A crazy kind of subsidy

What happens if tax holidays get replaced by subsidies? Well, maybe not so much – at least, that’s what most people think at first. Yet that’s wrong! Why? Because subsidies with the same features as tax holidays are highly unusual, and therefore a shift to subsidies would be a big improvement. In this blog I’ll explain why.

Earlier this month, the OECD held a public consultation about proposals for global minimum tax rules. Such rules would not just address aggressive profit shifting and create a more level playing field for well-behaved multinationals. The new rules would also disable full tax holidays for foreign investors, by putting a floor in effective corporate tax rates. This second effect is particularly important for developing countries, which often find themselves caught in competition with their neighbours to attract foreign investors.

Some responses to the OECD’s consultation emphasize that governments may easily circumvent the new rules by replacing low-tax regimes with equivalent subsidies. That seems plausible, but wait a minute, let’s consider it more carefully. What would an equivalent subsidy look like? A subsidy with the same features as a tax holiday would be proportional to a company’s profits, and zero if a company on balance keeps reporting losses. Such subsidies are unusual, and for a good reason.

The economic rationale of a subsidy is to encourage behaviour that generates social benefits in excess of private benefits. For example, a subsidy can stimulate a company to employ more people, invest more in R&D, and so on. To that end, a subsidy should be linked to a relevant variable, such as the number of jobs generated or the amount or R&D expenses. In short, a subsidy can compensate for positive externalities. However, there is no need to encourage a company to make profits. Markets may have many failures, but a lack of financial self-interest is usually not one of them. Giving a subsidy linked to the level of profits would be kind of crazy. Thus, it is highly unlikely that tax holidays get replaced by equivalent subsidies; they will be replaced by more useful ones.

Why, then, do countries provide tax holidays in the first place? In part because political reality is different from economic theory. If foreign investors demand full tax holidays and threaten to go somewhere else if they don’t get them, implementing well-designed subsidies instead is of little use.

Furthermore, tax breaks may be a safe bet for budget-constrained governments. A government might be unsure whether it can eventually collect a meaningful amount of corporate tax from a foreign investor, even if its business performs very well. After all, some multinationals still manage to shift their profits out of developing countries to jurisdictions with (near) zero tax regimes.

And sometimes, though certainly not always, tax breaks are a result of cronyism and corruption. The risk for this is highest if they can be granted in a discretionary and intransparent manner.

Fortunately, effective minimum tax rules will change political reality. Once they put a floor in corporate taxes worldwide, there will be no pressure anymore from foreign investors to go below the minimum. The new rules would also reduce profit shifting, and hence increase the likelihood that subsidized investments will generate corporate tax revenues. The key to better policies, then, would be to ensure that subsidies replacing tax holidays are transparent and non-negotiable, and therefore less sensitive to corruption.

In many cases, simply putting an end to full tax holidays and not replacing them with anything might be better, while allowing some transition period for existing investments. However, even if governments replace tax holidays by subsidies, such subsidies will have different features and effects – they will be less crazy than the tax breaks they replace – so that will still be a big improvement.