Despite ongoing criticisms about their effectiveness, tax incentives remain a central strategy developing countries use to attract investment. Tax holidays are, for example, used in almost 90% of developing economies. This continued reliance on incentives suggests a disconnect between evidence and practice, raising important questions about what drives policy-makers to use incentives, what pressures prompt them to do so, and what alternatives exist.

For the past 15 years, the International Institute for Sustainable Development (IISD) has convened the Investment Policy Forum—the only gathering of investment policy-makers from developing countries. This community of practice gives us a unique vantage point from which to begin to understand investment policy-makers’ perspectives on incentives. This year, in Manila, we had several sessions on tax incentives, where we began to explore these critical questions and the complexities surrounding the continued use of tax incentives in developing economies. Delegates highlighted several pressures that prompt them to continue to offer incentives.

Compensating for Perceived Political Risk

Investment policy-makers offer incentives to compensate for political risk. Investing in some developing countries can be risky for investors due to factors such as weaker institutions, less robust rule of law, and other governance challenges. These can impact the cost of capital, which in turn can impact the cost of investment. One response from governments has been to offer incentives to lower the tax cost and make investments more attractive.

However, it should not be taken as a given that developing countries are automatically high-risk or that this will necessarily deter investment. Argentina, for example, was named among the top 10 high-risk countries for investors in mid-2023. At the same time, it was still ranked amongst the top recipients of foreign direct investment in the world. Several developed countries face huge political instability and yet this does not necessarily lead them to offer incentives. There is a very different power imbalance between large companies and developing country governments compared to developed countries where incentives are less common. This can encourage companies to overstate the level of risk to take advantage of developing countries on incentives, amongst other terms.

Finally, the meaning of “high-risk” is complex, and it has various meanings across industries, affecting investment decisions in different ways. For example, in the Middle East and Northern Africa, during periods of political instability, non-resource tradeable investments are the most affected, while natural resource sectors and non-tradeable activities remain insensitive to such situations. Policy-makers should avoid generalizing risks. They should critically analyze the situation and break it down to determine precisely what risk, if any, exists and what impact it has on investment. Otherwise, they may give overly generous or unnecessary incentives that do not address specific barriers to investment.

Attracting Investment to Alleviate Economic Pressures

Investment policy-makers also cite political and economic pressures as a motivation for offering incentives. Investment is often seen as the catalyst for generating jobs in developing countries. A study by Tax Justice Network Africa found that several West African governments adopted incentives to attract investment with job creation as one of their main goals. However, there is no clear evidence that granting incentives leads to more jobs. In these same countries, the lack of targeted incentives favoured investment toward natural resource extraction instead of the manufacturing sector, which, unlike extractives, has greater potential to create high- and low-skilled jobs. Thus, even by providing incentives, these countries fell short of their employment goals. Moreover, incentives like the establishment of special economic zones might involve more flexible labour rules, which can undermine job quality and security.

Competition with neighboring countries can intensify these pressures. Governments perceive investment as limited, leading them to offer incentives to avoid losing investments to nearby nations with similar offerings. Membership in trade and customs unions or regional economic groups can exacerbate this competitive dynamic by eliminating non-tax-related barriers, such as tariffs, leaving tax as the main basis on which countries can compete for mobile investment.  This can heighten the risk of a “race to the bottom” for non-location-specific investments. For these reasons, it is important for regional economic groups to commit to harmonizing tax rates.

Path Dependency and Investor Expectations

Investment policy-makers highlighted that even where incentives are no longer appropriate or necessary, having previously granted them can create expectations from new investors that they will receive the same treatment. New investors might also exploit this dynamic, leveraging information shared by existing investors to strengthen their negotiating position.

While this lock-in effect can influence policy decisions, governments retain the right to adapt approaches and regulations according to their economic priorities and, with strong political will and clear communication, push back on excessive investor demands.

What Are the Alternatives to Incentives to Attract Investment?

Investment policy-makers were clear that incentives remain the easiest tool to reach for in their investment promotion toolbox and that more time and resources are needed to explore viable alternatives. The first alternative mentioned by policy-makers was the improvement of the business environment to attract investment. This consists of good infrastructure, macroeconomic stability, clear property rights rules, and good governance and judicial system, among other elements. Tax incentives will not offset the lack of any of these factors, and ironically, offering these benefits will reduce the revenue available to the state to develop a better business environment.

Investment facilitation and process digitalization were also mentioned as potential alternatives. Investment facilitation measures aim to waive ground-level obstacles to investment, foster transparency, and provide administrative efficiency to place investments. Providing easy and accessible information online and digitalizing and simplifying administrative procedures can make it easier for companies to invest. IISD, through its Tax Incentives and Sustainable Investment work, encourages policy-makers to question the assumptions underpinning the use of incentives and explore alternative approaches.

Investment policy-makers have an important role to play in incentives reform. A report by IISD found that 80% of 70 surveyed investment laws contain incentives. The continued use of incentives despite the overwhelming evidence that they are not necessarily effective suggests a significant disconnect that can only be overcome by better understanding the pressures investment policy-makers to grant incentives and building a shared understanding across government of the different ways to attract investment.

Through initiatives like the Investment Policy Forum, we support efforts to ensure that tax and investment policies do not operate in silos but instead reinforce each other, creating a stable and balanced environment to attract sustainable investment in developing countries that contributes fully to domestic revenue mobilization goals and other policy priorities.