Policy makers and recent studies have highlighted the increasing importance of Foreign Direct Investment (FDI) in increasing welfare as well as its impact on economic development, tax revenue growth, income growth and employment.
East African Community (EAC) countries have made impressive progress in attracting FDI in the last two decades, though they experienced a decline in FDI between 2012 and 2016. The United Nations Conference on Trade and Development data for 2019 indicates that Kenya was the leading destination of FDI and it attracted about US$ 1322 million, followed by Uganda (US$ 1266 million), Tanzania (US$ 1112 million), Rwanda (US$ 420 million), South Sudan (US$ 18 million) and Burundi (US$ 1 million).
However, the ability of EAC countries to gain maximally from the potential benefits of FDI remains very low. Specifically, the rapid expansion of FDI in the EAC countries has resulted into the influx of multinational corporations and industries, but with the creation of fewer jobs, low tax revenues, low wages and low production levels. That notwithstanding, the African Continental Free Trade Area (AfCFTA) is likely to increase the momentum for attracting FDI in EAC countries in order to take advantage of the market access opportunities that will be provided by the free trade arrangement.
To realise the benefits from the expected increase in FDI, the EAC economies need to develop stronger domestic institutions, especially in tax administration. Evidence from the other jurisdictions indicates that countries with weaker tax administration institutions are likely to receive less than the optimal corporate tax revenues.
It is important to note that EAC countries greatly depend on corporate tax revenues to finance their budgets. However, with weak tax administration capabilities, attracting FDI could make the EAC countries worse off at best. This is partly because benefits from FDI such as increased production, higher incomes and employment, maybe more than offset by domestic tax base erosion and profit shifting.
Domestic tax base erosion and profit shifting refer to the corporate tax planning strategies used by multinational enterprises to shift profits from higher-tax jurisdictions to lower-tax jurisdictions, thus eroding the tax-base of the higher-tax jurisdictions. Multinational enterprises can engage in this kind of behaviour because they exploit the loopholes and mismatches between the tax systems of different countries.
In most cases, these enterprises shift income with both transfer prices and internal debt thus resulting in lower domestic profit and lower corporate tax revenue. In addition, policies such as corporate tax incentives (i.e. tax holidays and investment tax credits) could increase the corporate tax revenue losses.
Therefore, it would not be beneficial for the EAC countries to strengthen policies (investment promotion policies and corporate tax policies) to attract FDI if the existing multinational corporations are still actively involved in tax avoidance and profit shifting to tax havens. Besides, the effectiveness of those policies is also influenced by the ability of the tax administration institutions to audit and correct the most abusive transfer prices by multinationals.
Therefore, countries with weak tax administration institutions can attract more FDI and realise a few benefits because multinationals might employ transfer-pricing mechanisms to shift more income out of the host country undetected. It is important to note that lenient thin capitalisation rules could partly explain the pervasiveness of income shifting, amidst increases in FDI in some EAC countries.
To mitigate this practice, the EAC countries need to strengthen their tax administrations institutions to curb aggressive transfer pricing while attracting welfare-enhancing FDI. To improve the quality of tax administration, EAC countries need to set aside adequate funding for tax administration, hire competent staff that understand the behaviour of multinational enterprises and curb the pervasive corruption that is undermining revenue mobilisation efforts.
The current COVID-19 pandemic might result in a slow-down in attracting FDI; however, it also provides an avenue for the EAC economies to improve the quality of their tax administration authorities. This will enhance their ability to curb income shifting and ensure that these countries benefit more from attracting FDI. Further, before attracting more FDI because of the AfCFTA, EAC countries need to build sufficient tax administration capabilities.