Tax holidays and investments

The tax holiday - an incentive frequently used in developing countries to encourage capital investments - offers benefits for short-term investments but could in fact penalize long-term capital investments. For some countries with high inflation rates and relatively fast writeoffs for depreciable capital, the effective tax rate on long-term investments is higher during the tax holiday than after. For one thing the tax law may require assets to be depreciated during the holiday. If so, the value of tax depreciation writeoffs may be lower than the true economic cost of depreciation. For another the tax benefit of nominal interest deductions associated with debt financing of capital are of no value to the firm during the holiday - whereas after the holiday they may be quite beneficial. After estimating the effective tax rates on capital for holiday and post holiday investments, the author concludes that for some countries the effecctive tax rate on long-term capital is higher during the holiday than after.