IMF Warns: Subsidies and Tax Breaks Could Harm Production Growth

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The International Monetary Fund (IMF) cautioned that many industrial policies heavily lean on expensive subsidies or tax breaks, potentially harming productivity and welfare if not carefully directed.

This warning was outlined in a recent report titled ‘Industrial Policy Is Not a Magic Cure for Slow Growth.’

While acknowledging that industrial policy, which involves government backing of specific sectors, can spur innovation if executed correctly, the IMF emphasized the importance of striking a delicate balance.

The report underscores the significance of learning from past policy errors, which often resulted in substantial fiscal burdens and adverse effects in other nations.

In addition, the report highlighted that numerous countries are increasingly adopting industrial policies to stimulate innovation in particular sectors, aiming to revive productivity and foster long-term growth, particularly in light of security concerns.

The report read in part, “Most industrial policy relies heavily on costly subsidies or tax breaks, which can be detrimental for productivity and welfare if not effectively targeted.

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“This is frequently the case, for example, when subsidies are misdirected toward politically connected sectors. In addition, discriminating against foreign firms can prove self-defeating, as such policies can trigger costly retaliation and most countries—even major advanced economies—rely on innovation done elsewhere.”

As per the report, the recent shift towards employing industrial policy to bolster innovation within specific sectors and technologies is not a panacea.

“However, well-designed fiscal policies that support innovation and technology diffusion more broadly, with an emphasis on fundamental research that forms the basis of applied innovation, can lead to higher growth across countries and accelerate the transition to a greener and more digital economy,” it noted.

The report recommended that governments implementing industrial policies prioritize investment in technical capabilities, adjust support measures as circumstances evolve, and align their actions with principles of open and competitive markets.

It added, “In some cases, industrial policy can be justified, such as when it supports sectors that generate strong knowledge spillovers to the domestic economy (for example, in the semiconductor industry).

“Another important use case is driving green innovation—reaching net zero emissions will require technologies that do not yet exist. But subsidies to green innovation should be transparent, focused on environmental objectives, and complemented by robust carbon pricing to minimise fiscal costs.”

Since assuming office, the Bola Tinubu-led administration has initiated extensive reforms focused on discontinuing subsidies, which many analysts attribute to Nigeria’s current economic challenges.

During his inauguration on May 29, 2023, President Bola Tinubu declared the end of the fuel subsidy regime.

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Two weeks later, the Central Bank of Nigeria floated the local currency to allow it to determine its true value.

Despite facing criticism from certain segments of society, these two significant policy reforms have garnered praise from international observers.

In a previous report released in January, the IMF lauded Nigeria and three other countries for their recent subsidy reforms, which are expected to free up resources for developmental spending.

It said, “Building resilience in the face of these trends requires countries to act. Some countries have made progress— for instance, Angola, The Gambia, Nigeria, and Zambia have taken steps to implement significant energy subsidy reforms to create space for development spending.”

However, the IMF expressed concern that numerous countries, particularly in efforts to boost revenues, were falling behind, citing the need for measures like expanding the tax base, minimizing tax exemptions, and enhancing tax administration efficiency.

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