THE PARADOX OF TAX INCENTIVES IN DEVELOPING COUNTRIES

A number of arguments have been proposed to explain how tax incentives attract foreign direct investments and jeopardize public revenues. Unfortunately, these arguments hardly explain why some developing countries in Eastern Europe suffer from low capital inflow in recent history. This paper examines the rationales and specifics of tax systems of the region and explains the aspects that constitute decisions on investments of multinational corporations. Rather than choosing to do business in countries that offer considerable tax incentives but of greater uncertainty, managements decide on establishment in countries with lower levels of incentives but with strong legal protection and policy credibility. Since the deficiency of legal certainty in taxation is more prominent in developing countries than in developed countries, this explains the less than expected inflow of foreign direct investments and the existence of the paradox of tax incentives.