Are tax credits effective in developing countries? The recent Uruguayan experience

Investment promotion through tax incentives has been a key component of the growth strategies pursued in Uruguay by the last three administrations. A new regime was established, regulated by Executive Decree 455, which implemented a major overhaul in the main channel for subsidizing investment. This regime immediately generated a battery of researchable questions about its effectiveness and efficiency. Using a large data set, first put together for this study from firm-level administrative records kept by the tax collection and pensions institutes between 2005 and 2011, we test the hypotheses of significant and positive effects of obtaining a tax credit through the new regime on investment and employment outcomes. A matched difference-in-differences strategy confirms that the promotion regime introduced in 2008 had a statistically significant effect on the firms’ rate of investment (around 11 percent), while the effects on employment growth rate were more ambiguous. These findings are buttressed by several robustness tests. Further probing uncovers heterogeneity along the promotion timeline, with the greatest effect on the investment rate occurring in a project’s first year.