What Is a Tax Holiday?

A tax holiday is a government incentive program that offers a tax reduction or elimination to businesses. Tax holidays are often used to reduce sales taxes by local governments, but they are also commonly used by governments in developing countries to help stimulate foreign investment.

Key Takeaways

  • A tax holiday is a governmental incentive that reduces or eliminates taxes on businesses.
  • A tax holiday can encourage economic activity and foster growth.
  • Tax holidays are instituted by local governments and governments in developing countries to help stimulate foreign investment.
  • Tax holidays are believed to increase long-term tax revenue because they help businesses maintain or grow operations, which creates more taxable revenue for the tax authority.

How a Tax Holiday Works

When a government body wants to encourage the purchase of certain items or bolster participation in certain activities, it may issue a tax holiday, a temporary period during which the tax rate applied to certain products or services is reduced or removed. For instance, many local governments have a sales tax holiday the weekend before school resumes in the fall to reduce the cost burden that parents carry when shopping for their children’s school supplies or clothing. Sales tax holidays, like the back-to-school one described, are a common type of tax holiday administered by state governments. Researchers found that on sales tax holidays, households increase the quantities of clothing and shoes bought by over 49% and 45%, respectively, compared to what they usually buy during that timeframe.

A tax holiday is also implemented for businesses to encourage economic activity and foster growth. Used in the hopes of increasing the gross domestic product (GDP) in developing countries, tax holidays are a way in which governments attract foreign investors or foreign companies that establish base in the host country. Tax holidays are often put in place in particular industries to help promote growth, develop, or diversify domestic industries. In some cases, new businesses are given tax holidays which helps the business reduce some of its costs of operation, while it focuses on increasing revenue and growing. This fiscal policy measure may also serve as an incentive for more people to start businesses.

Special Considerations

Whether there is any benefit to tax holidays is still a debate. On the one hand, even though the government loses out on revenues that would have been generated from sales during the temporary tax-break periods, tax holidays are said to increase tax revenue over the long term because they help businesses stay in business or grow, creating more taxable revenue for the tax authority. In addition, the lost revenue is also said to be offset by the increased purchases of consumers looking to take advantage of the tax break.

On the other hand, it is believed that the increased sales during a tax holiday is preceded by reduced sales before the holiday; thus, the tax holiday simply shifted sales that would have happened before or after the holiday to the holiday dates. In effect, consumer don’t buy more, they simply shift the timing of purchases. Also, since retailers do not pay sales tax out-of-pocket (the consumer is responsible for sales tax), some retailers may unethically take advantage of tax holidays by increasing the prices of the goods and reducing consumer savings.