Tax incentives as a factor of economic growth ivana domazet and darko marjanović

2. Literature Review 
Fiscal measures and various tax incentives are the most common forms of state 
intervention in the function of creating competitiveness. The policy of tax incentives 
is implemented in the framework of industrial policy, which represents a wider area of 
economic policy, and includes measures and instruments of state intervention in order 
to encourage the creation of competitiveness [Vukovic-Domazet, 2013].

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Domazet, I., Marjanović, D.
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In a situation when the country is trying to reduce tax burdens through creation 
of their tax policy, whether in terms of reducing tax rates or introducing new tax 
incentives, there occurs tax competition. According to the opinion of the group of 
authors [Heady 
et al
., 2009, pp.12-17], that aims at preventing the outflow of 
production resources, with the involvement of all structures in order to encourage 
them to enter a specific market. Therefore it is very important that every country has a 
strategy that will be applied at a certain point in order to attract investors to invest 
their capital [Aleksic, 2016]. Taxes are not the only factor which will contribute to 
greater competitiveness of a country. Investors find other macro-economic indicators 
very important, which are reflected through the banking system, the rule of law, 
political stability in the country, the qualifications of the labor force as well as 
conditions in the local capital market [Domazet 
et al.
2015, pp. 1-36].
Davies and Voget (2008, pp.11-23) conclude that the main reasons which 
explain the emergence of tax competition can be found in increasing flows of 
international trade and investments, with greater labor mobility among countries, as 
well as the faster technology transfer. When such an economic environment is 
concerned, the tax rates are very difficult to maintain at high levels. In order to 
continue to be very attractive for inflow of investments, free movement of capital 
creates a certain pressure on the state to reduce, primarily, a tax rate of income tax. 
In relation to the territorial tax competition, which involves competition among 
countries with the aim of providing better conditions for attracting capital and labor, 
sectoral approach to tax competition implies attracting only certain types of 
investments. Sectoral approach implies direct negotiations with investors which are 
offered certain tax incentives which are primarily reflected in lower rates compared to 
other countries. Depending on the objectives of economic policy, the country has 
interest to attract certain investments that contribute to achieving the set goals 
[Marjanovic, 2014, pp.11-12]. 
Morisset starts from the idea that tax incentives also have many other, less 
obvious costs. Because they influence the investment decisions of private companies, 
they can distort the allocation of resources. And they can attract investors looking 
exclusively for short-term profits, especially in countries where the basic fundamentals 
(such as political and macroeconomic stability) are not yet in place [Morisset, 2003, 
p.3]. If properly designed and implemented, tax incentives are a useful tool in 
attracting investments that would not have been made without the provision of tax 
benefits [Zolt, 2015, p.12]. Tax incentives are justified if they correct market 
inefficiencies or generate positive externalities.
Many of the principles for good general tax policy also apply to tax incentives, 
including transparency and predictability. These are important, because investors will 
need to be able to understand incentive schemes if they are to base their investment 
decisions on them. Investors will also need to be able to rely on a certain stability of 
tax incentives granted, before engaging in a major investment [Klemm, 2009, p .12]. 
In countries where high taxes are the biggest obstacle to investment, tax incentives 
will have the greatest effect. However, if in some country some other, non-financial 

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The State and the Market in Economic Development: In Pursuit of Millennium Development Goals 
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factors are barriers to investment, then tax incentives will not greatly affect the inflow 
of foreign direct investment [Marjanovic-Radojevic, 2013, pp. 350-352]. Accordingly, 
investors should first determine whether it is possible to achieve the desired rate of 
return, and after that take into account the tax incentives as a factor in allocating 
resources.
Income tax is one of the most important tax instruments to attract necessary 
foreign capital. It is a form of taxation which is intended to have the role in 
achievement of numerous development goals of the overall macroeconomic policy. 
Based on that, it can be said that all countries have developed tax incentives from 
income tax. Radičić and Raičević (2011, pp.136) mentioned two groups of tax 
incentives. The first group comprises those which reduce taxes, and the other group 
consists of those which affect the tax base.