Wednesday, 1 August 2012

Stopping the Race to the Bottom

By Hubert Schmitz

We have just launched a research report on ‘Who drives economic reform in Vietnam’s provinces?’.  Vietnam continues to surprise the world with the speed and depth of its economic transformation. Our project finds that the decentralisation of economic power from central to provincial government has contributed to this success. It explores who drives the economic reform in the provinces, by studying the role of business, government and public-private alliances. We found that the private sector played an important role, not against government but with government.  In the provinces which made most progress in reform the private sector was very much involved. Other positive things came out of this investigation:  For example the provinces competing with each other and learning from each other has contributed a great deal to Vietnam’s progress.

The web story on the websites of IDS and our partner organisation VCCI  give you some of our other findings. However, let me report here on a negative thing we found. In order to make themselves attractive to big investors, provincial governments offer tax exemptions. The effect is well known, it undermines the financial capacity of their governments. Such races to the bottom are also known from other countries.
Granting tax exemptions also seems to undermine policy processes. Good policy making requires collaboration between government and business. For this to happen the private sector needs to be organised and develop business association.  This is where tax exemptions have an undermining effect.  They drive a wedge between small and large business. When tax-paying small enterprises see that large enterprises are exempt from tax it is very difficult to join forces in an organisation. This is not the only difficulty in establishing effective associations but in our interviews with small firms it came up as a stumbling block. 

In my view the most effective measure is to stop all tax exemptions. The effect on actual investment is likely to be small. Investors are attracted by business opportunities. If this business opportunity can be pursued in several provinces, the investors will of course shop around and negotiate the lowest tax rates. If no tax incentives are available they are unlikely to abandon the business opportunity. In Vietnam such a measure might even be politically feasible because the Communist Party continues to be powerful. But is abolishing tax incentives too drastic from an economic point of view? It would be great to have reactions, especially reactions from countries struggling with similar problems. 


hallum.chr said...

ActionAid and Tax Justice Network-Africa have done a research project on tax incentives and revenue losses in the East African region. They also found that the incentives are not a good way of attracting investment and that the costs outweigh the benefits. Interestingly, the IMF, OECD, World Bank, African Bank for Development and others have also supported this conclusion to varying degrees (all referenced in the study).

You can find the study here:

And more information on TJN-A work on tax incentives and race to the bottom here (including the country studies that were used for the EAC report above):

Prachi Salve said...

Tax benefits are one of the policy initiatives and they do help in attracting investment especially to areas which are considered as unfeasible for investment. In case of India, the states of UP and West Bengal offer tax exemptions to industrialist to set up industries.This policy helps setup new industry and hence gives impetus to industrial growth. I would like to another point that tax exemptions by one state have not led to a race to the bottom at least in the case of India.
Lastly, i would say that tax exemptions were important in the growth of the IT industry.

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