Impact of Tax Equity Financing on Economic Development in Africa

In a post-Covid era where African countries struggle to develop their economies, African governments are locked in a “race to the bottom” as they compete to offer various tax incentives, including tax credits and tax deductions, in a bid to attract investors and pursue policy objectives such as developing diverse sectors of the economy. Such investment incentives can however prove costly to African countries, particularly those which already struggle with domestic revenue mobilization.

Research on investment location decisions suggests that while tax incentives have the potential to attract investment, other factors such as the wider investment climate and market opportunities are most crucial. Thus, their effectiveness has been subject of intense debate and scrutiny by policy makers and little consensus has emerged as regards the continued relevance of these tax benefits. This article assesses the impact of tax equity financing on economic growth and development on the African continent.

The African Context

African countries have joined the rest of the world in introducing tax incentives for the purpose of attracting investors, influencing their activities and spurring economic growth and development in various sectors of their economy. A recent study revealed that between 2009 and 2015, 46% of 155 countries adopted new tax incentives or made existing incentives more generous. The study further reveals that as of 2015, more than half of 107 developing countries were granting various tax benefits, including tax holidays and preferential corporate tax rates, across sectors at the domestic level.

Since many countries in Africa face several economic challenges that cannot be addressed through domestic investment, tax equity financing is needed to foster African economies, create new jobs, build infrastructure and agricultural projects and solve many other developmental problems that are directly or indirectly improved by foreign direct investment, or FDI.

For African countries with large informal sectors and tax evasion challenges, it has been observed that tax incentives serve as a means of enhancing productivity and fostering economic growth by preventing firms and enterprises from shifting into the informal economy or tax evasion-prone activities. Yet, despite the potential of tax equity financing, there is strong evidence that questions the effectiveness of tax benefits for investment, particularly special tax-free zones and tax holidays. Indeed, research shows that over-generous or poorly designed tax incentives do not compensate for a poor investment climate and may distort the revenue base of developing countries, complicate tax administration, promote harmful tax competition, erode resources for the real drivers of investment decisions, and provide the opportunity for corruption.

Overview of Tax Equity Financing in Africa

The term “tax equity” is often used to describe a passive ownership interest in a transaction or series of transactions where an investor receives a return based not only on cash flow from the transaction but also on government income tax incentives, including tax credits and tax deductions. These transactions involve governments agreeing to assign the rights to claim tax credits and other tax benefits to investors in exchange for an equity investment in particular sectors of their country.

It has been observed that the exchange sometimes refers to the “selling” or “trading” of tax credits and occurs within a partnership or contractual agreement which is legally binding between the two parties with a view of satisfying federal tax requirements that the tax credit claimant have an ownership interest in the underlying physical investment.

Typically, tax equity investors are large profitable tax-paying entities—such as banks, insurance companies, corporate bodies, and even wealthy individuals—utilizing these investments to mitigate future tax liabilities.

Many African governments offer tax incentives to investors in a bid to facilitate investment and stimulate manufacturing, industrial, and agricultural development in their respective countries. By attempting to diversify their economies to shift away from over-reliance on extractive industries and to branch out into other mainstream sectors, African countries appear to be introducing new tax benefits in order to compete successfully for both local and FDI.

Nigeria, for example, has introduced various tax incentives and government grants in order to attract FDI to grow other sectors of the economy such as the manufacturing industry, given the decline of revenue in the country’s oil sector. Kenya has also enacted a Special Economic Zone Act which extends incentives to other sectors of the economy, including services that are established in designated zones. In the case of Rwanda, the country has published a new regulating investment promotion and facilitation code, which contains a package of investment incentives to foreign as well as local investors.

Role of Tax Equity in Africa’s Economic Development

There is no doubt that tax equity investments play a huge role in stimulating economic development and have contributed to the rapid economic growth of countries such as Ireland, Mauritius, South Korea, Singapore and Taiwan. Since most African countries do not have viable alternatives to raising funds for development, it is often believed that tax incentives can be structured to ensure that FDI spurs socioeconomic and technological growth and development.

However, over-reliance on tax incentives at the expense of maximizing domestic tax revenue may pose considerable challenges to economic development. Despite the potential of tax equity financing in attracting greater investment and boosting economic growth for African countries, global evidence suggests that governments in African countries, particularly in sub-Saharan Africa, spend too much in using tax incentives to attract FDI. Indeed, investment tax incentives have proven detrimental to economic growth and their impacts have posed devastating consequences on developing economies, as many have failed and have been abused by both investors and some government officials at the expense of the general population.

Research indicates that overgenerous tax credits and other tax benefits granted to tax equity investors are likely to affect developing countries negatively and have detrimental consequences for African economies in particular.

According to a report published by the African Tax Administration Forum (ATAF), African countries lose significant amounts of tax revenue due to special tax arrangements such as tax holidays, tax credits and tax deductions. In East African countries, a report by Action Aid International and Tax Justice Network Africa revealed that revenue losses from providing tax incentives totaled up to $2.8 billion annually— $1.2 billion for Tanzania, $1.1 billion for Kenya , $272 million for Uganda and $234 million for Rwanda.

There is no doubt that these squandered tax revenues could have been better channeled towards funding health, education and other public services. In the case of Nigeria for example, evidence shows that just one tax incentive granted in 2019 cost the federal government $3.2 billion in revenue, an amount that is nearly identical to what the government spent on healthcare, and double what it spent on education that year. Tax incentives amount to a revenue loss of 8% of gross domestic product (GDP) in Mauritania and more than 6% in Cape Verde and Senegal.

A report on the use of tax incentives between 2008 and 2013 in Ghana revealed that tax incentives accounted for a loss of about 14.18% to 41.20% of total revenue, which is about 5.31% of the country’s total GDP. A similar situation can also be seen in Kenya, where tax incentives have been found to deprive the country of revenue needed to improve the welfare of its citizens, as an estimated amount of $1.1 billion in tax revenue is lost annually through the use of tax incentives.

For sub-Saharan African countries in particular, tax equity financing with overgenerous tax benefits to attract FDI may not be the best approach to tackling developmental challenges. Tax incentives are often known to come with increased administrative and compliance costs which may sometimes outweigh their benefits and erode African countries’ tax base. In addition, evidence shows that investment tax benefits involve extensive tax planning and implementation strategies—the absence of which may result in corruption, distortions in revenue allocation, and benefit the home countries of investors more than the host countries.

How Important are Incentives to Investors?

Moreover, tax incentives have often been considered redundant, as they are often adopted even when an investment would have been made without them. Research shows that tax incentives are one of the least important factors influencing investment location decisions, as other factors such as good infrastructure and political stability contribute far more to investment decisions.

An analysis of 12 West African countries also found that providing more generous tax incentives to investors had no impact on FDI in respective countries. Tax credits and investment allowances which are often granted to tax equity investors have the potential to distort the situation in favor of short-lived capital assets, since further credit or allowance becomes available each time an asset is replaced.

Moreover, it has been observed by the International Monetary Fund that qualified entities may attempt to abuse the incentive by selling and purchasing the same assets for the purpose of claiming multiple credits or allowances, or by acting as a purchasing agent for entities that are not qualified to receive the tax benefit.

Conclusion and Way Forward

While tax equity financing may contribute positively to economic development in Africa, there is no doubt that ineffective and poorly designed tax benefits and tax credits offered to investors may damage the revenue base of African countries and complicate tax administration on the continent.

As shown in this article, tax incentives are not key drivers of investment, and their inherent costs are often high, with devastating consequences for some sectors in African countries.

Accordingly, in implementing tax equity financing as an economic policy option, African governments must consider the potential harmful effects of tax incentives and ensure that investment tax incentives programs are properly designed to maximize efficiency and reduce the opportunity for rent-seeking and corruption attendant on such government grants.

To ensure transparency, accountability, and to reduce the associated costs of investment tax incentives, there is a need to implement simple, uniform tax incentive schemes, with a consensus among stakeholders concerning their fitness for purpose.

Governments in Africa must ensure that all tax benefits are only considered for tax equity investments after cost-benefit analysis of the potential impact of the tax incentives is conducted. Furthermore, in adopting investment tax equity, African governments should avoid targeting sectors geared towards production for domestic markets or extractive industries, which have little impact, and focus more on sectors for export and mobile capital.

In addition, since investment tax incentives are not the primary factors influencing investment location decisions, there is a need for African governments to put in place other enabling conditions to facilitate investment, such as good infrastructure, rule of law, macroeconomic policies, and industrial policy changes.

Upon the granting of tax incentives to tax equity investors, African governments should also put in place a periodic monitoring and evaluation system to ensure that the purpose and objectives are achieved, in order to avoid abuse by some investors and government officials.

The views expressed herein are personal.

This article does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Aimée Dushime is a tax and transfer pricing specialist.

The author may be contacted at: aimeedushime@outlook.com