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back to index backAMERItalk February,  2005


Tax incentives: An endangered species?

This powerful tool for increasing the competitiveness of states and nations is increasingly coming under fire.


In September 2004, an investment tax credit granted to DaimlerChrysler AG by the state of Ohio was ruled unconstitutional by the U.S. Appeals court. In the European Union (EU), a movement is under way to halt tax competition among member states; meanwhile the Organization for Economic Co-operation and Development (OECD) — a group of major Western economic powers that cooperate to improve international economic development — is acting to end what it labels "harmful tax practices."

The United Nation's World Investment Report 2004 is urging a number of countries to ensure that tax rates remain competitive in order to lure foreign investment from more developed countries. Incentives — particularly tax incentives — play an important, if controversial, role in this.

Tax incentives can take many forms. For example, the widely-used Dutch Holding Company, a tax-exempt entity, can be combined with offshore holding company intermediaries. Double-tax treaties can then be used to yield low effective tax rates on flows of profits and capital gains from business interests in jurisdictions that, on the surface, appear to have high tax regimes. In addition to playing one tax regime against another, businesses also enjoy tax incentives offered by governments.
     
Governments everywhere are offering businesses a wider variety of incentives beyond income and property tax abatements, as well as increasingly larger packages. How successful are these lavish packages when it comes to influencing expansion and business location decisions? An even more important question to most site and new facility planners is: What does the future hold for such incentives, both domestically and internationally?

Tax Incentives Soon a No-No in the United States?
The recent adverse court ruling in Ohio may foretell a trend. It casts doubt on the future of a major tool used by many state and local governments in the United States to attract new businesses and create jobs. What's worse, the ripples from this court decision could extend beyond DaimlerChrysler and hobble similar strategies nationwide.
     
The lawsuit was filed in 2000 by a group of 12 taxpayers and three small business owners in Ohio, naming Chrysler, the City of Toledo, and the state of Ohio as defendants. The suit challenged both the state's investment tax credit and local property tax waivers given to Chrysler. The investment tax credit was what the court ruled unconstitutional.
     
Specifically, the Sixth Circuit Court of Appeals in Cincinnati ruled that the state of Ohio showed preferential treatment to DaimlerChrysler by awarding it an investment tax credit for expanding in Ohio over other states. Writing on behalf of the three-judge appeals panel, Judge Martha Craig Daughtrey explained that the Constitution authorizes Congress to regulate commerce and "implicitly limits the state's right to tax interstate commerce."
     
Chrysler's plant opened in April 2001 and could, potentially, be on the hook to repay tax credits. Although the Chrysler group reportedly received $280 million in incentives to build a $21 billion Jeep manufacturing plant, it is unclear how much of that incentive package involves the tax credit or how Chrysler could be affected by this decision.
     
If the decision stands, it could have a far-reaching impact not only on the four states under the court's jurisdiction — Ohio, Kentucky, Tennessee, and Michigan — but also on other states with similar tax credit programs.
     
States understandably want to attract businesses with investment and tax credit appeal. If this case has created a precedent, this type of tax incentive package may represent unconstitutional impediments to interstate commerce by discriminating against investments in other states. A similar controversy may exist in the European Union.

Tax Competition in the European Union
The European Commission — the ruling body of the EU — has decreed that tax competition among the member states is here to stay, but not all member states agree. French Foreign Minister Nicolas Sarkozy, in fact, recently suggested that the new EU member states should be prevented from slashing their corporate tax rates, especially while receiving large amounts of structural aid.
     
Sarkozy argues that "One does no favor to either Europe or new members by engaging in and financing fiscal and social dumping . . . .. What else can you call it if certain countries are authorized to cut their taxation on companies to zero, while at the same time they receive financing — in very significant proportions — paid for by the taxpayers in other member states?"
     
Sarkozy, supported by his counterparts in the German government, wants the EU to consider linking to corporate tax rates the amount of infrastructure aid received from the EU's structural budget.
     
However, the EU's incoming tax commissioner, Ingrida Udre, has rejected the idea of fixing company tax rates, saying that tax competition "is normal in a free market."

OECD Versus the U.S.
The Senate Appropriations Committee recently approved a funding bill containing language that would bar the U.S. government from funding the Organization for Economic Cooperation and Development (OECD) if the OECD has tried to identify, report on, or penalize any country that encourages foreign investment through the use of tax incentives. The bill would specifically prevent the United States from contributing its share of the OECD's funding unless the Secretary of State certifies that the OECD hasn't even attempted to engage in such activity. Yet for years the OECD has pursued this course of action as part of its ongoing campaign against harmful tax competition.
     
While this provision will not likely appear in the final version, it does at best convey a mixed message to the OECD and its ongoing efforts to stem unfair tax competition. By demanding on the one hand that the OECD end its efforts to curtail "harmful tax practices" among member states while on the other hand engaging in its own "unfair trade practices" by offering foreign investors in the United States preferential tax treatment, the U.S. government is also sending mixed messages to the world.
     
Many countries offer tax breaks of some kind to encourage investment. The OECD, for its part, seeks to establish standards that encourage an environment in which fair competition can take place. Unfortunately, the results of a study recently released by the OECD listed 49 countries — 14 of them among the OECD's own members — indulging in what the OECD labels as "unfair tax competition."
     
The OECD does not seek to dictate to any country what its tax rate should be, or how its tax system should be structured. Its bylaws, after all, encourage the creation of a level playing field among all countries and jurisdictions. Under those bylaws, that level playing field is to be accomplished, at least in the area of taxes, by promoting principles designed to enable each country to apply its own tax law without interference of practices that operate to undermine the fairness and integrity of each country's tax system.
     
According to the OECD's Project of Harmful Tax Practices, a low or zero effective tax rate is the necessary starting point when seeking to identify a preferential tax regime, but that alone does not suffice to find harmfulness. Any such finding requires an overall assessment of factors such as: (1) the regime imposes low or no taxes on the income from geographically mobile financial and other service activities; (2) the regime is ring-fenced from the domestic economy; (3) the regime lacks transparency — for example, the details of the regime or application are not apparent, or there is inadequate regulatory supervision or financial disclosure; and (4) there is no effective exchange of information with respect to the regime.
     
The OECD goes one step further, stating that any evaluation requires an overall assessment of each of the above factors and that, once a regime has been identified as potentially harmful, the economic effects must be examined.

Fairness on an International Scale
Most industrial countries have pursued tax reforms to ensure that their economies remain attractive for investment. The average top personal income tax rate in the major industrial countries of the OECD has fallen 20 percentage points since 1980. The average top corporate income tax rate has fallen six percentage points in just the past six years.
     
Rising tax competition has caused governments to also adopt defensive rules in order to prevent residents and businesses from enjoying lower tax rates abroad. In the United States, such tax rates are hugely complex and affect the ability of U.S. companies to compete in world markets. Other defensive responses to tax competition include proposals to harmonize taxes across countries and to restrict countries from offering tax climates that are too hospitable to foreign investment inflows.
     
Through its work, the OECD endeavors to build support for fair competition so as to minimize tax-induced distortion of financial aid and (indirectly) real investment flows, and to increase the confidence of taxpayers in the evenhanded application of tax rules. The EU, despite a few critics, espouses competitive tax rates while the United States continues to modify its tax laws and cut tax rates in an effort to attract foreign investment. The state and local governments so heavily dependent on tax incentives to attract industry must now consider the latest setback handed them by the courts.

Realpolitik Makes Incentives Resilient
As economic integration increases, individuals and businesses gain greater freedom to take advantage of foreign economic opportunities. That, in turn, places an increased emphasis on the investment and location decisions impacted by taxation. Countries feel pressure to reduce tax rates to avoid driving away their tax bases. International "tax competition" is increasing as capital and labor mobility rises.
     
Although incentives offered by governments to attract businesses have been in use for well over a century and have been subjected to widespread academic scrutiny, few can claim with any degree of certainty that tax incentives actually influence any business's location decisions. Do tax incentives stimulate business activity in blighted areas or do companies simply gravitate to the richest places with the most money to offer?
     
Without government incentives, all companies would locate wherever it was most profitable for them to operate. They would seek things such as a skilled labor force, the availability of raw materials, and short distance to markets. The only inducement for a firm to locate in a sub-optimal place would be an abatement sufficiently large to offset the disadvantages of operating there. Even as many experts and scholars wonder why abatements are still used, the growth of that usage continues, and the EU continues to promote tax competition with a few discordant notes.
     
Tax incentives and abatements appear to be here to stay. The only real questions are what form they will take and who they will benefit.

Source: Area Development magazine  - GAI


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