The effectiveness of tax incentives in attracting Foreign Direct Investment to Ethiopia

Foreign direct investment plays a significant role in the development process of developing countries. Given this many developing countries particularly, Ethiopia made a number of attempt to attract FDI. Fiscal incentive was one among the attempts made to create investment friendly environment. Tax holiday and custom duty exemptions have been extensively used by Ethiopian government to attract foreign direct investment. However the results of the available empirical evidence on effectiveness of such incentive in attracting FDI are inconsistent. This paper analyzes the effectiveness of tax incentive in attracting foreign direct investment to Ethiopia. It also analyzes the differential impacts tax incentive has on different sector by disaggregating FDI in to ten sectors. Dummy variables are used to indicate the presence and absence of tax incentives, tax holiday and custom duty exemption, in the sectors under consideration. Panel data on 10 sectors over the period of 1992-2012 and an econometric model that include tax holiday, custom duty exemption and control variables are used in the analysis. The empirical result shows that of the tax incentives, only tax holiday was found significant while custom duty exemption is insignificant in the general model. Among the control variables, openness of the economy was significant. However when sectorial distribution of FDI is taken into account, tax holiday have significant impact only on the manufacturing sector while custom duty exemption have a significant impact on construction and electricity and water supply sectors. This result indicates that tax incentive sensitivity of FDI depends on the sector to which the investment is flowing. Using aggregate data in these types of analysis will have a risk of underestimating or overestimating the results. On the other hand market size and openness of the economy were found important in attracting FDI to the country.