investment policy tax incentives and the enabling environment
TRANSCRIPT
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Investment Policy, Tax Incentivesand the Enabling Environment
David Ray
VNCI - VietnamCompetitiveness Initiative
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Introduction to VNCI
New USAID project implemented by DevelopmentAlternatives Inc (DAI)
VNCIs policy component implemented by TheAsia Foundation, the main subcontractor to DAI Key focus areas: regulatory and microeconomic reform,
competition policy, investment policy etc
Key legislation: enterprise law, investment law,competition law and others
Important tool: Regulatory impact analysis (RIA)
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Focus on Investment Policy
Assumption for todays presentation: Possibleextension of the Enterprise Law (EL) to govern
corporate behaviour and entry for all businessentities (regardless of ownership type).
Key question arises: what is the likely role &content of a unified investment law given an
expanded and more comprehensive EL ? Possible focus on investment incentives
Key issues for policy analysis: Do they costs justify the benefits?
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Lively and ongoing debate on
investment incentives Economists:
In general tax incentives dont attract much additional
investment. They create too many distortions and are notworth the costs. Developing country governments should
instead focus on improving the enabling environment.
Policy makers and investment agencies:
Tax incentives represent a useful policy tool to promote
and direct investment flows.
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Key reasons why governments
use investment incentives To correct for market failures
Promoting more externality generatinginvestment: e.g. technology spillovers
Mitigating the effects of risk and uncertainty
Promote industrial or regional development
policy objectives Overcome first-mover risk in new region/sector
Pick winners (subsidise losers?), create/retain jobs
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Costs of investment incentives
Loss of tax Revenues Primary argument against granting tax incentives to
investors is the redundancy problem. Redundancy: Tax incentives often are provided to firms
that would have invested even in the absence ofincentives and so have no effect on their investmentdecision.
The result: For investing firms: lower tax liability resultsin windfall gains. For host governments: losses in scarcetax revenues necessary to fund service delivery And a transfer of resources from tax payers in the host country to
the investing firms (typically a transfer from poorer developingcountries to richer OECD countries)
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Subsidy Equivalent of a 5-Year Tax Holiday, a
10% Discount rate, and a 35% Tax Rate
Rate of Return on Assets
Redundancy rate 10% 20% 25%
20% 3% 5% 7%
30% 5% 9% 12%
40% 7% 14% 18%
50% 11% 22% 27%
60% 16% 33% 41%
70% 25% 51% 63%
80% 43% 87% 109%
90% 98% 196% 244%
Assumption:
- No other incentives given to investors (further incentives would increase the redundancy rate)
- Further foregone tax revenues are discounted using a discount rate of 10% (no discounting results in even higher subsidy
rates)Source: Louis Wells and Nancy Allen (2001)
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Other select costs of using investment
incentives Distortions in investment decisions, leading to high economic costs from
a misallocation of scarce capital (inefficient investment)
Over-bidding due to capacity constraints of investment agencies
incentives granted are usually more generous than necessary. Beggar thy neighbour policies: Provincial governments compete away
the benefits of hosting investment. Incentive policy represents anegative, not zero sum game. National welfare is undermined
Erosion of tax system: Managers will transfer costs from taxed to
untaxed units of their businesses Diversion of attention: using incentives makes it easier to ignore the
more important, and more difficult reforms necessary to improve theenabling environment.
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Costs of investment incentives:
Specific examples in Vietnam Creates distortions in company behavior and
decisions, particularly during expansion New factories/facilities disguised as new companies to
enjoy tax holiday benefits.
Incentives dissuade consolidation and mergers. Businessprefer to stay small with separate multiple units hencelocal suppliers less efficient.
Major Constraint on the development of a mutualfunds management industry Capital Gains Tax exempted for individual share market
investors, but not institutional investors.
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Key pressures in favour of tax
incentives Agency problems: Whats good for the investment agency
might not be in the broader national interest. Revenue generated by the incentive might be less than the revenue
foregone Hidden nature of costs: easy to hide, difficult to measure.
Tax incentives are a subsidy, not paid out as such, butcomprise income forgone.
Easy to implement: much easier to cut taxes rather than takethe more difficult and more important step of improving theenabling environment (cutting red tape, streamlininggovernment procedures and regulations)
Investor interests: Individual investors will always insist on
tax cuts, whether they influence their investment decision ornot.
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BIAC position on incentives
But the business community as a whole do notsupport the use of investment incentives: Most business people would prefer to live in a world where government
subsidies and incentives were unnecessary, where the policy environment issufficiently robust and supportive.
The most important factor in creating favourable conditions is goodgovernance, i.e. clear, stable and business-friendly legislation and economicpolicies, which are administered in an efficient and equitable manner to provide
a level playing field, with a minimum of red tape. If such conditions prevail, nospecial incentives are needed to attract foreign, or indeed domestic directinvestment
Source: Business and Advisory Committee to the OECD (comprising the keyemployer and business associations in the OECD). Investment - BIACPosition on Incentives
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BIAC position on incentives (contd)
..incentives are not necessarily undesirable. [But] it isimportant to assess the value and effect of incentives...
There are often more powerful factors [that can be used] byaspirant hosts, for example Investment in primary, secondary and tertiary education and
research
Improvements in labour availability and preparation
Better roads and communication infrastructure More efficient ports and customs facilities
More flexibility with regard to corporate structures
More efficient regulatory and permit processing
A more reasonable tariff regime..
Building business confidence is job number one!
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Other pressures mitigating in
favour of investment incentives Pressure on governments to be seen as job winners
or to attract landmark investments also mitigate in
favour of overbidding Competition from other countries in the region:
Instructive to look at Indonesias experience whereinvestment incentives were abandoned in the mid 1980s.
Despite use of aggressive incentive policies in otherASEAN countries, flows of FDI remained robust in thelate 1980s/early 1990s and Indonesias regional share ofFDI inflows actually increased in the early 1990s.
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Using TAF-VCCI governance
survey (14 provinces) Enables a preliminary look at the relationship
between incentives, the enabling environment and
investment outcomes Red = no provincial incentives offered beyond that outlined in central laws
Green = provincial incentives going beyond that outlined in central laws
Blue = lack documents necessary to assess incentive policies as yet
Note:1. results are preliminary and unpublished, and used with the kind
permission of TAF and VCCI.
2. For explanation of governance indicators see back of handout
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Relationship between Implemented FDI and
the Total Score on Provincial Policies and Planning
Statistical Handbook, 2003
The Asia Foundation-VCCI Economic Governance Survey
Total score on provincial policies and planning
12108642
11
10
9
8
7
6
5
4
3
2
Investment Incentive
Insuffcient info.
Greater than
Central Law
Same as Central Law
Total Population
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Relationship between Implemented FDI and
the Sum of All Provincial Governance Scores
Statistical Handbook, 2003
The Asia Foundation-VCCI Economic Governance Survey
Total sum of all economic governance scores
12011010090807060
11
10
9
8
7
6
5
4
3
2
Investment Incentive
Insufficient Info.
Greater than
Central Law
Same as Central Law
Total Population
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Relationship between Private Registered Capital and
The Efficiency of Provincial Registration Procedures
CIEM, 2004
The Asia Foundation-VCCI Economic Governance Survey
Total score on the efficiency of registration procedures
121110987654
8
7
6
5
4
3
Investment Incentive
Insufficient Info.
Greater than
Central Law
Same as Central Law
Total Population
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Relationship between Non-State Investment and
Firm Perceptions of Transaction Costs
Statistical Handbook, 2003
The Asia Foundation-VCCI Economic Governance Survey
Total score on firm perceptions of transaction costs
181614121086
10.5
10.0
9.5
9.0
8.5
8.0
7.5
7.0
6.5
Investment Incentive
Insufficient Info.
Greater than
Central Law
Same as Central Law
Total Population
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Interpretation of results
Important caveats:
Difficult to determine direction of causation. Red provinces may not need toaggressively use incentives
The analysis of incentives comes from the regulations voluntarily submittedby the provinces. There may be incentives being used which the province donot reveal.
Nevertheless results are consistent with the following statements:
There appears to be a positive relationship between the enabling
environment (governance quality) and investment outcomes By extension: the most successful provinces in attracting investment (i.e.
the red provinces) have the best enabling environments (and notably donot use local incentives)
Some provinces are using locally initiated investment incentives (i.e. beyondthat outlined in central laws) but record low scores on governance quality.
This suggests a need to re-order policy priorities to focus on the enablingenvironment.
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Shares of Total Foreign Investmentin Five ASEAN Countries (%)
Indonesia Philippines Thailand Singapore Malaysia Total
Avg 1970-84 10.8 2.6 7.7 46.4 32.5 100.0
Avg 1985-90 9.2 6.9 17.0 49.3 17.6 100.0
Avg 1991-96 19.8 6.5 11.7 33.8 28.1 100.0
Sources: 1970-84 data from IMF, as imported in Hal Hill, Foreign Investment and Industrialisation in Indonesia (Singapore:
Oxford University Press, 1988), p 48.
Remaining data from United Nations, World Investment Report, 1997
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Cumulative No. of Approved FDI
Projects, Indonesia 1975-93
0
400
800
1200
1975
1977
1979
1981
1983
1985
1987
1989
1991
1993
Incentives stopped
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Estimating the costs of tax
incentives Wells and Allen (2001) use a simple approach to calculate the
indicative value of the subsidy equivalent of a tax incentive:
Let
T = Tax rate
Y = Investors average return from the investment (RoA)
R = Redundancy rate (proportion of investors that would haveinvested even without the tax incentive)
N = No. of years of tax holidayI = Total investment
Source: Tax holidays to attract FDI: Lessons from two experiments LouisWells and Nancy Allen, in Using tax incentives to compete for foreign
investment: Are they worth the costs? FIAS Occasional Paper 15.
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Estimating costs (contd)
Hence the tax unnecessarily given up to the investor
(i.e. the wasted subsidy) is
R x I x Y x T x NThe incremental investment (i.e. the investment occurring due to
the tax incentive) is
(1 - R)I
The subsidy as a proportion of incremental investment (i.e.amount of tax revenue forgone to generate the extrainvestment) is
R x I x Y x T x N / (1 - R)I
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Sample
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Estimating the redundancy rate
No. of firms receiving CIT
incentives 20 37 70
Response to Q1
Yes No Don't know Yes No Don't
know
Yes No Don't
know
Yes No Don't
know
No. of firms 9 1 3 16 2 2 34 1 2 59 5 7
% 69.2% 7.7% 23.1% 80.0% 10.0% 10.0% 91.9% 2.7% 5.4% 84.3% 7.1% 10.0%
Implied redundancy rate 69.2% 80.0% 91.9% 84.3%
Response to Q2Agree Disagree No opinion Agree Disagree No
opinionAgree Disagree No
opinionAgree Disagre
eNo
opinion
No. of firms 10 0 3 16 3 1 31 3 3 57 6 7
% 76.9% 0.0% 23.1% 80.0% 15.0% 5.0% 83.8% 8.1% 8.1% 81.4% 8.6% 10.0%
Implied redundancy rate 76.9% 80.0% 83.8% 81.4%
Average redundancy rate 73.1% 80.0% 87.8% 82.9%
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Tien Giang Binh Duong HCMC Whole Sample
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Other variables
T = tax rate, use both 28% and 32%
N = number of years of tax holiday = 4 years 80% of incentive receiving firms in sample enjoy
full tax exemption for 2 years, the 50% forfollowing year, thus total = 4 years (discounted =3.29 years, using 7% discount rate)
Y = reported average return on assets (ROA)from survey
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Subs
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Subsidy equivalent (non-disc)
Non discounted
ROA
Redundancyrate 3.0% 5.0% 7.0% 9.0% 11.0% 13.0% 15.0% 17.0% 19.0% 21.0%
Subsidyequivalent 60% 5.8% 9.6% 13.4% 17.3% 21.1% 25.0% 28.8% 32.6% 36.5% 40.3%
Tax rate = 32% 65% 7.1% 11.9% 16.6% 21.4% 26.1% 30.9% 35.7% 40.4% 45.2% 49.9%
Years of taxholidays = 4 70% 9.0% 14.9% 20.9% 26.9% 32.9% 38.8% 44.8% 50.8% 56.7% 62.7%
75% 11.5% 19.2% 26.9% 34.6% 42.2% 49.9% 57.6% 65.3% 73.0% 80.6%
80% 15.4% 25.6% 35.8% 46.1% 56.3% 66.6% 76.8% 87.0% 97.3% 107.5%
85% 21.8% 36.3% 50.8% 65.3% 79.8% 94.3% 108.8% 123.3% 137.8% 152.3%
90% 34.6% 57.6% 80.6% 103.7% 126.7% 149.8% 172.8% 195.8% 218.9% 241.9%
95% 73.0% 121.6% 170.2% 218.9% 267.5% 316.2% 364.8% 413.4% 462.1% 510.7%
Subsidyequivalent 60% 5.0% 8.4% 11.8% 15.1% 18.5% 21.8% 25.2% 32.6% 36.5% 40.3%
Tax rate = 28% 65% 6.2% 10.4% 14.6% 18.7% 22.9% 27.0% 31.2% 40.4% 45.2% 49.9%
Years of taxholidays = 4 70% 7.8% 13.1% 18.3% 23.5% 28.7% 34.0% 39.2% 50.8% 56.7% 62.7%
75% 10.1% 16.8% 23.5% 30.2% 37.0% 43.7% 50.4% 65.3% 73.0% 80.6%
80% 13.4% 22.4% 31.4% 40.3% 49.3% 58.2% 67.2% 87.0% 97.3% 107.5%
85% 19.0% 31.7% 44.4% 57.1% 69.8% 82.5% 95.2% 123.3% 137.8% 152.3%
90% 30.2% 50.4% 70.6% 90.7% 110.9% 131.0% 151.2% 195.8% 218.9% 241.9%
95% 63.8% 106.4% 149.0% 191.5% 234.1% 276.6% 319.2% 413.4% 462.1% 510.7%
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Subsidy Equivalent (disc)
Discounted 7%
ROA
Redundancyrate 3.0% 5.0% 7.0% 9.0% 11.0% 13.0% 15.0% 17.0% 19.0% 21.0%
Subsidyequivalent 60% 4.7% 7.9% 11.0% 14.2% 17.4% 20.5% 23.7% 26.8% 30.0% 33.1%
Tax rate = 32% 65% 5.9% 9.8% 13.7% 17.6% 21.5% 25.4% 29.3% 33.2% 37.1% 41.0%
Years of taxholidays = 3.29 70% 7.4% 12.3% 17.2% 22.1% 27.0% 31.9% 36.8% 41.7% 46.6% 51.5%
75% 9.5% 15.8% 22.1% 28.4% 34.7% 41.0% 47.3% 53.6% 60.0% 66.3%
80% 12.6% 21.0% 29.5% 37.9% 46.3% 54.7% 63.1% 71.5% 79.9% 88.4%
85% 17.9% 29.8% 41.7% 53.6% 65.6% 77.5% 89.4% 101.3% 113.3% 125.2%
90% 28.4% 47.3% 66.3% 85.2% 104.1% 123.1% 142.0% 160.9% 179.9% 198.8%
95% 60.0% 99.9% 139.9% 179.9% 219.9% 259.8% 299.8% 339.8% 379.7% 419.7%
Subsidy
equivalent 60% 4.1% 6.9% 9.7% 12.4% 15.2% 17.9% 20.7% 23.5% 26.2% 29.0%Tax rate = 28% 65% 5.1% 8.5% 12.0% 15.4% 18.8% 22.2% 25.6% 29.1% 32.5% 35.9%
70% 6.4% 10.7% 15.0% 19.3% 23.6% 27.9% 32.2% 36.5% 40.8% 45.1%
Years of taxholidays = 3.29 75% 8.3% 13.8% 19.3% 24.9% 30.4% 35.9% 41.4% 46.9% 52.5% 58.0%
80% 11.0% 18.4% 25.8% 33.1% 40.5% 47.9% 55.2% 62.6% 70.0% 77.3%
85% 15.6% 26.1% 36.5% 46.9% 57.4% 67.8% 78.2% 88.7% 99.1% 109.5%
90% 24.9% 41.4% 58.0% 74.6% 91.1% 107.7% 124.3% 140.8% 157.4% 174.0%
95% 52.5% 87.4% 122.4% 157.4% 192.4% 227.3% 262.3% 297.3% 332.3% 367.3%
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Estimated Subsidy equivalent
Tax rate32% 28%
Non-discounted Discounted Non-discounted Discounted
Equivalent years of tax holiday 4 3.29 4 3.29
Whole Sample (70)
ROA 13.8% 13.8%
Redundancy rate 82.9% 82.9% 82.9% 82.9%
Effective public subsidy 85.4% 70.2% 74.7% 61.5%
Binh Duong (20)
ROA 19.6% 19.6%
Redundancy rate 80.0% 80.0% 80.0% 80.0%
Effective public subsidy 100.4% 82.5% 87.8% 72.2%
HCMC (37)
ROA 12.4% 12.4%
Redundancy rate 87.8% 87.8% 87.8% 87.8%
Effective public subsidy 114.4% 94.1% 100.1% 82.3%
Tien Giang (13)
ROA 4.0% 4.0%
Redundancy rate 73.1% 73.1% 73.1% 73.1%
Effective public subsidy 13.8% 11.3% 12.1% 9.9%
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Conclusions
The current fiscal incentive regime for domesticinvestment is not incentivizing investment
Redundancy rate of 83% suggests fiscal incentivesnot a primary factor motivating investment
This translates into an effective public subsidy ofaround 70%
Thus for $10 million dollars of investmentqualifying for fiscal incentives, the nationalgovernment must surrender $7 million in scarcerevenue required for service delivery.