The effectiveness of tax incentives in attracting foreign direct investment : the case of the Southern African Development Community

Abstract

The problem of low domestic savings is inherent in most Southern African Development Community (SADC) countries. This has motivated most of the SADC countries to institute policies that seek to attract foreign capital to cover the investment deficit that arises from low domestic savings rates. This study gives robust conclusions on the effectiveness of individual tax incentives commonly used by SADC countries in attracting foreign mobile capital. This study has broadened the dimensions research can take in analysing the contribution of tax incentives to Foreign Direct Investment (FDI) inflows into developing countries. In separating individual tax incentives mainly used in the SADC region the study gives a robust analysis on the impact of each tax incentive on FDI inflows into SADC countries. The tax incentives used in this study are: tax holidays, corporate income tax (CIT), reduced CIT in specific sectors and losses carried forward. The study also derives data indices for governance, infrastructure and economic policy variables which gives the study clean and reliable data for efficient regression results. These macroeconomic data derivations assist in giving the FDI attraction analysis more variables and well behaved data in drawing conclusions. Through an analysis and comparison of trends in FDI inflows and stock data in different African regions the study draws important conclusions on the impact of the socio-economic environment in FDI attraction. The study, in consultation with data from the period 2004 to 2013 separates the SADC countries into four panels based on resource richness. Panel 1 includes the resources-rich countries, Panel 2 the resources-poor countries, Panel 3 all SADC countries, except South Africa and Panel 4 all the SADC countries. Each of the estimate models in this study, use individual tax incentives variables to avoid the effects of collinearity between different tax incentives variables and to improve the predictive power of the panel data models. This study derived tax incentives data for individual SADC countries, from Ernst and Young’s worldwide tax data. Regular tax incentives in the SADC are derived from tax holidays, corporate income tax (CIT); losses carried forward and reduced CIT in specific sectors. This study seeks to achieve two major objectives: firstly, to establish the effectiveness of tax incentives in attracting FDI inflows into SADC countries, and, secondly, to establish other variables that influence FDI inflows into SADC countries. The study estimated four panels for SADC countries, separated according to resource richness. This was done because different types of FDI are dependent on the available resources in developing countries and thus factors that influence the FDI inflows differ according to resource richness. Resource-seeking FDI moves to resources-rich economies, market-seeking FDI goes to economies that have access to larger markets and efficiency-seeking and strategic-asset-seeking FDI move to economies that ensure efficient use of their capital resources. Thus, as expected, factors that attract FDI to countries in the separate panels differ in direction of causality and magnitude of impact. The study adopts a system Generalised Method of Moments (SYS GMM) methodology to address the problem of endogeneity associated with dynamic panel data models. The estimated results established that tax holidays positively explain FDI inflows in Panel 2. CIT was found to negatively affect FDI inflows into all SADC countries despite their particular category of resource-richness. Losses carried forward are insignificant in all panels and reduced CIT in specific sectors negatively influences FDI inflows in Panel 1 and surprisingly positively influences FDI inflows in Panel 2. The lagged FDI variable shows a positive relationship with current year FDI inflows. The governance index is significant and positively affects FDI inflows in panels 1, 3 and 4. Panel 2 shows a negative relationship between governance and FDI inflows. Market potential measured by GDP growth rate is insignificantly different from zero in all the four panels in the study and negatively signed, except in models A and C of Panel 2. The stock of infrastructure is significant and negatively signed in all the panels. The log natural resources variable though insignificant in some models, mainly, exhibit a significant and negative effect in most models of the study’s panel estimations. The trade openness variable is positively related to FDI inflows in Panel 1. Panel 2 show negative effects of trade openness to FDI inflows. Financial globalisation significantly impacts positive FDI inflows in all the four panels. The economic policy variable is insignificant in all the four panels of the study, except, in model B of Panel 1 where it is weakly significant at 10% level and negatively signed. The study concludes that tax incentives are important in FDI attraction in the SADC countries; therefore, an effective tax mix that ensures efficient use of tax incentives is important to ensure sustainable FDI inflows into the region. Good governance is important in the region for FDI inflows to increase. Increasing government rents from natural resources reduces FDI inflows in the SADC. Previous year flows of FDI are positively related to current year inflows, thus consistent FDI attraction policies in the SADC are important. Infrastructure in the SADC should be consistently improved to ensure suitability with the dynamic nature of foreign investment. Financial markets should be developed to ensure effective flow of capital and growth in economies through more investment.