Foreign Direct Investment, Tax Incentive and Tax Competition in Africa: Is it Time for a New Policy Direction?

Fanwell Kenala Bokosi,1 PhD

Introduction It is undeniable that Africa needs development finance if it is to address the many development issues facing the continent. In order to make progress on economic growth and achieve the Millennium Development Goals targets for 2015 and beyond access to good quality development finance is a crucial, especially in the current uncertain financial context. The world has not yet recovered from the global financial problems that started in 2008 and the situation is likely to get worse due to the unending Eurozone crisis which will eventually affect African countries, specifically those that rely on aid and loans from European partners. In this context, attracting Foreign Direct Investment (FDI) has become an important strategy in the region with many countries discovering new natural resource deposits. In addition FDI is perceived to be a non-debtcreating financial flow and hence a better option in the current global financial environment. Believing that FDI is an engine of growth, which also has the potential to transfer technological know-how and workplace skills, while at the same time stimulating new export opportunities and providing above average wages to new jobs many African countries have put in place tax incentives and other policy instruments aimed at attracting this sought after source of development finance. Foreign Direct Investment (FDI) is generally defined as an investment made to acquire a lasting management interest in a business enterprise which
1

Dr Fanwell Kenala Bokosi is a Policy Advisor on Economic Governance and Development Aid at the African Forum and Network on Debt and Development (AFRODAD). He can be contacted at fanwell@afrodad.co.zw

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operates in another country other than that of the investor (World Bank, 1996)2. The World Trade Organisation (1996)3 says that FDI occurs when an investor based in one country (the home country) acquires an asset in another country (the host country) with the intention of managing that asset, and that the management dimension is what distinguishes FDI from portfolio investment in foreign stocks, bonds and other financial instruments. This intention to manage the acquisition is said to manifest itself as FDI if it results in the establishment of normally 10% of voting stock. Otherwise at proportions of less than 10% the interest is deemed a portfolio investment.4 FDI can take the form of Greenfield investments which entails direct foreign investment of new resources such as capital, transfer of technology, management techniques. Acquisitions (MA). create new It can also be in the form of Mergers and Mergers and Acquisitions involve the transfer of equity capacity, but can actually lead to the

from domestic to foreign hands and do not usually transfer technology or productive denationalization of domestic firms, employment reduction and loss of technological assets. FDI is a package a potent bundle of capital contacts and managerial and technological knowledge. It is the cutting edge of globalization.5

Tax Incentives in Africa After independence most African and other developing countries relied on foreign assistance (bilateral and multilateral) as a major source of development finance to support their social and economic growth objectives.
2

World Bank. 1996. World Debt Tables: External Finance for Developing Countries, Vol. 1. Washington DC. 3 WTO (1996), Annual Report Vol.1 Trade and Foreign Direct Investment, WTO, Geneva. 4 The science involved in the 10% threshold is not entirely clear, but it is accepted generally. Evidently we are already dealing with a very illusive concept. 5 Tandon Y (2001).

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The importance of FDI as a complementary source of FDI became popular in the decade between 1990 and 2000 when there was a global decrease in the flows of foreign assistance.6 Since then FDI has emerged as an important source of development finance together with trade (export earning) and other external sources of development finance. Attracting FDI has now become the preoccupation most African countries and in the process they have undertaken many structural and regulatory reforms such as privatisation of state enterprises and the liberalisation of their foreign exchange markets. Tax incentives have been at the heart of many governments efforts to attract FDI. A tax incentive is a deduction, exclusion or exemption from a tax liability, offered as an enticement to engage in a specified activity such as investment in capital goods for a certain period.7 These tax incentives include a menu of exemptions and allowances such as, tax holidays or reduced tax rates; tax credits; investment allowances; exemption from or reduction of withholding taxes, import tariffs, export duties, sales, wage income or property taxes. In addition some countries also do offer several fiscal incentives to make in pursuit of FDI by offering financial and regulatory incentives like subsidised financing, grants or loan guarantees and delivery of goods and services, provision of infrastructure, training and even preferential access to government contracts as well as protection from import competition. So what has been the trend of FDI on the continent after these efforts that put faith in the power of FDI and the many policy adjustments made to attract it, FDI flows across African regions vary greatly. For several consecutive years, the top five countries in terms of FDI inflows have been
6

IDA (2007) Aid Architecture: An Overview of the Main Trends in Official Development Assistance 7 See http://www.businessdictionary.com/definition/tax-incentive.html accessed on 18 July, 2012.

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receiving as much as about 60% of total FDI to the continent. According to the World Investment Report (2011), FDI inflows to Africa reduced by 22% and 9% in 2009 and 2010 respectively. In terms of regional distribution of FDI inflows Southern Africa has been the hardest hit with reductions of 43% and 32% in 2009 and 2010 respectively. An analysis of the country level distribution of the FDI in Africa is so skewed that the top three countries in terms of FDI inflows in 2010 accounted for about 41% of all FDI inflows to the continent. The top five destinations of FDI inflows in 2010 received over $31,209 million representing over 57% of the total inflows. The major observation of these countries is that none of these are what would be characterized as working democracies; however, they all have massive mineral resources. It is therefore not surprising that some have argued that this is more to good luck and not because of, the lack of congeniality of its policies and environment.

Source: World Investment Report (2011) Benefits and costs of FDI for African development If used properly additional development finance in the form of FDI can offers the opportunity for African countries to move beyond aid dependency. FDI
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like other forms of development finance should be treated as a compliment to aid as a source of funding for sustainable poverty-reducing growth and development. Aid, although important, is shrinking and hence should be It is important to ensure that FDI does not complemented by domestic as well as other types of external resources which might include FDI. undermine domestic investment and local entrepreneurship and in the process cause more problems than it solves. This is particularly important since the a greater share of FDI inflows goes into the extractive industry which if not regulated properly these resources can be will continue to be exploited beyond sustainable levels. There are costs to attracting FDI in addition to the benefits. So far the debate has been mostly focused on the supposed benefits of FDI and little has been discussed on the costs that the host country incurs in the process. The initial capital from FDI is indeed a benefit to the host country in that it represents an injection of funds into the host economy; however, in the long run the main objective of a foreign investor in a country is profit which is ultimately a financial outflow. In the simple logic of a private company the decision to invest will mainly be based on the calculation that the outflow will eventually be greater than the initial inflow, otherwise what is the use of investing. It is also possible due to market dynamics and rigidities the introduction of a stronger and bigger foreign company can lead to displacement of existing local companies. The foreign company is most likely to benefit from economies of scale due to size, technology and advances skill. In addition FDI attraction entails some form of tax incentives which then reduces the cost of production of the foreign company giving it an unfair advantage over the local companies which are normally small and suffer from technological constraints. A critical analysis of the potential impact of tax incentives to foreign firms on costs and profitability for domestic firms is paramount. The type of FDI to attract is also important since not all FDI might beneficial. Is
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the type of FDI African countries are attracting greenfield or mergers and acquisitions since the costs to the host country are much more in cases of acquisitions and mergers (firm does not create new assets, but merely takes over existing ones). . Cases of loss of employment, especially if the investment takes the form of mergers and acquisitions, lack of capital injection or capital flight through unbridled profit remittances have been observed in a number of African. Success in attracting FDI should not be an end in itself; it is only an input in the many activities needed to solve a countrys economic problems. African governments should be strategic in balancing the costs of the reforms and incentives extended to attract FDI against the benefits expected from the FDI. This means that policy makers should have weight these costs against the multitude of economic considerations that are required for their development. Emphasis should be put on designing strategies which will get the best out of FDI to the economy. The costs of attracting it should be weighed against the benefits. A clear assessment of the supposed benefits in terms of creation of forward and backward linkages to the economy, the transfer of technology and job creation should be balanced to the potential costs like environmental damage and social impact and who will ultimately compensate for these damages. The objective of FDI from a firm point of view is profit-making while the host governments objective of FDI is normally to maximize foreign earnings and fiscal revenue needed for its development. These objectives will need to converge at some point and to facilitate this convergence governments need to be assertive to ensure that the costs of attracting FDI do not outweigh the benefits. It is the responsibility of the host government to balance their expectations with those of the foreign investors. The ability to balance these competing objectives is particularly critical in the extractive industries where

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in African governments have found it difficult to manage the complex bargaining pressures over the terms of investment. African policy makers should interrogate issues like the likely extent of positive spillovers and linkages generated by FDI, the nature and strength of domestic firms to take advantage of the FDI and therefore reap benefits as well what measures are put in place to mitigate illicit capital flight and profit repatriation. Tax Justice-Africa and ActionAid International8 (2012) estimates that in total, Kenya, Uganda, Tanzania and Rwanda are losing up to US$2.8 billion a year from all tax incentives and exemptions. The levels of tax incentives offered to attract investors in the extractive sector have benefitted the foreign companies as African countries engage in fierce investment competition battles leading to a race to the bottom resulting in foregone fiscal revenue. The efforts on attracting FDI have often been short term focused. If FDI is to contribute to long term development of the continent since the tax incentive are an immediate opportunity cost (lost revenue) on the side of the government versus the future benefits of FDI. The international agenda regarding FDI has not helped matters for the continent; most economic reforms that come as a condition for multilateral institution support to the host country have come at a cost to the domestic firms. These reforms have included regulations that put the domestic firms at a disadvantage in that poor African countries have ended up forcing those countries to withdraw strategic support from domestic firms while at the same time extending support and incentives to foreign ones. It is also proper to question the employment creation benefits of the FDI in extractive sector, since most African government lack control over private mining companies activities and production. In addition, since mining is a
8

Tax Justice Network-Africa and ActionAid International (2012) Tax competition in East Africa: A race to the bottom? http://www.actionaid.org/sites/files/actionaid/eac_report.pdf

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specialised field, the foreign investors bring with them qualified foreign workforce hence the local human resources cannot be absorbed in the technical levels of the investors companies. These investors do not develop the local infrastructures nor carry out large-scale social actions. While FDI is often promoted as a risk-reducing source for development finance, it is important to understand that it is sensitive to business cycles and might not be as "permanent" as conventionally believed. The global financial crisis has led to the evaporation of liquidity manifesting itself in reductions in foreign components of development finance like aid (commitments reduced by 8.8% between 2009 and 2010), trade and FDI (reduced by 9% between 2009 and 2009). Rethinking policy approaches to FDI in African development The motivation behind FDI by foreign firms is not the development of the host countries but their own survival and profitability. African policy makers need to take this fact into account because taking FDI as a major source of development finance is a risky strategy. It is therefore important for Africa to focus their effort not only on attracting FDI but also managing it in a strategic way bearing in mind that FDI is a useful but not a magic ingredient for development. A strategic combination of the available sources of development finance which should include both domestic and external sources beyond foreign aid should be the goal. Attracting FDI through tax incentives and tax competition is not only open to serious empirical reservations but it tends to undermine the role of other FDI. In fact in research by the IMF, OECD, UN and World Bank in 2011 concluded that tax-driven investment does not provide a stable source of investment in the recipient country9 This is not a new observation since the IMF in 2006 also made a similar conclusion in their report on East Africa by stating that
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IMF, OECD, UN and World Bank, Supporting the Development of More Effective Tax Systems, Report to the G-20 Development Working Group, 2011, p.19

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investment incentives-particularly tax incentives-are not an important factor in attracting foreign investment10. The policy direction in attracting FDI in light of this empirical evidence would be much more effective if it focused on the main critical factors for foreign investment which among other things include good-quality infrastructure, low administrative costs of setting up and running businesses, political stability and predictable macroeconomic policy Moreover, simply pointing to the higher returns on FDI in Africa as indicative of missed investment opportunities is a distortion of the other costs involved in attracting FDI through tax incentives. Apart from the fact that the tax incentive is in effect a loss in terms of current and future tax revenue, they also lead to rent seeking and corruption. Policy makers should be suspicious of assessing benefits of FDI from the firms point of view. Compared to other sources of development finance FDI is an expensive option for financing development by far. The global financial crisis and the subsequent reductions in FDI inflows into Africa is an opportunity for policy makers on the continent to re-examine over emphasis on attracting FDI and seek other efficient, cheaper and strategic approach to suit the needs of the continent. The focus of policy makers should be on a basket of policies which can raise investment, diversify the export base, and raise profits of domestic firms. Instead of spending resources and efforts to attracting foreign firms, perhaps, those resources could be better spent on nurturing and strengthening domestic industries and domestic invest in nontraditional activities.

10

IMF, Kenya, Uganda and United Republic of Tanzania: Selected Issues, 1 December 2006, p.11

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