Taxes are very important to an economy in that they contribute to state-building, reduce the reliance on foreign aid, prevent crises related to debts and finances, and help the government meet the financial demands of developing economies. Maseagni, Moore, and McCluskey, (2014) stated that the challenges that governments in low-income countries face with regard to tax mobilization are related to unequal rent-sharing, tax exemptions as well as tax evasion and avoidance.  

While hoping to attract investors to the economy, both developed and developing nations provide incentives. The use of tax incentives in low-income countries has, however, become an issue of concern.  This study concentrates on tax-free zones and tax holidays offered to foreign investors to free them from tax laws applicable to businesses in the host country.

Tax-Free Zones and Tax Holidays on Economic Development

According to IMF, OECD, UN, and World Bank (2015), low-income countries have offered tax incentives for investments that would have happened without the incentives. In such cases, the government uses tax revenue for the wrong purpose and will most likely fail to achieve the most important duty of providing infrastructure, educational facilities, and security to the local population. The Investor Motivation Surveys in various African countries including Tanzania, Rwanda, Uganda, and Burundi reported that 90% of the investors did not require the incentives at all. Low-income countries, therefore, offer unnecessary incentives at the expense of their own economies.

Keen & Mansour (2009a) reports that Sub-Saharan countries were unaware of tax-free zones in 1980 but by 2005, 50% of the countries had incorporated the practice. The number of countries offering tax holidays also rose from 40% in 1980 to 80% by 2005. This is not the case in developed economies. In Southeast Europe, for example, investors reported a lack of incentives to foreign investors, and in other cases, special tax incentives would be initiated to prevent such investments. Investors in such situations are generally confronted with higher costs of running a business and greater business uncertainty.

Analysis of Eastern Caribbean Currency Union reports that tax incentives do not have substantial effect on foreign direct investment (Chai & Goyal, 2008). Moreover a study of Latin America, Caribbean and African economies from 1985 to 2004 showed that no effects on overall investment or economic growth could be attributed to tax incentives (Klemm & Parys, 2009). The two studies by IMF are supported by Parys & James (2010) who reported that tax holidays were not positively related to tax increased investment in 12 Western and Central African between 1994 and 2006. The present study is based on the view that the two categories of tax incentives slow economic growth in three ways.

  • First, when governments of the low-income countries offer the favorable tax regulations to foreign direct investment the foreign companies get competitive advantage over the domestic companies in the same sector. The multinational companies therefore monopolize their operations and use the chance to their own advantage. At the same time, they prevent the SMEs within the host country from growing. The reduced chances of operation deprive opportunities for domestic investment so that there is increased unemployment, and the outcome is increased poverty.
  • Secondly, offering tax incentives has a direct impact on government taxes. It leads to reduction in tax revenue so that the government is not able to provide the public goods that citizens need. This also increases rates of poverty in the society and prevents economic development. Lastly, exemption from tax laws protects foreign investors from domestic taxes. However, since they operate in the economy and have competitive advantage over local businesses they make more profits and carry the wealth of the host country to their mother country. Despite the tremendous economic activity, therefore, the gross domestic product (GDP) is not improved by operations of the foreign companies.


The null hypothesis and alternative hypothesis for this study are as follows:

  • (Null hypothesis) H0: Tax-free zones and tax holidays have no significant influence on economic development in developing countries.
  • (Alternative hypothesis) H1: Tax-free zones and tax holidays have a significant influence on economic development in developing countries.

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Testing the hypothesis

The hypothesis will be tested based on Structural-change theory. Structural-change theory studies the means that underdeveloped economies use to change their economic structure from subsistence agriculture through modernization and urbanization to industrial ones characterized by increased manufacturing and service economy.  While the theory recognizes the importance of savings and investment on the economy, it explains that these are not sufficient conditions for economic growth. The sufficient conditions are thus represented by human and physical capital endowment and transformation of the economic structure because this sets ground for transition from traditional to modern economic system.

Todaro & Smith (2003) explain that changes must be incorporated in production, system of consumer demand, international trade, utilization of available resources, urbanization, as well as population expansion and distribution. Moreover, the Structural-change theorists stated that differences in rates of development of low-income countries are greatly dictated by constraints at both domestic and international levels. The domestic factors in this regard consist of economic factors such as resource accumulation, population size, physical size, and institutional features (like government aims and policies).

Conversely, the international factors relate to acquisition of external capital, access to advanced technology, and ability to participate in international trade. The structural-change theory explains that international factors are responsible for the development gaps between developed and developing countries.


When it is confirmed that the desire for international factors will make the domestic government to make policies that favor foreign investors, in the form of tax incentives, at the expense of economic development, the null hypothesis will be rejected and the alternative hypothesis accepted. This will mean that tax-free zones and tax holidays have a significant influence on economic development in developing countries. However, if the policies made by the domestic government to attract foreign investors do not affect economic development in any way, the null hypothesis will be accepted.

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The role of tax revenue in the economy is very clear. The government depends on tax revenue to meet its responsibilities of providing public goods to societies. Offering tax-free zones and tax holidays to multinational corporations, however, deprives developing countries of the chance to make effective use of government taxes. Even though this claim is not yet proved empirically, its confirmation would imply that tax laws in developing economies require reviewing to prevent the adverse consequences on economic development.