allowances of 20 percent applies to machines; different rates for different assets.

Declining balance with initial allowance of 10 percent for buildings and 20 percent for equipment.

Cannot reduce taxable income by more than 50 percent in any one year.

Except for losses on life insurance business.

Loss-carry forward is only granted to enterprises which maintain regular accounts with consistent annual balances. Losses incurred after the first 3 years of operations maybe carried forward over the next 7 years.

Main rate. Many countries exempt food staples and medicines. In Barbados certain items are zero rated; a 7.5 percent tax applies to hotel accomodations. In Jamaica taxpayers in the toursim are liable to ½ of the prevailing rate. In Suriname, 10 percent applies to goods, 8 percent to services, 25 percent to luxury goods. In Trinidad & Tobago, services performed abroad are zero-rated.

Dominica introduced a VAT in March 2006 at a standard rate of 15 percent.

Includes other duties and charges.

Fifty-five percent for oil companies.

Sources: Country authorities; and Fund staff.

Based on tax code for 2003–05.

Highest marginal rate.

In 2005, the DR increased the CIT rate from 25 to 30 percent and the VAT rate from 12 to 16 percent. Starting in 2007, the CIT rate is set to decline gradually to 25 percent by 2009.

Manufacturing noncommercial corporations pay 35 percent on net profit, Non-manufacturing commerical corporations pay 45 percent on net profit.

The rate was lowered to 30 percent as of October 2006.

Some assets are subject to accelerated depreciation or straight line depreciation rules. Initial allowances of 20 percent applies to machines; different rates for different assets.

Declining balance with initial allowance of 10 percent for buildings and 20 percent for equipment.

Cannot reduce taxable income by more than 50 percent in any one year.

Except for losses on life insurance business.

Loss-carry forward is only granted to enterprises which maintain regular accounts with consistent annual balances. Losses incurred after the first 3 years of operations maybe carried forward over the next 7 years.

Main rate. Many countries exempt food staples and medicines. In Barbados certain items are zero rated; a 7.5 percent tax applies to hotel accomodations. In Jamaica taxpayers in the toursim are liable to ½ of the prevailing rate. In Suriname, 10 percent applies to goods, 8 percent to services, 25 percent to luxury goods. In Trinidad & Tobago, services performed abroad are zero-rated.

Dominica introduced a VAT in March 2006 at a standard rate of 15 percent.

Includes other duties and charges.

Fifty-five percent for oil companies.

Fiscal consolidation will have to continue in many countries if debt levels are to be brought down to more comfortable levels. While in some cases debt restructuring may facilitate the return to a sustainable debt position, even in such cases a commitment to a substantial fiscal effort is usually needed to achieve sustainability and the necessary support from creditors.4

  • Further improvements in fiscal balances may require further revenue mobilization efforts. While expenditure restraint, and cuts in some cases, will be necessary, considerable social and infrastructure needs persist throughout the region, which limits the scope for adjustment on the expenditure side. In light of this, options to increase public revenues will need to be considered.

  • The streamlining of tax incentives could be one option to improve revenues. Tax incentives erode the tax base and thereby limit revenue buoyancy. Streamlining tax incentives would also help to limit some of the other potentially harmful effects of tax incentives, such as distortions to resource allocation and unproductive rent-seeking and corruption.

Tax incentives in the Caribbean

Tax incentives are pervasive in the Caribbean. Virtually all countries in the region have special incentive regimes, most of them to stimulate private investment. These incentives grant qualified investors a more favorable treatment compared to the general taxpayer (Table 3.4). While most tax incentives are aimed at foreigners, some countries also make them available to domestic investors.6 Usually, tax incentives are only directed at a few sectors in the economy, mostly export-related industries. In some cases, tax incentives form part of a regional initiative to promote development in key sector (e.g., the Hotel Aids Act in the case of tourism).

Table 3.4.Summary of Tax Incentives in Caribbean Countries
CountryTax HolidaysOther Incentives
Antigua & BarbudaUp to 5 years (hotels).

10–15 years (mfg)+ 1

Up to 15 years (enclave enterprises/export-oriented)
Reduced tax rate available only through special permission of the government.

Reduced tax rate on Custom duties and VAT.

No taxes for offshore banking insurance.

Incentives for export processing zones.
BarbadosUp to 11 yearsReduced tax rate on Custom duties and VAT.

Special treatment to investment.

Export allowance provisions.

Credit of 50 percent of the net foreign currency earned.

Deductions:
  • Special treatment accrued to investment under the Fiscal Incentives Act.

  • Foreign currency earnings credit of 50 percent of the net foreign currency earned.

  • Losses maybe carried forward for 9 years.

  • Branch profits to the extent that the branch has reinvested.

BelizeUp to 5 yearsReduced tax rate on Custom duties and VAT.

Exemptions:
  • Receipt of less than BZ$54,000 per year.

  • Rental receipts less than BZ$1,650 per month and sole source of income.

  • Interest on savings.

  • Employment income.

  • Charitable contributions up to BZ$30,000 per year.

DominicaUp to 20 years (hotels).

10–15 years (mfg)+ 1,2

10–15 years (mfg)+ 1,2
Investment allowance or tax credit.

Reduced tax rate on Custom duties and VAT.

No taxes for offshore banking insurance.

Exemptions for expenses incurred in generating income.

Tax holiday of 15 years for enclave enterprises.

Exemptions on withholding tax:
  • Expenses incurred in accruing the income.

  • Interest accruing from deposits in banks in Dominica.

  • Interest accrued on any loan charged on the public revenue.

  • Interest earned from loans made by commercial banks in long-term housing mortgage schemes.

Dominican Republic15–20 years (export processing zones)

5 years (renewable energy generation)

20 years (frontier zones)

10 years (tourism sector)
Export processing zones are exempt from CIT taxes, taxes on construction, corporations, local taxes, import taxes, export or re-export taxes, patent taxes, assets or net wealth taxes.

Nonprofit and charitable organizations are exempt from income taxes as well as import duties, VAT and local taxes.

Equal treatment for domestic and foreign investors

Tax exemptions are established by law, although there is some room on how to apply qualifying criteria.
GrenadaUp to 10 years (hotels).

10–15 years (mfg) + 3,4

Up to 15 years (enclave enterprises/export-oriented)
Reduced tax rate on Custom duties and VAT.

Exemptions on expenses incurred in generating income.

Projects with exports over 60 percent are given tax holidays.

No taxes for offshore banking and insurance.

Investment allowance or tax credit
Guyana5–10 years 5Noncommercial companies face a 35 percent corporate income tax.

Exemptions include:
  • Import duty for all oil products, imports from CARICOM, fuel imports from Venezuela and Curacao, vehicles for public servants, and certain manufacturing equipment and raw materials.

  • Introduced on January 1, 2007, tax credit for VAT on goods imported for business, and zero rate on large working capital items.

  • Up to 75 percent reduction in corporate income tax for exporters of non-traditional products outside the CARICOM area.

  • Nontraditional agro-processing; communication technology, petroleum exploration and refining, mineral extraction, and tourism. Charitable organizations are exempt from CIT, withholding tax, and property tax.

Exempted types of income:
  • 50 percent of capital gain on developed property.

  • 25 percent of capital gain on underdeveloped property.

  • Interest and other income which attract withholding tax.

  • Treasury bill discounts earned by commercial banks.

  • Donations to companies, limited to 10 percent of their chargeable income.

Transparency:
  • Tax exemptions are published annually, starting in 2004.

  • Exemptions are established at the level of laws. Some exemptions are given under the Customs Duties Orders.

HaitiUp to 15 yearsTax holiday: Zero rate for up to 15 years, gradually increase thereafter starting at 15 percent.

Tax incentives are established by law, with no discretion. Available to both domestic and foreign investors.

Sectors: Exports and re-exports, agriculture, craft, manufacturing, tourism and associated services, free trade zones.

Exemptions of turnover tax for local manufacturers that import their new material and export their production or sell to an exporter.

Offshore banking, nonprofit organizations, and charitable organizations are exempt from customs and income tax. Export processing zones are exempt from: royalties, local taxes (except license), VAT and other indirect taxes, and custom duties/fees on equipment imports.
JamaicaUp to 15 yearsInvestment allowance or tax credit.

Reduced tax rate on Custom duties and VAT.

Income from qualifying activities in the export zone is exempt from tax indefinitely.

Exemptions:
  • Charitable, religious, scientific and educational organizations.

  • Other enterprises under the Industrial Incentives Act, the Export Industry Encouragement Act, the Hotel Incentives Act, the Shipping Incentives Act, the Motion Picture Industry Encouragement Act, the Jamaica Export Free Zone Act, the Foreign Sales Corporation Act, the Income Tax Act, in respect of prescribed agricultural activity the Cooperative Societies Act, and the Resort Cottages Act.

  • Income and Incentives on Capital expenditure to an approved organization in a special development area.

  • Income derived from hotels may be exempt up to 15 years.

St. Kitts & Nevis5–10 years (hotels).

10–15 years (mfg)+ 6

Up to 15 years (enclave enterprises/export-oriented)
No taxes for offshore banking insurance.

Enterprises under the Fiscal Incentives Act 1974 and the Hotel Aids Ordinance.

Export allowance at the end of tax holidays calculated as a rebate of a portion of income tax, based on export profits as a percentage of total profits.
St. LuciaUp to 15 years (hotels).

10–15 years (mfg)+ 6

Up to 15 years (enclave enterprises/export-oriented)
Reduced tax rate on Custom duties and VAT.

Investment allowance or tax credit.

No taxes for offshore banking insurance.

Exemptions:
  • Income from and contributions to non-profit institutions

  • All expenses which are wholly and exclusively incurred in the production. of income

  • Capital allowances (initial and annual) on plant and equipment and on industrial buildings.

  • Contributions to nonprofit institutions.

SurinameUp to 10 yearsHoliday period depends on the value of the investment and employment generation.

Tax incentives are based on the Investment Law of 2001.

The Raw Material Act, based on a presidential resolution, has a lower level of regulation. Reduced tax rate on Custom duties and VAT.

The exemption does not apply if the profits, after set-off of losses, amount to twice the invested capital.

Sectors: agriculture, fishery/aquaculture, mining, forestry, tourism (except casino), construction, manufacturing, road transport, and trade.

Exemptions of import duty and turn over tax in case of

  • Imports of investment goods according to Investment Law 2001

  • Imports of project goods if they are financed by investment donors according to the Tariff Act

  • Imports of all goods from the Caricom which are wholly produced within the community, according to the Tariff Act (with the exemption of sales tax)

  • Imports of raw materials according to the Raw Material Act

  • Nonprofit organization and charitable institutions do not pay taxes

A Currency License in Respect of
  • Repayment of foreign equity obtained to finance investment

  • Distribution of profits and/or dividends

  • Interest payments on, and the principal repayment of foreign loans

  • Inter alia, management, technical assistance, know-how and license fees

A Permit in Respect of
  • Residence and establishment of foreign personnel

  • Secondment of foreign personnel

  • Establishment of a company

  • Import and export of goods and services

Both domestic and foreign investors have the same incentives.
Trinidad & TobagoUp to 5 yearsReduced tax rate on Custom duties and VAT.

Allowance to companies which export to countries outside of CARICOM.

An allowance that equals 150 percent of all promotional expenses is deducted from profits.

An allowance that equals 15 percent of capital cost.

An allowance that equals a maximum of 25 percent of the value of investment is deducted from chargeable profits.

Deductions:
  • Wear and tear on plant and machinery and buildings used in the production of income.

  • Bad and doubtful debt. Rates and taxes on real estate.

  • Premium paid on fire insurance.

  • Payments by an employer to an improved fund.

Source: Country authorities.

Exemption for CIT and duties and VAT on imports of plant, equipment, and inputs for approved cases.

No dividend taxes during the tax holiday.

Exemption for CIT and duties and VAT on imports of plant, equipment, and inputs for approved cases.

No dividend taxes during the tax holiday.

Holidays are limited to new firms that create employment in depressed areas or in specific fields. In general, limited to 5 years, with a few exceptions up to 10 years; nonrenewable.

Exemption for CIT and duties and VAT on imports of plant, equipment, and inputs for approved cases.

Source: Country authorities.

Exemption for CIT and duties and VAT on imports of plant, equipment, and inputs for approved cases.

No dividend taxes during the tax holiday.

Exemption for CIT and duties and VAT on imports of plant, equipment, and inputs for approved cases.

No dividend taxes during the tax holiday.

Holidays are limited to new firms that create employment in depressed areas or in specific fields. In general, limited to 5 years, with a few exceptions up to 10 years; nonrenewable.

Exemption for CIT and duties and VAT on imports of plant, equipment, and inputs for approved cases.

CIT holidays are the most widely used incentives in the region. All 15 countries covered by this study (Table 3.5) currently offer CIT holidays, with exemption periods ranging from 5 to 25 years. Longer exemptions are usually granted to key sectors of the host economy (e.g., tourism and manufacturing). Many countries in the region also fully exempt offshore banking and insurance from the corporate income tax.

Table 3.5.Developments in Corporate Income Tax (CIT) Across Caribbean Countries
Variable1990–941995–992000–04
1. CIT Revenue (in percent of GDP)
Average13.113.484.02
Minimum (Haiti)0.591.071.68
Maximum5.446.339.66
(Guyana)(Guyana)(Trinidad & Tobago)
2. CIT Rate (percent)
Average35.233.133.2
Minimum33.025.025.0
(Grenada)(Dominican Republic)(Dominican Republic)
Maximum (Guyana)47.045.045.0
3. CIT Yield2
Average10.0930.1050.127
Minimum (Haiti)0.0170.030.048
Maximum0.1550.1540.307
(Guyana)(St. Kitts & Nevis)(Trinidad & Tobago)
Sources: Country authorities; and Fund staff calculations.

Data in all sample periods exclude The Bahamas with zero CIT rate. In addition, Barbados and Trinidad and Tobago are excluded in 1990–94, and Barbados is excluded in 1995–99 due to data limitation.

Ratio of Corporate Income Tax Revenue to GDP/CIT Rate (percent of GDP).

Sources: Country authorities; and Fund staff calculations.

Data in all sample periods exclude The Bahamas with zero CIT rate. In addition, Barbados and Trinidad and Tobago are excluded in 1990–94, and Barbados is excluded in 1995–99 due to data limitation.

Ratio of Corporate Income Tax Revenue to GDP/CIT Rate (percent of GDP).

Exemptions from indirect and other taxes are also commonly offered. Much like the CIT holiday, indirect tax incentives exempt qualified investors from paying custom duties and VAT on imports for a defined period of time. Other commonly used incentives include employment tax credits (to encourage job creation) and property tax exemptions, including privileged access to preferential land. These incentives are particularly targeted at export-oriented industries, including tourism.

Many countries provide investment cost recovery incentives (investment allowances and accelerated depreciations) as part of their CIT regimes. Investment allowances provide for the deduction of a percentage of the initial investment from taxable income, in addition to the normal allowable depreciation. They are a common feature of the tax code in about half the countries in our sample, and on average allow the immediate write-off of 20–30 percent of investments in machines (the allowed write-off may differ depending on the asset). Accelerated depreciation schemes are found in 9 out of the 15 countries in our sample, and distinctions are made in certain cases between investment in equipment and structures. In contrast to investment allowances, they do not increase the total allowable depreciation for an investment beyond its original cost, but by allowing a faster deduction of investment costs they reduce the distortion of a tax on capital.

Investment incentives are not always fully rules-based and automatic. In most countries, governments retain some discretion in determining the extent of the incentive, including the duration of tax holidays. In some cases the authorities even have discretion over the qualification process, as eligibility criteria are not clearly specified in the Law. For example, in Belize the approval and the duration of income tax holidays for specific investment projects are in the hands of the Minister of Finance. In the Dominican Republic, many investment incentives have been granted through administrative decisions, without congressional authorization, and are not reflected in the tax code.

Moreover, little information is publicly available on concessions that have already been granted. Most countries do not publicize and/or keep a central registry of decisions to grant tax incentives. Also, in many cases—particularly when tax holidays are involved—beneficiaries are either not required to submit financial information to the tax authorities or these requirements are not effectively monitored and enforced. As we will argue in more detail below, the failure to collect basic information about the use of tax incentives is an important shortcoming because it makes it almost impossible to undertake a proper evaluation of the costs and benefits of these incentive schemes.

B. The Effectiveness of Tax Incentives

Whether tax policy, and in particular tax incentives, can attract FDI is a key question for policymakers. We begin our investigation of this subject with a look at the available data for the Caribbean. Unfortunately, little can be said about the composition of FDI, since most available data are aggregates and do not distinguish between the different components of FDI, such as equity increases, investment in new plants, retained earnings and mergers and acquisitions.

Overall, FDI in the Caribbean region has grown both as a share of GDP and in absolute dollar terms over the past two decades, in line with global trends. The average share of FDI to GDP (Table 3.6) increased from 3 percent of GDP in 1990–94 to 5.2 percent of GDP in 2000–05. FDI reached US$3 billion during 2000–05, US$2 billion more than a decade earlier. FDI grew in all countries, except Guyana and Suriname.

Table 3.6.FDI in the Caribbean Region
1990–941995–992000–05
(In percent of GDP)
Caribbean Sample (weighted avg)3.04.65.2
Dominican Republic2.03.84.1
Trinidad and Tobago5.410.17.7
Jamaica3.24.17.1
ECCU9.110.613.2
Other11.92.72.8
(In US$ million)
Caribbean Sample8561,9873,042
Dominican Republic171594870
Trinidad and Tobago264605869
Jamaica161285581
ECCU158248386
Other1103255335
Memorandum items:(In percent)
Caribbean FDI/LAC FDI4.902.813.98
Caribbean FDI/World FDI0.430.310.39
Sources: UNCTAD; and Fund staff estimates.

Includes The Bahamas, Barbados, Belize, Guyana, Haiti, and Suriname.

Sources: UNCTAD; and Fund staff estimates.

Includes The Bahamas, Barbados, Belize, Guyana, Haiti, and Suriname.

Table 3.7.Net FDI in the Caribbean Region, 1990–2005(In percent of GDP)
1990–941995–992000–041990–2005
Antigua and Barbuda8.45.914.39.9
Bahamas0.23.63.62.7
Barbados0.70.70.81.0
Belize3.43.64.84.3
Dominica8.210.68.59.1
Dominican Republic2.03.84.33.4
Grenada7.810.314.710.6
Guyana16.48.96.210.4
Haiti0.30.20.30.3
Jamaica3.24.17.24.9
Saint Kitts and Nevis13.213.222.716.0
Saint Lucia9.39.110.69.9
Saint Vincent and the Grenadines9.420.611.513.4
Suriname-1.2-0.2-5.9-2.2
Trinidad and Tobago5.410.17.97.7
Source: United Nations Conference on Trade and Development (UNCTAD).
Source: United Nations Conference on Trade and Development (UNCTAD).

However, the share of the Caribbean in global and regional FDI has been volatile and has declined somewhat from the early 1990s. During the second half of the 1990s, the Caribbean suffered a significant loss in FDI market share that was only partially reversed more recently. FDI as a share of total inflows into Latin America and the Caribbean reached about 4 percent during 2000–05, after a decline to 2.8 percent during 1995–99. Still, this share remains below the 4.9 percent market share that the Caribbean held in the early 1990s.

The intraregional distribution of FDI is uneven. The region’s largest economies, the Dominican Republic, Jamaica, and Trinidad and Tobago, received over three-fourths of the region’s total FDI during 1990–2005. However, when measured relative to GDP, ECCU countries stand out as the largest recipients of FDI (about 11 percent of GDP during 1990–2005).7

FDI flows are highly persistent. Countries with the largest initial stock of FDI (measured as a share of GDP) also attract the largest inflows. This finding is consistent with that of other empirical studies, and suggests the existence of agglomeration externalities.8 In addition, we find that the countries from where FDI originates vary little over time (Table 3.8).9

Table 3.8.FDI by Sector and Country of Origin
ECCU (1997–2005)Dominican Republic (1994–2005)Trinidad & Tobago (1996–2005)Guyana (2000–05)
FDI by sector (in percent of total)
Tourism58.322.0
Energy (petroleum/electricity)0.217.690.7
Mining2.230.9
Agriculture18.0
Industry/manufacturing 128.70.87.0
Services (telecom/finance)0.424.330.3
Other41.15.18.513.8
FDI by country of origin (in percent of total)
United States24.429.855.3
Canada2.815.62.8
Europe19.737.129.9
Of which:
Italy13.6
Spain18.5
United Kingdom25.3
Caribbean11.1
Other42.117.512.0
FDI by type (in percent of total)
Equity (incl. land sales)57.481.3
Reinvested earnings18.121.5
Other39.2-2.8
Sources: Country authorities; and Fund staff estimates.

Includes Free Trade Zones in the case of the Dominican Republic.

Sources: Country authorities; and Fund staff estimates.

Includes Free Trade Zones in the case of the Dominican Republic.

FDI tends to be highly concentrated in key export sectors, reflecting factor endowments (see Table 3.8). In the case of the ECCU close to 60 percent of FDI has gone to tourism, while in Trinidad and Tobago over 90 percent of FDI has been absorbed by the oil and gas sector. The distribution of FDI is more balanced in the case of the Dominican Republic, reflecting the size and diversity of its economy. There is some evidence that FDI in oil and mining activities (e.g., gold mining in Guyana) responds to changes in commodity prices. Given the recent increase in commodity prices, FDI may increase in these sectors responding to higher internal rates of return on investment.

The observed FDI trends over time and across countries raise a number of questions. Why have Caribbean countries not fared particularly well in the competition for FDI, despite the existence of widespread tax incentives? Why are there strong intraregional variations in FDI inflows, despite the fact that there appear to be much less differences in terms of tax policy, including incentives across countries? These observations already suggest that country-specific factors other than tax systems could be important in determining FDI flows. We will assess this question more formally in the following sections.

Existing empirical evidence

While the literature does not provide a standard model for evaluating the impact of tax policy on FDI, it offers a framework for considering the set of decisions that firms face in the determination of their investments. Horstmann and Markusen (1992) point out that this decision process consists of three distinct and sequential steps. First, a firm must choose whether to access a market or region by producing at home and exporting, or by producing abroad. Conditional on choosing to produce abroad, the firm must then decide where to locate its production. Once a location is selected, the firm has to decide on the scale of its investment, which in theory should be an amount such that the marginal product of capital equals the cost of capital. Taxes affect decisions in all three steps, although likely to a different extent. The first two stages of the decision are discrete choices where the firm chooses the option that generates the highest expected after-tax profit. The decision of how much to invest, conditional on choosing a location, will depend, inter alia, on the marginal effective rate (after incentives) at which the return from the investment is taxed.

A large and growing body of empirical literature suggests that FDI is sensitive to tax policy, although to an extent that varies greatly across studies (Box 3.1).11 The responsiveness of FDI to taxes depends on the tax measure used (statutory, average or marginal tax rates), the sectoral composition and type of FDI considered (new plants, plant expansions, mergers and acquisitions, joint ventures, equity increases), the industry being considered, and other characteristics of the tax regime (Box 3.2). In addition, other country-specific factors are believed to play an important role in FDI determination. Estimations will be biased if these factors are not controlled for. Most studies focusing on developing countries have found that factors such as infrastructure, business climate, the legal system, the availability of skilled labor, and macroeconomic and political stability were more important determinants than taxes to a firm’s investment and location decisions.12

Box 3.1.Literature Review

The literature on tax policy and FDI is vast and increasingly sophisticated for the case of industrial countries. This is particularly true for the United States, where industry and firm-level data are now readily available. While earlier studies used statutory corporate rates to measure the tax effects on aggregate FDI, more recent studies have relied on some type of effective tax rate and distinguished between the different FDI components. In addition, the availability of industry and firm-level data has allowed researchers to study the location decisions of firms. What follows is a short summary of the different studies and methodologies:

  • Time-series studies1 estimating the responsiveness of aggregate FDI to annual changes in tax policy have found a strong and positive correlation between FDI levels and the after-tax rates of return at the industry or country level. Studies using U.S. data find that the sensitivity of FDI to changes in the corporate tax rates ranges between −0.5 and −1.0 (i.e., a 1 percent reduction in taxes leads to a 0.5–1.0 percent increase in inbound investment), while intra-European investment flows appear to be even more responsive to taxes.

  • A series of cross sectional studies have analyzed the effect of taxation on the ownership of capital of U.S. multinationals in foreign countries, using firm-level survey data compiled by the U.S. Commerce Department. Mody and Wheeler (1992) uncover strong evidence for the existence of agglomeration externalities, while finding that taxes do not play a significant role in investment decisions after controlling for a number of important factors, including openness, infrastructure, market size, and labor costs. More recent studies, by Hines and Rice (1994) and Altshuler, Grubert, and Newlon (2001), however, found that capital ownership was quite responsive to different tax measures and that these tax elasticities have increased substantially over time. Studies about the effect of subnational taxation on the distribution of FDI across U.S. states found that new plants were less likely to be established in states with higher income taxes (Swenson, 1998), and that state taxes influenced the origins of FDI across the United States. (Hines, 1996).

  • Discrete choice models have analyzed the effect of taxes on location decisions, using firm-level survey data. Kemsley (1998) finds that U.S. firms are more likely to use exports to serve foreign markets that have heavy tax burdens than those with low ones. Devereux and Griffith (1998) study the choice of U.S. firms, conditional on having chosen to locate in Europe, to produce in France, Germany, or the United Kingdom, and find that statutory rates have considerable more predictive power than the effective (marginal and average) rates. More recent work by Buettner and Ruf (2007) on location decisions of German multinationals in EU countries confirms these findings.

  • Panel data studies using aggregate data on FDI flows have found taxes to have a significant impact on investment flows. Devereux and Freeman (1995) use a panel of seven industrialized countries to show that effective marginal tax rates have a negative and significant impact on FDI flows relative to GDP. More recent work by Billington (1999) and Yong (1999) have yielded similar results.

For developing countries, taxes appear to have a more modest impact on FDI, with other factors playing a more important role. Shah (1995) examines the effects of tax incentives using different methodologies across a set of developing countries. He finds that while tax incentives may encourage new investment, particularly in machinery and equipment and in export-oriented sectors, they significantly erode the tax base. More recent studies by Gastanga, Nugent, and Pashamova (1998) and Wei (2000a) using a panel data set for developing countries have found that, after controlling for country-specific effects, different tax measures have a small and adverse effect on FDI. These findings are also consistent with survey studies conducted by the OECD (1994 and 1995) across Asian and transition economies, where tax incentives were found to have a limited role in the investment and location decision of multinational firms, with basic economic and institutional environment being far more critical. A case study by the McKinsey Global Institute (2003), which covered four large emerging economies and five industry sectors reached similar conclusions. However, data constraints in most developing countries limit the analysis regarding the role of taxes on the investment and location decisions of multinationals. In fact, most studies continue to use aggregate FDI data, and tax measures are often limited to statutory corporate rates, which do not capture the extent of tax incentives.

1 See Hartman (1984); Boskin and Gale (1987); Newlon (1987); Young (1988); and Slemrod (1990).

Box 3.2.Taxation of Foreign Income and FDI

In theory, the impact of tax incentives on a firm’s investment decisions depends on the tax regime in the firm’s country of origin.

  • Under a source-based system, income earned abroad is not taxed in the home country. In this case, a decline in host country taxation increases the net return on investment, and has a potential positive impact on FDI. Most EU countries have source-based tax systems.

  • Under a residence-based system, income earned abroad is taxable, but firms can claim a credit on taxes paid abroad. Since a decline in host country taxation will be associated with a higher tax liability at home, changes in host country taxation (e.g., through the introduction of tax incentives) would generally not have an impact on FDI, unless a firm has an excess tax credit position (in which case an increase in host country taxes does affect the net return on investments). The United States, Japan, Greece, Ireland, Spain, and the United Kingdom all tax income on a global basis.

However, according to empirical studies, the impact of home country tax regimes on FDI is mixed. Slemrod (1990) finds no clear evidence indicating that investors from countries that exempt U.S. profits from home country taxation are more sensitive to tax changes than investors from countries granting foreign tax credits. Tanzi and Bovenberg (1990) argue that excess foreign credit and tax deferrals render the distinction between tax credit and tax exemption systems of little importance, while others claim that residence-based systems are de facto source-based systems, because taxation of repatriated earnings can usually be avoided. Another study by Hines (1996), however, found that investors from Germany (which exempts foreign-source income) were more likely to locate in lower-tax U.S. states than investors from the United Kingdom (which provide tax credits).

Studies for the Caribbean suggest that taxes have played a limited role in attracting FDI. Using a panel sample of ECCU countries for the period 1990–2003, Chai and Goyal (2006) find that the benefits of tax incentives, in terms of increased FDI, are far outweighed by the tax revenues forgone, estimated in the range of 10–16 percent of GDP. Similarly, a recent survey of about 160 multinational firms operating in the Caribbean (see FIAS 2004; and World Bank, 2006) found that tax concessions did not rank among the most important factors for investment decisions. Instead, the availability of telecommunications services, power supply, political stability, a favorable attitude toward FDI, and labor productivity played a more important role in attracting investment.

However, the importance of taxes appears to be more pronounced in the tourism sector. According to a recent survey of multinationals in the Caribbean (FIAS, 2004), investment in the tourism sector is more sensitive to tax incentives relative to other sectors. In fact, generous incentives have been in place since the 1960s, including through regional initiatives such as the Hotel Aids Acts, which grant firms tax holidays and special exemptions from indirect taxes. Currently, the bulk of the tourism resorts in the region are foreign owned and tourism receipts have grown to represent on average close 25 percent of GDP. In pressing for investment incentives, the tourism sector has often argued that:

  • Investments in tourism are associated with important positive spillovers, including employment generation, access to new technology, and agglomeration externalities (e.g., once a hotel is set up, others will follow).

  • Unlike other sectors, investments in tourism are somewhat different in that they are normally associated with large upfront and sunk investment. Therefore, unless guarantees and incentives are provided foreign firms would be reluctant to invest, particularly where institutions and property rights are weak.

To summarize, while most studies find that FDI is sensitive to taxes, the international empirical evidence is not conclusive. The magnitude by which taxes and tax incentives influence investment decisions varies considerably across studies and has tended to be smaller in developing countries, including the Caribbean.

Further empirical work: Determinants of FDI in the Caribbean

We build on the existing literature for developing countries by using panel data to examine the sensitivity of FDI in the Caribbean to different tax measures. Data were compiled for our set of 15 Caribbean countries between 1990 and 2004, a summary of which is provided in Appendix 3.1. As a first step, we evaluate whether statutory tax rates can help explain FDI flows using different estimation techniques. Subsequently, we extend this analysis by using marginal effective tax rates (METRs), in an attempt to better capture the effect of tax incentives.

We start by estimating the determinants of FDI using pooled OLS methods.13 The regressions are estimated without country-specific dummy variables because much of the interesting variation in the data is across countries—most of our explanatory variables are either very slow moving or constant. However, the time-series dimension of our data set is retained to avoid suppressing useful information about within-country variation. To overcome a potential omitted-variable bias problem, we control for as many determinants as possible and include dummy variables for the ECCU, where FDI has been traditionally very high. The results are summarized in Table 3.9.

Table 3.9.Results Using Pooled OLSDependent Variable: Log (FDI/GDP)
BaselineWith Time TrendWith Lag-FDIBothWith Initial Stock of FDIWith METRWith METR Buildings
CIT rate-0.09***-0.09***-0.08***-0.08***-0.09***
-8.62-8.51-7.81-8.04-8.27
METR-0.01*-0.03***
-1.82-3.11
FDI Incentives1.54***1.54***1.30***1.30***1.33***0.170.43**
7.235.238.919.196.020.842.04
FDI Restrictions-3.14***-3.14***-2.66***-2.66***-3.18***-1.40***-1.71***
-10.14-8.88-9.68-9.86-9.91-8.65-7.86
Governance3.76**3.76**2.56**2.56**4.05***4.66***5.14***
2.512.512.202.202.602.812.90
Infrastructure0.63***0.63***0.63***0.63***0.63***0.48***0.46***
3.783.795.445.524.162.862.61
ECCU dummy0.44***0.44***-0.08-0.090.47***0.47***
3.323.32-0.72-0.793.213.13
Initial stock of FDI0.15***
3.83
Constant-3.92***-3.96***-3.43***-3.38***-3.91***-3.46***-3.81***
-5.81-5.66-6.61-6.09-5.84-5.07-5.54
Time trend0.004-0.005
0.18-0.27
Lag FDI0.07***0.07***
5.305.33
Observations122122122122122122122
R-Squared0.720.720.790.790.720.590.60
Source: Authors’ calculations.Numbers below coefficients are z statistics based on panel-corrected standard errors.

* significant at 10 percent; ** significant at 5 percent; ***significant at 1 percent level.

Source: Authors’ calculations.Numbers below coefficients are z statistics based on panel-corrected standard errors.

* significant at 10 percent; ** significant at 5 percent; ***significant at 1 percent level.

  • Statutory CIT rates are found to have a significant impact on FDI. We find that a 1 percentage point reduction in statutory taxes rates leads to about a 0.6 percent of GDP increase in average in inbound investment.14 This result is similar to those found elsewhere in the literature for industrialized countries, and suggests that statutory tax rates are a more important determinant of FDI in the Caribbean than in other developing country studies.

  • Measures of FDI restrictions and incentives also play a significant role in explaining capital inflows. While FDI restrictions (in the form of foreign ownership limitations and exchange controls) are an important deterrent of FDI, incentives (in the form of tax concessions and free trade zones) play a significant, yet less important, role than restrictions in attracting capital inflows. The number of tax treaties does not seem to affect FDI.

  • Measures of institutional quality and infrastructure development (proxied by phone lines) are found to be significant and important determinants of the FDI. The governance indicator developed by Kaufman and others (2005) did better than other institutional measures, including the ICRG political and social risk indices and the World Bank’s Doing Business indicators. In line with the results of the recent survey of multinational firms operating in the Caribbean, the development of telecommunications (proxied by the number of telephone lines per 1,000 inhabitants) turned out to be a more relevant measure of infrastructure than paved roads, which were also positively related to FDI but not statistically significant.

  • Other determinants commonly used in the literature are less relevant. Measures like openness, macro stability, GDP per capita, and schooling/education are positively related to FDI but not statistically significant. The level of public indebtedness, meant to capture future tax pressures, is not statistically significant, and its sign is not robust to the different specifications, perhaps reflecting the fact that countries that are able to attract FDI are also able to obtain other forms of financing.

FDI is on average more than 3 percentage points of GDP higher in the ECCU than other Caribbean countries. This may reflect special circumstances (i.e., the high reliance on tourism) or non-linearities associated with agglomeration externalities.15 On the latter point, we find that the initial (1990) stock of FDI captures the same effects as the ECCU dummy. This finding provides some support to the first-mover advantage hypothesis.16

FDI persistence plays a small yet significant role in explaining FDI differences across countries. With the introduction of a lagged FDI term in our pooled OLS regression, the long-run elasticity of the CIT is unchanged. However, the importance of FDI incentives/restrictions and governance declines somewhat, while the ECCU dummy is no longer significant. The latter finding suggests that the high FDI to GDP ratios observed in the ECCU could be attributed to the stickiness of capital inflows. Controlling for a time trend does not affect our estimations significantly. This implies that changes in CIT rates, governance, and infrastructure development can explain the evolution of FDI over time, despite their slow-moving nature.

To better capture the tax burden on investment, we estimate marginal effective tax rates (METRs) on foreign investments and introduce them into our regressions.17 METRs are often considered to be a more comprehensive measure of the tax pressure than statutory rates, because they incorporate the impact of other relevant provisions of the tax code. We find that METRs have a much smaller impact on FDI. The economic and the statistical significance, however, are higher in the case of buildings (which have a much lower depreciation rate than machines). This finding is consistent with the fact that much of FDI in the region is in the tourism sector, a large component of which is buildings. It should be noted, however, that our METR measure still provides an imperfect measure of the tax liability of an investor because it only captures part of the provided tax incentives (since it excludes the impact of tax holidays and incentives on indirect taxes, particularly import duties).

Determinants of FDI in developing countries

To gain additional perspective, we extend our analysis to a larger set of developing countries.18 In particular, we examine whether the determinants of FDI that were identified for the Caribbean also hold more generally for developing countries. While focusing on the Caribbean region allows us to analyze FDI determinants taking regional characteristics as given, the broader developing country set allows us to capture factors that differentiate the Caribbean region from the rest of developing countries.

For the sample of developing countries, our baseline model does not explain differences in FDI across countries as well as for the Caribbean countries alone. The results are summarized in Table 3.10.

Table 3.10.Results Using Pooled OLSDependent Variable: Log (FDI/GDP), Developing Countries
BaselineWith Time TrendWith Lag-FDIBothWith Small Island DummyWith Openness
CIT rate-0.01***-0.01***-0.001-0.001-0.01***-0.01***
-2.66-2.66-0.41-0.40-2.68-3.03
FDI Incentives-0.05-0.05-0.06***-0.05**-0.1*-0.02
-0.92-0.94-2.64-2.35-1.66-0.41
FDI Restrictions-0.22***-0.22***-0.05***-0.05***-0.17***-0.18***
-16.06-16.07-3.02-3.23-9.80-10.77
Governance0.92**0.9**0.350.291.08***0.04
2.292.310.850.712.650.10
Infrastructure0.16***0.15***0.040.050.12***0.14***
3.603.491.101.282.963.09
Small island dummy0.28***
2.41-0.50-0.523.07
Openness0.005***
11.43
Constant0.580.370.110.95*0.6**0.50*
2.080.730.401.692.141.85
Time trend0.007-0.03*
0.48-1.88
Lag FDI0.75***0.76***
9.639.94
Observations392392390390392392
R-Squared0.160.160.640.640.170.22
Source: Authors’ calculations.Numbers below coefficients are z statistics based on panel-corrected standard errors.

* significant at the 10 percent; ** significant at 5 percent; ***significant at 1 percent level.

Source: Authors’ calculations.Numbers below coefficients are z statistics based on panel-corrected standard errors.

* significant at the 10 percent; ** significant at 5 percent; ***significant at 1 percent level.

  • Statutory CIT rates are found to have a significant but much smaller impact on FDI. A 1 percentage point reduction in statutory taxes rates leads to less than a 0.1 percent of GDP increase in FDI, which is more in line with findings of previous studies focused on developing countries.

  • While FDI restrictions play a significant role in explaining FDI, the FDI incentives measure is no longer statistically significant. This finding is consistent with other studies, including Desai and others (2004), and Mody and Murshid (2002). The fact that FDI incentives matter for FDI distribution within the Caribbean, but not in the larger developing country sample, may reflect region-specific characteristics, including higher competition for FDI.19

  • While measures of institutional quality and infrastructure development continue to be significant, they are a less important determinant of FDI. The governance indicator developed by Kaufman and others (2005) again performs better than other indices. Much like in the case of the Caribbean, the development of telecommunications is a more relevant measure of infrastructure than roads.

  • Other determinants commonly used in the literature such as macro stability, GDP per capita, and schooling are not statistically significant. The level of openness of the economy, however, is found to be positively and significantly related to FDI.

  • FDI is on average more than 2 percentage points of GDP higher in small island economies than in other developing countries. This may reflect special circumstances, including tourism dependence, the lumpiness or indivisibility of FDI, and competition.

  • The explanatory power of the regression improves substantially after controlling for FDI persistence. However, with a lagged FDI term in our pooled OLS regression, most variables including the CIT rate are no longer significant, with the exception of the FDI restriction composite. Controlling for a time trend does not affect our estimations significantly, in line with the results for the Caribbean subsample.

To summarize, these findings broadly confirm the existing empirical literature on the subject. While we find that FDI is sensitive to tax policy, other factors such as institutional quality, infrastructure development, and FDI restrictions are also important determinants of FDI flows. FDI incentives do not appear to have a significant impact on FDI flows in the larger developing country sample, unlike in the Caribbean subsample where incentives seem to matter. In addition, controlling for the persistence in FDI flows reduces the significance and magnitude of the impact of taxes and other variables.

The empirical results are subject to a number of caveats. First, we do not have a comprehensive measure that encompasses all investment incentives. While we capture some of the tax incentives (limited to the corporate income tax and those specified in the tax code), we do not capture other incentives such as exemptions from indirect or property taxes, as well as incentives offered outside the tax code.

Second, we do not control for home country tax policies, owing to lack of a consistent data set. Finally, since we only have aggregate FDI flows, we cannot capture the impact of tax incentives across sectors and on different components of FDI.20

C. The Efficiency of Tax Incentives

Even if tax incentives are effective in attracting FDI, policymakers should weigh the benefits against possible costs. Tax incentives will only be efficient policy instruments if their benefits exceed costs. According to Zee, Stotsky, and Ley (2002), these costs essentially consist of distortions to resource allocation arising from the fact that only some investments/sectors benefit from incentives, foregone revenue, resources required to administer incentives, and social costs of corruption and/or rent seeking activities connected with the abuse of incentive provisions.

Because of insufficient information estimating the costs and benefits of tax concessions is difficult and therefore seldom constitutes the basis for policy decisions. Typically, efforts to assess the efficiency of tax incentives are limited to an estimation of costs in terms of revenue forgone.

Revenue costs

The revenue loss from tax concessions has two dimensions. First, there will be investment projects that would have taken place even without tax incentives. The revenue foregone from these projects represents a cost to the government. In addition, the availability of incentives could lead to potential abuse by firms that are not eligible to benefit from them, thus generating additional revenue losses.

Because of the difficulty to identify the amount of investment that would have taken place without investment incentives, cost estimates often focus on the total revenue loss from all tax concessions. This tends to overestimate the costs, since it also counts lower revenue from firms that would not have invested in a particular country without the incentives. Potential tax collections are estimated based on statutory tax rates and tax bases, while effective tax collection is based on the actual revenue collection. While the impact of tax incentives will be embedded in this gap, a variety of other factors may also contribute to it, such as the efficiency of tax collection and tax administration.

A rough estimate for the Caribbean based on a tax gap methodology shows that existing tax incentives appear to be costly. The average tax gap for the CIT alone is estimated at about 5½ percent of GDP across our sample of 15 Caribbean countries for the period 1995–2004, and consistent with a ratio of effective to potential tax receipts of only about 40 percent.21 In estimating the potential corporate income tax, and in absence of reliable national accounts data across countries in our sample, we assume that corporate income represents one-fourth of GDP, a figure consistent with national accounts data for Jamaica. If indirect taxes (custom tariffs) are included, the total tax gap doubles to over 10 percent of GDP.23 These estimates are somewhat lower than those provided by Chai and Goyal (2006) for the ECCU during 1990–2003.

As noted, the gap between potential and actual taxes is only indicative but not conclusive of the true cost of tax incentives and should therefore be interpreted with caution. The tax gap (Table 3.11) represents an upper bound on revenue losses associated with incentives as some foreign investment projects would not have taken place in their absence. Moreover, other factors such as evasion, inefficiencies in tax administration, or the business cycle position (i.e., the effect of carry-forward of losses) contribute to keep tax revenues below potential. On the other hand, the tax gap also does not capture the distortions in resource allocation associated with tax incentives that discriminate across sectors. By favoring one form of economic activity (such as tourism) over another, tax incentives distort relative prices, and facilitate rent seeking and corruption by making the tax system more complicated and nontransparent.

Table 3.11.Potential Less Actual Taxes (1995–2004)(In percent of GDP)
Corporate Income Taxes1Import-related TaxesTotal
Caribbean (average)5.65.210.8
Dom. Republic4.03.97.9
Trinidad3.32.45.7
Jamaica6.23.910.1
ECCU5.45.711.1
Other6.15.711.8
Source: Authors’ calculations.

Assumes corporate sector represents ¼ of total GDP.

Source: Authors’ calculations.

Assumes corporate sector represents ¼ of total GDP.

Relative cost-effectiveness of tax incentives

Because of the difficulties in conducting cost-effectiveness assessments, the literature has developed some guidance for policymakers about the comparative merits of alternative types of tax incentives.24

  • Direct tax incentives. Tax incentives that provide for a faster recovery of investment costs (such as investment allowances, investment tax credits, or accelerated depreciation) are generally preferable to income tax holidays. The latter are costly, because they are prone to revenue leakage through transfer pricing and other abuses. In addition, the effectiveness of tax holidays is believed to be limited because the benefit is not directly linked to the desired investment activity, and because it is of little value for projects that achieve their profitability in the more distant future. Incentives that grant faster investment cost recovery are, by contrast, less prone to abuse through income shifting, easier to control, and leave the government the potential to collect revenue from highly profitable investment projects.

  • Indirect tax incentives. Incentives in the form of partial or full exemptions of indirect taxes are very costly because of the high risk that qualified purchases are diverted to unintended beneficiaries. Also, in a functioning VAT system an exemption on the purchase of inputs is not very valuable to the beneficiary, since VAT on inputs would be creditable. Additional considerations for the tourism sector can be found in Box 3.3.

  • Statutory basis of incentives. Tax incentives should have their statutory basis in the tax law and not be established in legal instruments that can be changed on an ad hoc basis. Similarly, access to incentives should be fairly automatic upon the fulfillment of a set of objective criteria, and the public entities in charge of administering the incentives should have little room to determine the eligibility and/or the extent of the benefit. Incentive schemes with little discretion are more likely to limit socially wasteful activities such as rent-seeking and corruption, and thus more likely to be cost-effective.

Box 3.3.Indirect Tax Incentives in the Tourism Sector

Advocates for tax incentives in the tourism sector have often argued that the tourism tax base is highly mobile, in that demand is very price sensitive. If tourists can readily substitute between broadly similar locations, lower tax rates (in the form of lower VAT) could be justified on the basis of optimal taxation—the higher the elasticity of demand the lower the tax.

However, there is no clear evidence that demand for tourism is more elastic than that for other goods and services. Studies for The Bahamas suggest that changes in relative prices between competing locations played only a minor role in tourist destination decisions, though they did affect marginally the amount spent by the tourist while in the country (IMF, 2005). Gago and others (2006) find that in the case of Spain, the imposition of hotel and lodging taxes had only minor effects on the activity level of the hotel industry.

Strategies to create a unique tourist destination could help lower the elasticity of demand. However, in the case of the Caribbean exploiting uniqueness will likely require some regional coordination since countries offer somewhat similar opportunities for tourists. Thus, while the elasticity of demand for each country in isolation is relatively high, collectively they face a much lower elasticity if they were to limit intraregional tax competition. This argument should not be overstated given competition with countries outside the region.

Hence, if incentives are to be provided, some form of coordination to avoid excessive tax competition would be useful. The suggested approach to coordination outlined in the next section applies also to the tourism sector. There may also be scope for harmonization in some of the difficult tax policy and administration issues such as the tax treatment of foreign tour operators.

D. Policy Implications

What implications can be drawn from this analysis for policy? The empirical results of our study, which are consistent with the bulk of the existing evidence in developing countries, suggest that tax policy has had an impact on foreign investment flows to the Caribbean. At the same time, however, there appear to be other factors such as the quality of institutions and infrastructure that have a large positive and very significant effect on FDI. This suggests that there are limits to the role that tax incentives and, more generally, tax policy can play in attracting FDI. Instead, addressing structural, institutional, and other policy shortcomings would appear to be at least equally valid—if not more promising—avenues to foster investment inflows and economic development.

The fact that tax incentives may have significant revenue costs also raises efficiency issues. While the absence of data precludes a thorough cost-benefit analysis, the very rough indicative calculation in the previous section shows that the revenue costs of tax incentives could be significant, and strategies to stimulate FDI through tax incentives could therefore well be uneconomical. Reducing the scope of tax incentives and putting the savings to use on other aspects that have been shown to affect FDI decisions, such as a sound macroeconomic environment or better infrastructure and institutions, could on a net basis improve the prospects for attracting foreign investment to the region.25

Even if policymakers prefer to maintain tax incentives, there is scope for efficiency gains through improvements in their design. The types of incentives that are currently most widely used in the region deviate in a number of aspects from best practice, and they could be replaced by other more cost-effective instruments.

Improving the design of tax incentives

Overall, there are good reasons for the Caribbean to continue to follow the global trend of lowering CIT rates, while broadening the tax base, including by reducing the level of tax incentives. This approach would (i) lower the level of taxation at the margin;26 (ii) improve the equity of the system by leveling the playing field for all firms; (iii) increase economic efficiency by removing distortions created by incentives; and (iv) reduce the complexity of the tax system. While statutory rates in the Caribbean have fallen by an average of 2 percentage points since 1995, this decline has been much sharper in the OECD, where statutory rates have been reduced by 7–8 percentage points over the same time period. In this context, CIT rates in the Caribbean have become relatively less competitive.27

Tax incentive regimes should be reformed based on a number of basic principles:

  • Legal basis. Tax incentives should be consolidated in one law (or in the relevant tax laws), be available to all firms on the same terms, and be granted through a fairly automatic and objective administrative process that leaves little—if any—discretion.

  • Phasing out of tax holidays. Tax holidays should not be renewed and new holidays should not be granted. Tax holidays and exemptions are especially inefficient in promoting investment in new enterprises, which are often unprofitable in the early years and unlikely to benefit from the incentive.

  • Use of depreciation allowances. If tax incentives for investment are to continue, these should normally be in the form of accelerated depreciation allowances. Such schemes are known to be a well-targeted and transparent way of encouraging investment. However, they should not be too generous otherwise they can encourage the development of capital intensive over labor intensive industries. Investment allowances need to be carefully considered since they favor investment in short-lived assets, and are prone to abuse.

  • No undermining of indirect tax reform. Incentives provided to existing indirect taxes should not be extended to new indirect taxes. This is particularly relevant given the global trend of offsetting the revenue losses of lowering tariffs through the adoption of modern broad-based indirect taxes such as the VAT and excises.

  • Acquired rights and time-bound limits. When tax incentives are repealed, investors eligible for the prior incentives should typically be grand-fathered. If incentives are to continue, then they should be subject to a time limit to ensure a regular review of their costs/benefits and whether they continue to meet the purpose for which they were introduced.28

  • Transparency. All tax incentives other than holidays should be reviewed to determine their cost and effectiveness. The cost of the incentives should be published alongside the annual budget expenditure figures, in the form of a tax expenditure budget. However, this will require an effort to collect systematic information on the granting of tax concessions and beneficiaries.

A broader tax base with a low corporate rate facilitates tax administration. In particular, it is simpler to administer uniform tax provisions which are granted to all, such as a low CIT rate or accelerated depreciation, then trying to administer specific incentives such as tax holidays. Moreover, the streamlining of tax incentives should be accompanied by efforts to modernize and professionalize revenue administration. Foreign investors often press for tax holidays to avoid high tax compliance costs, including from corruption. Properly administering an accelerated depreciation scheme, considered a superior choice to tax holidays, will demand a more sophisticated and well-trained administration.

Regional coordination

Reforming tax incentive systems require coordination at the regional level. Countries are often reluctant to reduce tax incentives for fear of loosing investment to neighboring countries who offer more generous incentives, whether real or perceived. Countries may try to outdo one another in providing incentives, leading to a “race to the bottom” in the region, resulting in tax rates that might be too low and tax bases too narrow given fiscal constraints. Addressing this collective action problem requires some form of regional tax coordination.

Such coordination should follow some basic principles. These include protecting the tax base and strengthening the tax system of each country; maintaining a friendly tax environment for investment in the region through moderate and predictable taxes; avoiding tax discrimination and tax competition; and respecting national sovereignty. Based on those principles, a regional code of conduct could include the following elements:

  • Transparency. The investment incentives of each country, including its laws, regulations, guidelines, and administrative procedures, should be transparent and readily available. Each country should produce an inventory of existing tax incentives and strive to publish a tax expenditure budget for its incentives.

  • Nondiscrimination. Domestic and foreign investors should be able to make investments in a country on the same terms, and there should be no discrimination between foreign investors from different countries.

  • Limiting tax competition. Countries within the region should not compete by granting tax holidays, lower tax rates, other incentives (both monetary and in-kind), or preferential administrative treatment, which unduly favors a particular location for investment.29 The region may wish to establish certain minimum rates for the corporate income tax and the standard VAT, as well as maximum limits on the overall size of benefits that can be granted to individual projects (scaled by project size).

  • Rollback of existing investment incentives. Current investment tax incentives should be reviewed and assessed against the above criteria. Agreement should be sought on a timetable to phase-out incentives failing to meet those criteria.

The success of regional coordination efforts will depend on each country’s compliance with the code of conduct and the existence of effective mechanisms to enforce it. An important design issue is whether there is a mechanism to ensure enforcement of the code. A legally binding code requires a body that has legal power to enforce the code, including imposing penalties for infringements, and a judiciary to rule on disputes. The most likely regional body to monitor a code would be CARICOM, given that it already has a role in monitoring regional agreements, while the recently formed Caribbean Court of Justice could fill the judicial role. However, countries may be reluctant to give up sovereignty on these issues by entering into legally binding arrangements. If so, countries could at least agree on a nonbinding code that is essentially a moral obligation of participating countries and relies on each country’s goodwill.30 In addition, there may be opportunities for tax harmonization in other areas, including tax administration, taxpayer information sharing, and tax issues affecting large taxpayers such as transfer pricing methodologies. Box 3.4 includes some examples of other regions that have attempted tax coordination to reduce tax competition.

Box 3.4.The Experience with Tax Harmonization in Other Regions

European Union

The European Union has been successful in establishing a number of rules and proposals for tax coordination. These include:

  • Sixth VAT Directive. This directive seeks a uniform basis of assessment for VAT. The directive provides a minimum standard rate for VAT of 15 percent, and lists goods and services that may be exempt or taxed at a lower rate.

  • Code of Conduct for business taxation. This is a nonbinding code of coordination whereby members agree to rollback, and not introduce, measures that unduly affect the location of investments.

  • EU State Aid rules. The tax systems of member states must also be in line with EU state aid rules. These rules prohibit any aid granted by a member state or through state resources, in any form, that distorts or threatens to distort competition by favoring certain undertakings or the production of certain goods, in so far as it affects trade within the European Union. In contrast to the business taxation code, state aid rules are enforceable under EU law, such that if they are breached the member state must recover the aid together with interest.

  • Common consolidated corporate tax base. The European Union is also researching the possibility of developing a common corporate tax base, with profits being distributed between countries on a formula basis. The perceived benefits of this approach include reducing the compliance costs resulting from the need to deal with 25 tax systems within the European Union; doing away with transfer pricing problems at least within the European Union; allowing for the offset and consolidation of profits and losses on an EU basis; simplifying many international restructuring operations; avoiding many cases of double taxation; and removing many discriminatory situations and restrictions. A key and as yet unresolved issue is the appropriate formula for the allocation of the tax base. Allocation in part by capital itself, as in some of the U.S. states, may actually make tax competition worse.

Central America

Central America and the Dominican Republic, in the context of the free trade agreement signed with the United States, are in the process of developing a code of conduct on tax incentives. The idea of the code arose from a concern in the region that countries would increasingly seek to provide tax incentives to attract U.S. investment, resulting in an erosion of the already low tax base.

As a first step, finance ministers from the region set up a technical working group on tax coordination and established a regional Council of Finance Ministers. The working group, which is supported by the IMF, IADB, and the Spanish government has compiled a matrix of existing tax incentives, prepared a draft code of conduct on tax incentives for investment, as well as a regional model for tax treaties to avoid double taxation of income and capital. The draft agreement on tax incentives envisages limits on the concession of new incentives but would grandfather existing ones. Observance of such limits would be monitored by a standing technical group, reporting to the Council of Ministers.

In addition, success in harmonizing tax incentives hinges critically on the political backing and commitment of member countries. Past harmonization attempts in the Caribbean, including the Harmonized Scheme of Fiscal Incentives to Industry introduced in the 1970s by CARICOM, have failed because of the lack of a strong regional institution with the political mandate to guide, supervise, and enforce the agreement. The apparent success of tax coordination in the European Union reflects the willingness of member states to participate and mechanisms to enforce compliance. The experience in the European Union and Central America also indicates that developing a code conduct, and conducting an inventory of existing incentives, is a time-intensive process, which must be carefully prepared and sequenced to ensure a successful agreement is reached.

E. Conclusions

The reliance of many Caribbean countries on wide-ranging tax incentives to attract FDI merits reconsideration. The empirical results of this study, which are consistent with the existing literature, suggest that tax incentives and tax policy more broadly have had a positive, yet limited, impact on foreign investment flows to the Caribbean. However, because of data deficiencies it is not possible to ascertain whether the provided incentives have been efficient, given that they have likely imposed considerable costs in terms of revenue losses and other economic distortions. In the circumstances, a more sparing use of tax incentives may be warranted, particularly in light of the fiscal adjustment that is needed in many countries to address high debt levels. Instead, policies to promote FDI could focus more strongly on other instruments that have consistently been shown to have a large positive and very significant effect on FDI, such as improving the quality of institutions and infrastructure.

A number of steps could be taken to achieve a more rational and efficient use of tax incentives. A general strategy of lowering CIT rates, while broadening the tax base, including by streamlining tax incentives, would seem to be a promising avenue to ensure the continued attractiveness of the region as an investment destination. In this context, the design of existing tax incentive systems could be enhanced by phasing out tax holidays and—if deemed necessary—replacing them with investment cost recovery incentives. There is also room to curtail exemptions on indirect taxes. Tax incentives should receive a legal basis, become less discretionary, and their costs should be made more transparent. Implementing such changes in the region may require a stronger coordination effort, to help overcome collective action problems that otherwise could hamper reform efforts at the national levels.

Appendix 3.1. Data Sources and Definitions

Foreign direct investment. Data on aggregate FDI (inflows and stock) are taken from UNCTAD’s World Investment Report, which is also broadly consistent with the FDI inflow data from IFS. FDI inflows as a share of GDP is the dependent variable.

Fiscal measures. We use two tax policy measures based on information found in the annual World Wide Corporate Tax Surveys published by Ernst and Young, as well as Caribbean-specific tax surveys conducted by Bain and dos Santos (2004) and Rider (2004). While statutory CIT rates were compiled for all developing countries in our sample, marginal effective tax rate were computed for only our Caribbean sample, given data requirements. In addition, we collected data from UNCTAD on the number of tax treaties to control for double taxation factors.

FDI incentives and restrictions. To capture other forms of FDI incentives and restrictions, we use two series on FDI incentives and restrictions indices compiled by Wei (2000b), extended to the Caribbean by Chai and Goyal (2006). These indices, which range between 0 and 4, are based on the descriptions of government policies by PriceWaterhouseCoopers’ Investment Guides. Accordingly, FDI restrictions are the sum of four binary variables on (i) control on foreign exchange transactions; (ii) exclusion of foreign firms from certain strategic sectors,; (iii) exclusion of foreign firms from other sectors; and (iv) restrictions on the share of foreign ownership. Similarly, FDI incentives are the sum of four binary variables on (i) existence of special incentives for foreigners to invest in certain industries or geographic areas; (ii) tax concessions specific to foreign firms; (iii) cash grants, subsidized loans, reduced land for use, and other nontax concessions; and (iv) special promotion for exports (including export-processing zones).

Governance. We use several sources to capture institutional factors, including (i) the governance index compiled by Kaufmann (2005), capturing six dimensions of governance (voice and accountability, political stability, government effectiveness, regulatory quality, rule of law, and control of corruption); (ii) the ICRG political and social risk indices; and (iii) the World Bank’s Doing Business indicators.

Infrastructure. As a proxy for infrastructure development we use telephone lines per 1,000 people, as well as paved roads as a percent of total roads.

Other measures. We use other variables commonly used in this literature, including (i) secondary school enrollment as a proxy for degree of human capital; (ii) debt to GDP as a proxy for tax pressures looking forward; (iii) GDP per capita as a proxy for level of development; and (iv) openness (measured as the sum of exports and imports as a share of GDP inflation). In addition, we compute a macro stability index constructed as a weighted average of inflation, fiscal deficits, exchange rate and reserve volatility (similar to the one calculated by Jaramillo and Sancak, 2007). Finally, we include tourism receipts as a share of GDP, to capture the special features of this sector.

Appendix 3.2. Alternative Estimation Methods

Regressions are reestimated using panel data random-effects and fixed-effects methods to test the robustness of our results. We find that while random-effects regressions yield results similar to those in pooled OLS, the explanatory power of our fixed-effects regressions drops significantly (see Appendix Tables A3.1 and A3.2, which summarize the results). Fixed-effect regressions focus on the within-country variation, and by controlling for unobserved country-specific effects are protected from omitted variable biases. However, since most of our explanatory variables are either constant (FDI incentives and restrictions) or slow moving (governance and infrastructure), our fixed-effects regressions must be interpreted with caution since they tend to produce less precise estimates.

Appendix Table A3.1.Results Using Alternative MethodologiesDependent Variable: Log (FDI/GDP)
Pooled OLSRandom EffectsFixed Effects
CIT rate-0.09***-0.07***-0.06**
-6.23-3.51-2.44
FDI Incentives1.54***1.32**
5.351.97
FDI Restrictions-3.14***-2.59***
-9.11-4.21
Governance3.76***1.90*1.23
2.841.681.09
Infrastructure0.63***0.66**0.39
3.892.471.16
ECCU dummy0.44***0.54
2.431.24
Constant-3.92***-3.28*0.79
-6.51-1.860.41
Observations122122122
R-Squared0.720.710.08
Source: Authors’ calculations.Numbers below coefficients are t/z statistics.

* significant at 10%;** significant at 5%; ***significant at 1% level.

Source: Authors’ calculations.Numbers below coefficients are t/z statistics.

* significant at 10%;** significant at 5%; ***significant at 1% level.

Appendix Table A3.2.Results Using Alternative MethodologiesDependent Variable: Log (FDI/GDP), Developing Countries
Pooled OLSRandom EffectsFixed Effects
CIT rate-0.01-0.01-0.01
-1.78-0.67-0.53
FDI Incentives-0.05-0.02
-0.72-0.13
FDI Restrictions-0.22***-0.19**
-5.70-2.21
Governance0.92*2.27***3.15***
1.653.083.65
Infrastructure0.16**0.060.14
2.510.650.95
Constant0.580.08-1.02
1.290.12-1.09
Observations392392392
R-Squared0.160.150.09
Source: Authors’ calculations.Numbers below coefficients are t/z statistics.

* significant at 10%; ** significant at 5%; ***significant at 1% level.

Source: Authors’ calculations.Numbers below coefficients are t/z statistics.

* significant at 10%; ** significant at 5%; ***significant at 1% level.

In our fixed-effect regression using the Caribbean subsample we find that a 1 percentage point decline in the statutory corporate rate is associated with a 0.4 percentage point increase in FDI to GDP (compared to 0.6 percent using pooled OLS). However, improvements in governance and infrastructure, while contributing positively to FDI are not significant. Meanwhile, in our larger developing country sample we find that while changes in statutory rates are not significant in explaining changes in FDI flows, improvements in governance are positively related to FDI.

It should be noted that we excluded the lagged dependent variable in the fixed-effect regression, since this would produce biased coefficients. A proper way to control for the lagged FDI would be to run dynamic-panel data estimation methods. However, as with fixed-effect estimations, these methods would not produce precise estimates given that most of our explanatory variables are slow moving or constant and that dynamic-panel data methods are based on differencing the data to get rid of unobservable country-specific factors.

Appendix 3.3. Estimating Marginal Effective Tax Rates

METRs are estimated for investments in two assets (machinery and buildings) across all sectors using the cost of capital approach developed by Hall and Jorgenson (1967) and extended by King and Fullerton (1984) and more recently by Devereux and Griffith (1998). The user cost of capital includes both the opportunity cost of forgoing investments and direct costs such as depreciation and taxes. We build on the work of Sosa (2006), who estimated METRs for the ECCU, and extend it to include other Caribbean countries for 1990–2004.

Definition: The METR is defined as (r+δ)(τZ)(r+δ)(1Z)δ(1τ),

where

  • r = real interest rate;

  • δ = economic depreciation rate of capital;

  • τ = statutory CIT rate;

  • Z = present value of depreciation allowances.

Data and assumptions: The CIT rates, the nonresident withholding tax rates, and the depreciation schedule are taken from the tax code of the respective countries using information in Bain and dos Santos (2004) and the annual World Wide Corporate Tax Surveys published by Ernst and Young. In line with the literature, we use country and time-specific inflation rates and assume exchange rates are unchanged in real terms. Real interest rates are set at 10 percent, and the lifetime of assets are assumed to be 20 years in the case of machinery and 50 years for buildings. A weighted average METR is calculated assuming (in line with the OECD) that two-thirds of all assets are in machines and one-third is in buildings. We abstract from personal income taxes (PIT) since multinational corporations (those making FDI) do not make investment/location decisions on the basis of the PIT position of their shareholders. In addition, we exclude other fiscal and nonfiscal incentives in the host country, as well as tax holidays, since they are often granted on a discretionary basis.

Results: METRs are on average roughly 70 percent lower than the top statutory rates, though the importance of incentives appears to have increased slightly over time. METRs differ across countries with Barbados, Dominica, and Grenada offering the largest incentives (Appendix Table A3.3)

Appendix Table A3.3.Corporate Income Tax in Caribbean, 1990–2004(In percent)
Statutory RateMarginal Effective Tax Rate1METR/Statutory Rate
1990–941995–992000–041990–941995–992000–041990–941995–992000–04
Antigua and Barbuda40.040.037.033.533.630.50.840.840.83
Bahamas0.00.00.00.00.00.0
Barbados37.040.038.520.422.421.30.550.560.55
Belize41.035.029.037.731.525.50.920.900.88
Dominica35.033.030.021.318.115.80.610.550.53
Dominican Republic35.025.025.026.518.515.80.760.740.63
Grenada35.035.033.019.719.217.90.560.550.54
Guyana47.045.045.031.530.230.40.670.670.67
Haiti35.035.035.017.218.618.50.490.530.53
Jamaica33.333.333.324.122.622.30.720.680.67
St. Kitts and Nevis40.039.235.428.527.624.20.710.700.68
St. Lucia33.333.331.327.627.426.30.830.820.84
St. Vincent and the Grenadines40.040.037.026.526.523.70.660.660.64
Suriname45.040.836.833.629.726.30.750.730.71
Trinidad and Tobago42.035.635.033.427.026.40.790.760.75
Caribbean average35.934.032.125.423.521.70.700.690.68
Sources: Country authorities; and Fund staff estimates.

Excludes impact of tax holidays.

Sources: Country authorities; and Fund staff estimates.

Excludes impact of tax holidays.

Caveats: METRs are forward-looking measures of the tax burden of an investment which just covers the cost of capital, and hence are better suited to evaluate investment decisions conditional on a firm having made its location decision.

Average effective tax rates (AETR), which measure a firm’s overall profitability, are better suited to assess location decisions. Unfortunately, available FDI data are of an aggregate nature and do not separate FDI into new FDI and expansionary FDI. That said, AETRs lie somewhere in between the METRs and the statutory rates.

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Chapter 4 discusses the impact of trade preference erosion on the Caribbean.

For the purpose of this study, we refer to the Caribbean as a group of 15 countries that includes the ECCU members, The Bahamas, Barbados, Belize, Dominican Republic, Guyana, Jamaica, Haiti, Suriname, and Trinidad and Tobago.

The top statutory CIT rate was reduced from an average of over 35 percent in 1990–94 to about 32 percent during 2004–06. This decline in statutory tax rates is in line with observed trends elsewhere in the world. Devereux, Griffith, and Klemm (2002) provide evidence about the reduction of statutory corporate tax rates in industrialized countries, while Keen and Simone (2004) do so for developing countries.

Belize, Dominica, the Dominican Republic, and Grenada have recently restructured part of their public debt. Moreover, Guyana and Haiti continue to benefit from global initiatives (Heavily Indebted Poor Countries Initiative and Multilateral Debt Relief Initiative) to reduce the debt of highly indebted poor countries.

Limiting incentives to FDI has often been justified on grounds that the cross-border ownership of capital improves the efficiency of the domestic economy.

During 1990–2005, FDI-to-GDP averaged under 4 percent for a group of small developing country islands including Fiji, Malta, Maldives, Mauritius, and Seychelles.

Persistence of FDI flows could be due to other factors, including (i) herding behavior of firms; (ii) the fact that it takes time to build new plants/buildings, and inflows are phased over a period of time until the completion of the project; and (iii) the fact that an important portion of FDI is measured as retained earnings of multinational corporations, there is a natural persistence to these flows. Data for the ECCU and Trinidad and Tobago suggest that reinvested earnings account for about 20 percent of total FDI, while equity investments vary between 60–80 percent.

Over 40 percent of FDI to the region originates from the United States and Canada, and another 30 percent from Europe. Intraregional investment flows are small, accounting only for about 10 percent of total inflows in the case of the ECCU. The origin of FDI is likely determined by geographical proximity and historical ties.

For a detailed literature survey, see Devereux and Griffith (2002), Hasset and Hubbard (1997), Hines (1999), Mooji and Ederveen (2003), and Zee, Stotsky, and Ley (2002).

Lim (1983), who found a negative relationship between incentives and FDI, argued that incentives were symptomatic of an attempt to mitigate an otherwise unfavorable environment for investment.

Alternative estimation methods yield broadly similar results. Details are presented in Appendix 3.2.

Given that FDI in our sample averages 7 percent of GDP, an 8.6 percent increase in this ratio corresponds to a 0.6 percentage point increase in the FDI to GDP.

The share of tourism receipts in GDP is also positively associated with FDI, however, its statistical significance is not robust to changes in specification.

Markusen (1990) demonstrates that a firm’s early decision to invest in a region (including because of an accident of history) can promote the creation of specialized services that reinforce the areas attractiveness.

METRs were computed for all countries in the region for the 1990–2004 period. Appendix 3.3 contains a description of the methodology and documents METRs across countries over time.

For this purpose, data for a set of 80 developing countries (including the Caribbean) was compiled for the 1990–2004 period (see Appendix 3.1).

A possible explanation is that since multinationals have stronger bargaining power in small-island economies, FDI might be higher in the Caribbean region because it is easier to obtain investment incentives.

Data from firm-level surveys compiled by the U.S. Commerce Department are scarce for most of the Caribbean countries in our sample.

The income tax gap has been on a declining trend, falling from 6.2 percent of GDP in 1990–94.

In estimating potential revenues from custom duties we multiply imports by the average tariff rate published in the IMF Trade Statistics.

See McLure (1999), Chalk (2001), and Zee, Stotsky, and Ley (2002).

In the absence of reliable infrastructure (roads, electricity, water, and phone service), governments often resort to second-best solutions (i.e., tax incentives) to attract FDI.

While the METR could increase, the marginal rate on repatriated profits would fall.

While the average CIT rate in the OECD fell to 27.8 percent in 2007, the average rate in the Caribbean is still roughly 32 percent.

The time limit will depend on the type of incentive, but a review should be carried out at least every five years and preferably more frequently.

Some have acknowledged that a code of conduct could increase incentives for third countries to cut their taxes, because they then know that the signatories are less likely to follow.

While the EU code of conduct for business taxation is nonbinding, it does have political force. Meanwhile, state aid rules are enforceable under EU law, such that if the rules are breached the member state is required to recover the aid together with interest. In the ongoing efforts to establish a Central American code of conduct (see Box 3.4), the current draft envisages monitoring by a standing technical group, which would report to the Council of Ministers.

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