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Foreign Investment Advisory Service

_ _ S uOccasional Paper 4

Corporate Income Taxationand Foreign DirectInvestment in Centraland Eastern Europe

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Report No. :11361 Type: (MIS)Tit1e: CORPORATE INCOME TAXATIION AND FAuthor: MINTZ, JgACK M.Ext.A 0 Roofm l Dept.1-NOVEMBER 1992

Jack M. MintzThomas Tsiopoulos

FILE COPtYForeign Investment Advisory Servicea joint facility ofInternational Finance CorporationWorld BankMultilateral Investment Guarantee Agency

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Foreign Investment Advisory ServiceOccasional Paper 4

Foreign Investment Advisory ServiceA joint facility ofInternational Finance CorporationWorld BankMultilateral Investment Guarantee Agency

Corporate Income Taxationand Foreign Direct Investmentin Central and Eastern Europe

Jack M. MintzThomas Tsiopoulos

The World BankWashington, D.C.

© 1992 The International Finance Corporation, the World Bank,and the Multilateral Investment Guarantee Agency1818 H Street, N.W., Washington, D.C. 20433

All rights reservedManufactured in the United States of AmericaFirst printing November 1992

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Library of Congress Cataloging-in-Publication Data

Mintz, Jack M.Corporate income taxation and foreign direct investment in Central

and Eastern Europe / Jack M. Mintz, Thomas Tsiopoulos.p. cm. - (Foreign Investment Advisory Service Occasional

paper, ISSN 1018-4902 ; 4)Includes bibliographical references.ISBN 0-8213-2301-61. Tax Incentives-Europe, Eastern. 2. Tax incentives-Central

Europe. 3. Corporations-Taxation-Europe, Eastern.4. Corporations-Taxation-Central Europe. 5. Investments, Foreign-Europe, Eastern. 6. Investments, Foreign-Central Europe.I. Tsiopoulos, Thomas, 1962- . II. Title. IH. Series:Occasional paper (Foreign Investment Advisory Service) ; 4.HJ4709.7.Z7M55 1992332.6'73'0943-dc2O 92-37602

CIIP

Contents

Preface v

Executive Summary vii

1. Introduction 1Tax Burdens as Only a Part of the Investment ClimateThe Effective Tax Rate 1

2. Results 3Comparability of the CEE Tax Regimes 3Tax Competitiveness of CEE Countries 4Elimination of Holidays 4Debt Finance as a Tax Shelter 5Inflation and Corporate Tax 5

3. Policy Options for Tax Incentives 8Criteria and Objectives 8Tax Holidays 8

Low Corporate Tax Rate 10

Investment Tax Allowances or Credits 10Conclusion 11

4. Appendix 14

Calculating the Effective Tax Rates 14

References 18

iii

Preface

The tax treatment of foreign direct investment Romania) as well as experts from FIAS, the Orga-(FDI) is a potentially important part of the policy nization for Economic Cooperation and Develop-framework in Central and Eastern European ment (OECD), and UNIDO. Country delegates(CEE) countries. These countries, currently trans- considered changes to existing corporate incomeforming their economies from a centrally planned tax policy and these were analyzed in terms ofto a market orientation, need FDI both for priva- their impact on the profitability of foreign invest-tizing state enterprises and for investments in ments.new physical facilities. The capital, management This paper has two purposes. The first is to de-skills, technology, and access to export markets scribe the analysis and compare the corporate in-that foreign direct investment can bring are cru- come tax regimes in the five CEE countries withcial ingredients for success. the regimes in other countries that might compete

This report is based on a detailed analysis of for the same capital. The second purpose is to dis-the impact that CEE corporate income tax re- cuss the benefits and costs of the various optionsgimes have on the profitability of foreign invest- that the five CEE countries may consider for de-ment. The results were presented at a workshop velopment of their corporate income tax policies.sponsored by the Foreign Investment Advisory The expenses of this work were shared by FHAS,Service (FIAS), held in the United Nations Indus- the Europe and Central Asia Region of the Worldtrial Development Organization (UNIDO) Center Bank, the Europe Department of the Internationalin Vienna on November 7 and 8, 1991. Partici- Finance Corporation (IFC), and the Economicspants included representatives of five countries Department of IFC. Staff from these units, as well(Bulgaria, Czechoslovakia, Hungary, Poland, and as from the OECD, contributed to the project.

v

Executive Summary

For all five CEE countries considered (Bulgaria, ufacturing only), and Romania would not be taxCzechoslovakia, Hungary, Poland, and Roma- competitive.nia), the corporate income tax regimes as of mid- Some of the many other possible tax incentives1991 were attractive compared with those of other also were examined. It was found that if tax holi-countries competing for FDI from the United days were eliminated, reducing the corporate taxStates or Germany, two important sources of FDI rate to around 20 percent, or allowing investrnentfor CEE countries. Czechoslovakia's effective tax tax allowances of around 20 percent, would pre-burden was a bit higher, but in all five countries serve the tax competitiveness of regimes in thethe burdens were well below levels that might de- CEE countries. A review of the various advantag-ter interested investors. es and disadvantages suggests that investment

Particular attention was paid to the effects of tax tax allowances or credits would probably be moreholidays, which are temporary tax relief that all five cost-effective than tax holidays for attracting FDI,countries offer to foreign investors. The analysis without undue revenue losses to the treasuries ofshows that the tax holidays benefit companies if in- the CEE countries.flation rates are low or if the companies largely fi- A final observation concerns the effect of infla-nance investment with equity. If, on the other hand, tion on the tax policies of CEE countries. If infla-inflation is high and investments are financed in tion rates are eventually brought down to a ratepart with local borrowing, and if also the nominal commonly found in most OECD countries (i.e.,interest costs are fully deductible for tax purposes, less than 5 percent), indexation for inflation willthe tax holidays become essentially redundant. be unnecessary. On the other hand, if inflation

Without tax holidays, and under the assump- continues at high rates, the CEE countries sh.ouldtion of a normal debt/equity ratio with the debt consider indexation as a way of adapting their taxborrowed locally, Czechoslovakia, Bulgaria (man- policies.

vii

_ _1

Introduction

Tax Burdens as Only a Part inventory costs, interest deductions, and lossesof the Investment Climate also can affect the amount of profits, net of corpo-

rate tax, obtainable from a foreign investment. InTaxation's effect on flows of foreign direct invest- addition, many governments provide special in-ment must be judged in the context of the many centives such as investment allowances, invest-other factors that determine how much foreign ment tax credits, and tax holidays (temporary taxinvestment is made, and where. For most kinds of exemptions or reductions) that influence the com-such decisions, effective corporate income tax pany's obligations.levels are not the make-or-break factor. There are, The country's economic climate can also be ahowever, two important exceptions. First, factor. For example:extremely high taxes will deter foreign direct the interest rate that a company uses toinvestment. Second, so-called footloose invest- discount future benefits is high, then the curnentments-such as those in labor-intensive assembly value of write-offs given for depreciation wilc beof garments, electronics, and toys-can be made lof given intereciation hil ain many satisfactory locations. To attract such in- low. In general, when interest rates are high, avestments, it is necessary to have a highly com- company has less incentive to spread deductionspetitive corporate income tax regime, as well as over a period of time.other factors important to such activities. But * Similarly, if inflation rates are high and ac-othefrom these two exceptions, normally small counting does not allow assets and liabilities to beapart comntry twofexceptin normare unl revalued accordingly, future deductions such asintercountry differences in profit taxes are unlike- those for depreciation or losses carried forwardly to affect company decisions significantly, espe- are for depr hatin orulons where fla-

cialy inthe EE cuntr conext heremany are less valuable than in situations where infla-cially in the CEE country context where many tion is low or carried-forward amounts are in-economic and political factors dominate investor dexed for inflation.decisionmaking. * On the other hand, high inflation can reduce

The Effective Tax Rate taxes for companies that finance investments bydebt unindexed for inflation. With the deductibil-

Investors find that corporate income tax regimes ity of high nominal interest, unadjusted for infla-can have varyngefectonroftabiity.Ttion, the business is able to write off not only the

can have varying effects on profitability. The cur- "ral poto ofteitrs utas hetren satuor raesof such taxation range from as "real" portion of the interest but also the rest,rent statutory rates of such contrang Kom which is in fact an adjustment for inflation's effect

low as 15 percent in some countries (Hong Kong, on the value of the principal.for example) to more than 50 percent in others(such as Japan). As any astute investor knows, Because of these effects, the actual value of tax-however, the tax treatment of depreciation and es paid usually differs from the tax rate specified

1

in the law. Actual tax burdens can be higher or tries change considerably, as shown in the sensi-lower than the statutory rate, depending on the tivity analysis.presence and the relative importance of the ef- The base case results for each of the five CEEfects mentioned. To take all these effects into ac- countries, presented in Table 1, show the effectivecount, a useful summary measure called the tax burdens of the systems as they actually per-effective tax rate is commonly employed. The ef- formed (as closely as we were able to modelfective tax rate indicates the degree to which the them) in mid-1991. (Assumptions and parame-tax system in all its ramifications, and in its inter- ters are shown in Table 8.) Effective tax burdensactions with the economic environment, reduces were also calculated, and the results presented,the after-tax rate of return from a given before-tax for the same investments in two other countries,return. For example, if an investment earns 10 Greece and Portugal, and also for investments inpercent before taxes and the effective tax rate is 40 the home country, the United States.percent, the net-of-tax rate of return is 6 percent. Variations on the base case results are shown inThe appendix explains the methodology used to Tables 2 through 7. These variations apply only tocalculate effective tax rates for this paper.1 the five CEE countries; for Greece, Portugal, and

Calculations were made for two kinds of in- the United States only the actual situation wasvestments, a typical light manufacturing compa- analyzed.ny and a hotel. Results are presented only for aninvestor whose home country is the United NotesStates.2 The same calculations were nmade for aninvestor based in Germany, but the results were 1. The authors wish to thank Joel Bergsman for his helpfujl com-

so simiar tat tey rentprseitedere.The ments which much improved the argumentation given in this paper.so simlar that they are not presented here. Thecalculations are based on the assumtion, inter c2. It is assumed that the U.S. company is in an excess foreign taxcalculatins are baed on th assumptin, inter credit position. That is, the amount of taxes paid to the U.S. govern-alia, that the investments are financed with typi- ment, after application of foreign tax credits, is zero. Many U.S.

cal debt-equity mixes and that the debt is bor- companies, after the 1986 tax reform, are in this position, so this as-rowed locally. This assumption affects the results sumption is the most relevant. For an analysis of the case in which a

in soe of he contrie; if o locl deb is ued in U.S. multinational pays taxes on remitted income to the U.S. gov-in some of the countries; ff no local debt is used in uernment (deficient tax credit position), see Leechor and Mintzthe financing, the effective tax rates in some coun- (1991).

2

2Results

The conclusions of the analysis will be discussed existing rules (Table 4). But, if the tax holidayin this section. They can be summarized as fol- were to be eliminated, then under low inflationlows: the effective tax burdens of all five countries rise

to the range of 35 to 60 percent-somewhat high,* All five of the CEE countries impose rather in the range where they getesome invs

unifrm ax brdes o forigninvstor. Te i the range where they might deter some inves-uniform tax burdens on foreign investors. The tors (Table 5).differences among them in effective tax rates are t Eltd uunlikely to affect the relative attractiveness of one s ating the areconin t corpen-

conr vraohr(al ) sating with either a reduction in the corporate in-country over anther (Table ~~come tax rate to 20 percent, or permitting a 20

* Effective tax rates in CEE countries are com-petitive with those of other countries and are not percent tax allowance for new investments in de-high enough to deter foreign investors (Table 1) preciable assets, would maintain tax competitive-

h Elimighenati tax deterhforeidays isoud (Tabe 1 ness for Czechoslovakia, Hungary and Poland.* Eliminating tax holidays would make Bugai an Roai ol,hwvr aet

Romania and Bulgaria much less tax competitive BlaianRonawud,hevrhvetforaniavestaends Bia manufachtlessn competitive take stronger measures to remain tax competitivefor investments in manufacturing. The effective if they were to eliminate tax holidays (Tables 6tax rates in these countries would be high enough and 7).that some investors might well be deterred. Theeffective rates also would go up to some extent in The conclusions will now be discussed in rmoreCzechoslovakia if it stopped offering holidays, detail.but probably not enough to deter many investors(Table 2)1. Comparability of the CEE Tax Regimes

* In Hungary and Poland, the tax holidaysare essentially redundant to investors who bor- Table 1 summarizes the effective tax rates onrow locally. The full deductibility of high nominal manufacturing and service industries under theinterest rates in these countries makes the corpo- existing rules in each of the CEE countries. Therate income tax burdens so low that the holidays rates range from 6 percent to 22 percent in manu-are irrelevant. However, for investors who do not facturing-a wide range in percentage terms. Butborrow locally, eliminating the tax holiday would more importantly, all these rates are all reason-also reduce the tax competitiveness of these two ably competitive-not high enough to deter mostcountries significantly (Tables 2 and 3). investors from making an investment. From this

* Assuming low inflation moves the base case point of view, the rates are not significantly differ-results in the same direction as assuming no local ent in terms of their effects on investment deci-borrowing-but not as much. With low inflation, sions. For services qualifying for the holiday (forthe countries remain tax competitive with their example, hotels), a similar range from 5 percent

3

Table 1 Effective Tax Rates: Systems ciate assets during the holiday If companies couldas of mid-1991 delay their claim, depreciation could be postponed

until afterward, and effective tax rates would beCountry Manufacturing Services much lower than those illustrated in Table 1.2

Czechoslovakia 22.2 19.8 Tax Competitiveness of CEE CountriesPoland 7.6 14.3Hungary 6.0 5.1Romania 12.2 9.8 The effective tax rates in the CEE countries com-Bulgaria 10.2 9.8 pare well with those of other countries that mayGreece 15.1 -8.8 compete for the same foreign direct investmentPortugal 31.3 19.8 (Table 1). Moreover, the effective tax rate is muchUnited States 41.9 29.7 smaller than for investments in the United States

itself. The United States now has few incentives

to 20 percent in effective tax rates is observed. available for capital investment because the 1986However, the effective tax rate for investments in tax reforms abolished the investment tax creditthe Polish service industry, with a two-year holi- and scaled back deductions for depreciation. Atday, is much higher than that for Polish manufac- the same time, however, the United States re-turing, with a five-year holiday duced its corporate tax rate from more thaLn 50

The similarity of the effective tax rates across percent to less than 40 percent, a rate compa:rablethe countries (except to some extent for to that of most CEE countries (except BulgariaCzechoslovakia) is somewhat surprising given the with a 50 percent corporate tax rate).significant differences in corporate tax provisions The CEE countries are also tax competitivefrom country to country. As outlined previously, a with Greece (manufacturing only) and Portugalnumber of factors affect effective tax rates and in attracting foreign capital in manufacturing. 4

some of these offset some others. These factors in- Although neither country provides tax holidaysclude the following (besides the length of the hol- for investments, both permit companies to ex-iday as already discussed): pense a large portion of their capital expendi-

tures. Greece, for example, allows services toThe higher the corporate tax rate, the more write off at least 40 percent the first year, in addi-

taxes the company might pay on income earned tion to annual depreciation allowances.after the holiday. Bulgaria has the highest corpo-rate tax rate (50 percent) compared with the other Elimination of HolidaysCEE countries. Its effective tax rate on manufac-turing investments is higher than for manufactur- Table 2 provides effective tax rate measurements,ing in Poland, even though both countries have a assuming there are no tax holidays available infive-year holiday period and similar inflation ex- the CEE countries. Under these assumptions,perience. three of the countries would not lose their tax

* The more a company uses long-lived assets, competitiveness, given a typical project's debt/the more taxes the company pays after the tax equity ratio. In this case, the effective tax rates forholiday expires. In all CEE countries except Hungary, Bulgaria (services only), and Poland arePoland, manufacturing and services have thesame length of holiday. The higher effective taxrates in manufacturing than in services in the oth-er four countries are in part due to manufactur-ing's greater use of long-lived depreciable capital, Table 2 Effective Tax Rates: No Tax Holidayrelative to service activities which use more

short-lived capital. Country Manufacturing Services

* If the company depreciates assets during theholiday, tax depreciation allowances available af- Czechoslovakia 37.4 25.9

ter the holiday can be reduced in value. Thus, for a Hungary 4.2 -31.7

given asset, the more depredation claimed during Romania 60.9 32.4

the holiday, the more taxes paid after the holiday Bulgaria 241.7 -128.0

All five CEE countries require companies to depre-

4

actually lower than they are in the tax holiday Table 3 Effective Tax Rates: Manufacturing,case.5 No Tax Holiday: Different Debt/Asset Ratios

On the other hand, in Czechoslovakia, Bulgaria(manufacturing), and Romania, eliminating tax Debt/Asset Ratio (percent)holidays would mean that investments would Country 40 20 6face higher effective tax rates than investmentsmade in Greece and Portugal. This results prima- Czechoslovakia 34.8 55.7 63.9rily from the substantial deductions that Greece Poland -266.7 -18.4 77.4

Hungary -5.8 52.0 62,7and Portugal give for capital expenditures by ex- Romania 59.4 72.0 80.5isting businesses as well as new businesses. By Bulgaria 213.1 5.34.3 1,006.9contrast, incentives in the CEE countries benefitnew companies only. Bulgaria and Romania espe-cially would need to take other steps to reduce ef-fective tax burdens if they eliminated tax nominal interest rates, the effective tax rates areholidays. quite high compared with other countries. This is

especially true for countries such as Poland,Debt Finance as a Tax Shelter Bulgaria, and Hungary, where high inflation re-

duces the value of depreciation deductions. It isInterest deductions for debt in highly inflationary also true for Romania and Bulgaria, which pro-environments largely account for the somewhat vide an inadequate deduction for inventory costssurprising conclusions of the previous section. in the presence of inflation.7

The write-off of high nominal interest rates dras- On the other hand, even without a tax holiday,tically reduces tax burdens, having the same ef- when debt/asset ratios are normal (such as the 40fect as tax holidays. So the holidays are only percent assumed here), Poland and Hungary haveimportant if investments are financed by equity competitive effective tax rates on manufacturingand/or foreign borrowing in low-inflation coun- that are similar to or lower than those of Greece,tries or, as discussed in the following section, Portugal, and the United States. Czechoslovakiawhen the host countries experience low inflation. and Romania, however, would have relatively

For investments financed in significant degree high effective tax rates. The reason is that the latterby local debt (at least 40 percent), the holiday in- countries have relatively low inflation, so the de-centive does little to encourage foreign invest- ductibility of interest is of less value. As for Bulga-ment in Hungary, Poland, and Bulgaria (services ria, its effective tax rate on manufacturing remainsonly). In the absence of the tax holidays, compa- high because of its inadequate treatment of inven-nies can use interest deductions to shield invest-' tory costs for tax purposes under inflation. Table 2ments from corporate taxation. This can intensify shows that Bulgaria's effective tax rate on servic-inflation's effect on the value of depreciation and es, however, is quite low in the presence of infla-other deductions based on the asset's historical tion. Unlike manufacturing, services use littlecost. As discussed previously, when inflation in- inventory.creases interest rates and there is no indexation, All of this variation illustrates some of the un-the foreign investor can virtually eliminate any predictable effects of interest deductibility andcorporate tax paid to the host country on invest- inflation on the effective tax rate that companiesments. Thus, the effective tax rates in the three face in high-inflation countries. Further impactshigher-inflation CEE countries-Hungary, of inflation are discussed in the following section.Poland, and Bulgaria (services only)-are signifi-cantly less than in the tax holiday case. Inflation and Corporate Tax

The influence that varying debt/asset ratioshave on the effective tax rates for manufacturing As stated previously, the tax holidays in the GCEEacross the CEE countries is illustrated in Table 3. countries do little to reduce effective tax rates(Results are similar for services and are not re- when companies use some local debt to financeported.) The higher the debt/asset ratio, the low- investments. This may happen particularly iner the effective corporate tax rate in the absence of countries with high rates of inflation because thethe tax holiday.6 When companies finance invest- interest deductions, unadjusted for inflaltion,ments without using money borrowed at high shield corporate income from taxation.

5

Table 4 Effective Tax Rates: Tax System if inflation remains high and the companies areas of mid-1991 but Inflation = 3 percent able to shelter income from taxes by deducting fi-

nancing costs that are unadjusted for inflation.Country Manufacturing Services Thus, if high inflation continues, the corporate

tax holidays will be of little value to the investorPoland 17.7 13.8 who borrows locally. Moreover, inflation canHungary 73 477 have various unplanned and undesirable effectsRomania 14.9 5.8 on investments, especially in the absence of taxBulgaria 18.4 -4.3 holidays, depending on how the investments are

financed. For low debt-financed projects, infla-tion results in very high effective tax rates, if de-

Table 5 Effective Tax Rates: No Tax Holiday preciation and inventory deductions are notbut Inflation = 3 percent indexed for inflation. For high debt-financed

projects, effective tax rates can be extraordinarilyCountry Manufacturing Services low, because interest deductions are not adjusted

for inflation. Therefore, if for any reason inflationCzechoslovakia 43.1 35.2 continues, the tax system would need to be ad-Poland 41.1 36.2 justed to avoid these effects.

Romania 53.3 42.9 On the other hand, if inflation is only temporaryBulgaria 62.3 52.9 and price stability or a low rate of inflation is even-

tually experienced, the corporate tax holidays willthen be more effective in reducing the income taxburden. Without the tax holiday, however, the ef-

The importance of inflation can be illustrated fective tax rates on capital will then be quite highby a hypothetical situation in which these coun- unless corporate tax policies change in some com-tries experience an inflation rate similar to those pensating way. Thus, the evolution of corporateof the OECD countries. Assuming 3 percent infla- tax policy in the CEE countries will depend ontion, Tables 4 and 5 compare the effective tax rates their long-term experience with inflation.that could be expected under tax holiday andnon-holiday situations. Notes

As shown in Table 4, with the tax holiday, theeffective tax rates on manufacturing and services 1. In this table and some subsequent ones, the effective tax rate

in the five CEE countries are much lower than as calculated is negative for some countries. This means that the

those in Greece, Portugal, and United States. company would pay no corporate income tax in the host countiy un-Without the holiday, however (Table 5), the effec- less its rate of return is above its cost of capital. Furthermore, it

would have a loss on its books for tax purposes that could poteritiallytive tax rates in the CEE countries are much high- be used to reduce taxes on other income, which could be either its

er, somewhat surpassing those in the other own future income if losses can be carried forward, or income of

countries. Thus, with low rates of inflation, re- other linked companies if they could transfer income to it throughmoval of the tax holiday would significantly re- transfer pricing or other means. The size of the calculated negative

tax rate is an indication of the importance of this potential benefitduce the tax competitiveness of the CEE relativetotheincomeofthecompany.

countries. 2. Indeed, the tax holiday would encourage the use of long-livedThese results are especially important for capitalifcompaniescoulddelaytheirclaimingofdepreciationdeduc-

Romania and Bulgaria, which impose much high- tions until after the holiday. Mintz (1990) compares the impact of

er effective corporate tax rates on manufacturing mandatory and discretionary depreciation allowances on the invest-and services in the absence of a tax holiday. In ment decisions of companies during and after the tax holiday. See also

Mintz and Tsiopoulos (1992), who compare effective tax rates inthese two countries, depreciation and inventory Singapore with those in Taiwan (China), and Thailand for similar hol-

deductions are less generous than those in the oth- iday investments. Singapore, unlike the latter two countries, allowser CEE countries as well as in Greece, Portugal, companies to delay depreciation deductions until after the holiday. As

and the United States. a result, Singapore's effective tax rate for holiday investmelts isThe calculations in Tables 4 and 5 raise an im- much lower than those in Taiwan (China), and Thailand.

portant policy issue that the CEE countries face. 3. The United States has a 34 percent corporate tax rate at thefederal level. States increase the statutory tax rate by another 4 per-

Tables I and 2 show that the corporate tax holi- cent on average, taking into account the deductibility of state taxes

days may have little effect on foreign investment from the federal tax base.

6

4. The negative effective tax rate for Greece (Table 1) implies the holiday case can be higher than it would be for the non-holidaythat the tax system subsidizes marginal investment. Any tax losses case.generated by a marginal investment are being used to reduce taxes 6. Note that with the tax holiday the debt/asset ratio has little in-paid on inframarginal investment. If the company cannot apply all fluence on the effective tax rate in each of the five CEE Europeanthe tax losses to income earned on other investments, then the losses countries.must be carried forward and charged against future income. The ef-fective tax rate therefore will be higher, possibly zero, or even posi- 7. Romania and Bulgaria have a relatively high effective tax ratetive, in the case of a company that expects to pay taxes only in the in manufactung because mventones are valued usmg the pice offuture. For further discussion, see McKenzie and Mintz (1990). the oldest inventory purchased by the company (this is known as the

first-in, first-out or FIFO method of accounting). When prices are5. For the investment to have a higher effective tax rate with a tax rising, this implies that most inventory deductions are valued at his-

holiday than it would with no tax holiday, the investment must incur torical costs and unindexed for inflation. Hungary, Czechoslovalcia,some tax losses during the holiday period. Without the holiday, the and Poland allow companies to write off the value of the last-datedcompany can use tax losses to reduce income earned on other invest- unit of inventory purchased by the company (the last-in, first-out orments, while a holiday restricts the full use of the tax losses to reduce LIFO method). This can be similar to a deduction of the replacem.enttaxes paid on other investments. Therefore, the effective tax rate for cost of inventories.

7

Policy Options for Tax Incentives

Criteria and Objectives emptions) and a moderately low tax rate. Manygovernment officials in CEE countries, however,

The CEE countries are focused on their change are concerned that such a strategy may not be ef-from centrally planned to market-oriented econo- fective in attracting more foreign direct invest-mies. A significant objective for their policy, un- ment. In the short run they may fear that their taxlike those faced in industrialized nations, is to systems will appear unfriendly until they canattract not only foreign capital but also technolo- complete comprehensive reform measures. Or, ingy and managerial talent for industry. Rightly or the long run, they may feel that their countrieswrongly, these governments often consider cor- need lower rates to compete effectively for for-porate tax incentives a major tool for the transfor- eign capitalmation process. They see tax holidays or other Corporate tax policy in CEE countries rnustways to reduce tax on foreign direct investment concentrate on two objectives that must beas easier than other steps to make their economic weighed against each other: (1) revenue raisingclimate more hospitable, such as improving infra- and (2) economic policy, specifically the attrac-structure. This objective for corporate tax policy tion of foreign capital.1 The policymakers mustis not without its costs, however. Government ac- ask themselves: What is the best type of tax incen-tivities still must go on, such as education, public tive to attract foreign investment without losingsafety, social services, construction of roads and considerable revenue? There are three approach-bridges, and tax revenues are needed to pay for es they could consider: (1) tax holidays, alreadythem. employed in each of the countries studied in this

Specialists suggest that a tax system should report; (2) fast write-offs for investments such asmeet three criteria in raising revenue: accelerated depreciation, LIFO (last in, first out)

.Efficiency: The system should have a mini- accounting for inventories, investment allowanc-mal effect on the allocation of resources achieved es, or investment tax credits; and (3) a low corpo-by a market economy. rate tax rate applied to a broad corporate tax base.

b Equity: It should treat similar taxpayers in a (Other steps such as employment tax incentivessimilar Equity: tsoltasmltxaria could be considered, but these are not particular-similar way.* Simplicity: It should be easy to cornply with ly aimed at foreign investment and go beyond the

and to administer. analysis of this report.)

Efficiency, equity, and simplicity all favor tax- Tax Holidaysing investments at the same rate (not discriminat-ing, for example, among investors of different The tax holiday is the principal form of corporatenationalities), with a broad tax base (i.e., few ex- tax incentive now available in the CEE countries.

8

It operates by exempting, or taxing at a preferen- tal commitment. Discouragement of investmentstial rate, income earned during the first years of having a long-term stake could hurt the economythe founding of the company. In principle, when * The holiday can lead to a large erosion ofthe holiday ends, the company must begin to pay the tax base as taxpayers learn how to escape tax-taxes-the company is not allowed to transform ation of income from other sources. During theitself into a new company that would qualify for holiday years, companies operate at a preferen-a new holiday. Thus, the implementation of the tial corporate tax rate (zero in the case of the CEEholiday requires the tax authority to monitor the countries). When corporate taxpayers have adevelopment of the enterprise. The holiday in- choice, they have incentive to shift income into acentive is infrequently used in the industrialized company enjoying the tax holiday and take morenations. deductible expenses in another company they

The tax holiday offers several benefits as a may own that must pay taxes. They would prefermeans of attracting foreign investments, includ- to have the taxpaying company incur interesting: costs on borrowed finance and the tax holiday

company to be financed with equity. In fact, theIt provides large benefits as soon as the tax holiday company could hold debt in the non-

company begins earning income. While the holi- holiday company. The non-holiday company canday is of little immediate help to an unprofitable deduct interest while the tax-holiday companycompany, its prospective benefits are more valu- earns the interest tax-free.able than an incentive such as a lower corporate * Company turnover adds another complexi-tax rate that accrues more slowly over a longer ty. A company can try to lengthen its holidaytime. term by closing down in one location and restart-

* The holiday primarily benefits short-term ing (under the guise of new ownership) in anoth-investments, which often are undertaken in so- er location. Tax authorities may try to guardcalled footloose industries characterized by com- against such abuses, but it may be difficult topanies that can quickly disappear in one jurisdic- eliminate them entirely.tion and reappear in another. Thus, footloose * The tax holiday is a difficult incentive to tar-investments, which use capital that quickly de- get and thus can have unintended distorting ef-preciates or is easily disposed of, benefit most fects on the economy. It may help non-qualifyingfrom the tax holiday.2 The prospect of no or re- companies to shift away taxable income. A taxduced taxes for a limited time encourages foot- holiday given in a CEE country could ultimatelyloose projects to locate in such a place, and benefit investments in other countries if the par-therefore many countries compete for such in- ent company can shift its own income into itsvestment with very generous tax holidays. CEE company through transfer pricing, financ-

* With a tax holiday, interest deductions are ing, and other tax arbitrage techniques.of little tax value. Thus, the holiday removes anincentive for corporations to finance investment In summary, tax holidays have significant ad-bynborrowing. Indeed c i the holiday also implies vantages and disadvantages. A disadvantage toby if the government is that they can reduce neededthat company shareowners need not pay person- revenues. They create tremendous opportunitiesal income taxes on dividends and capital gains, for multinational companies to engage in taxequity finance will be encouraged instead. This planning strategies that result in steady erosionreduces the prospect of bankruptcy because the and leakage of revenues normally available to thecompany will likely be more financially viable. government. The revenue cost may be particular-

Some of the drawbacks to using tax holidays ly large even if some new investment is encour-are these: aged. As for attracting more foreign direct

investment, the tax holiday is of limited useful-* When assets must be written down for tax ness: the incentive is more effective in attracting

purposes during the holiday, the incentive dis- footloose industries rather than those that wouldcriminates against investments that rely on long- take a long-term interest in the economy. Finally,lived depreciable capital. While holidays may at- the tax holiday benefits the formation of newtract footloose industries, they are less likely to companies rather than investment in new pro-attract industries bringing more significant capi- ductive assets, when what the CEE countries

9

want is the new assets. Whether the investors are Table 6 Tax Rates: No Tax Holidays butnew or existing companies should not matter. Corporate Income Tax Set at 20 Percent

Low Corporate Tax Rate Country Manufacturing Services

CEE countries could consider eliminating tax in- Czechoslovakia 18.5' 11.1such the holiday, and levying a lowPoland -92.3 -1'27.6centives, such as the holiday, and levying a low Hungary 0.5 -12.7corporate tax rate on all industrial activities. The Romania 38.1 15.6tax base could be chosen to correspond roughly Bulgaria 58.7 -36.9with the corporation's income.3 As currently be-ing practiced in several CEE countries, compa-nies would deduct labor costs, depreciation, might be better off having a less neutral system toinventory costs, and interest expense from reve- minimize distortions.5 When corporate tax basesnues earned. Countries experiencing high infla- and rates are not uniform, multinational corpora-tion could index income and costs. As argued tions can exploit the differences to their ovvn ad-earlier, however, indexation would not be neces- vantage. For example, a multinational coulcd issuesary if inflation were reduced. debt in a high tax rate country to finance invest-

Table 6 shows the effective tax rate on manufac- ments in a low tax rate country. This would pro-turing and service investments in the five CEE vide a benefit for multinational companies thatcountries, assuming a corporate tax rate of only would not be available to local businesses.20 percent and no tax holiday4 As the table indi- * Because they face economic and politicalcates, all except Bulgaria would be tax competi- uncertainties, the CEE countries may need to of-tive. fer an incentive that provides immediate benefits

a lcrpe tax rate oaroad base ou to foreign investors. A low corporate tax rate mayhave three advantages over the current system of not suffice because the benefits largely accrue intax holidays: later years. Also, a cut in rates reduces taxes paid

* Compliance and administration would be on old investments, resulting in a windfall gain tomuch simpler. Governments would be able to owners of old capital and a considerable revenuemaintain corporate tax revenues because inves- loss to the government.tors would have few tax planning opportunities. * Most OECD countries give preferential cor-

* Investors would look favorably on a coun- porate tax treatment to activities that may bringtry offering a low statutory tax rate, especially long-term benefits, such as research and develop-one well below the worldwide norm of 35 percent ment. Investments in advanced-technology ma-to 40 percent. Also, a low corporate tax rate with chinery also are encouraged.6

few other incentives signals to foreign investorsthat the government is interested in letting the Investment Tax Allowances or Creditsmarket determine the most profitable invest-ments without undue governmental influence. A third form of tax incentive, found in many

* A low corporate tax rate is, in itself, an in- OECD countries, is a fast write-off for investmentcentive. It allows investors to keep a larger por- expenditures. These allowances take three forms:tion of profits. Also, in inflationary climates, an (1) accelerated depreciation, which allows com-unindexed corporate tax system has less effect on panies to write off capital more quickly for taxinvestment activities. purposes than for accounting; (2) an investment

Although a broad-based low corporate tax rate expenditure allowance that lets companies writeis consistent with the current philosophy of in- off a percentage of qualifying investment expen-dustrialized economies, this approach has limita- ditures from their taxable income; and (3) an in-tions. They include: vestment tax credit that allows companies to

reduce taxes paid by a percentage of investment* International linkages can undermine a expenditures. The second and third types are up-

country's efforts to make its tax system relatively front tax incentives that immediately benefit theneutral. In fact, a country with a corporate tax investing company. Actual use may be limited,system greatly out of line with other countries' however, if the company cannot write off the

10

allowance (for instance, if it were in a loss posi- Like the other tax incentives, the investmenttion for tax purposes and the government does tax allowance has its limitations and drawbacks.not refund the allowance in such a case), These include:

Table 7 shows estimated effective tax rates for * In many OECD countries, the allowance ap-manufacturing and service projects, assuming a phen many o ery cntries theualowanc ap

fully efundble 2 percnt inestmet taxallow plies only to machinery and perhaps structures. Iffullv refundable 20 percent imvestmnent tax allow- some types of capital, such as inventories, do notance for machinery and structures, with no tax qualify, the allowance discriminates against thoseholiday.8 As the table indicates, the effective rates industries that intensively use them.in all CEE countries are lower than those in * A company that must replace capital oftenGreece, Portugal, and the United States-except can claim the investment allowance frequently.for manufacturing in Romania and Bulgaria.9 Thus, the allowance favors assets that have high-Thus, a country can substitute investment tax al- er rates of economic depreciation. If governmentslowances for tax holidays and still maintain its do not want to favor certain assets, they wouldtax competitive position; Bulgaria and Romania have to gear allowance rates to the expected ratewould have to lower their tax rate or provide of capital depreciation.larger allowances than those assumed here. * If the investment tax allowance is not re-

Investment tax allowances have distinct ad- fundable, existing companies reap the full bene-vantages over other incentives the CEE countries fits while start-up companies must first earnvantages provide.Theyinclude:enough income before they can take the allow-could provide. They include: ance. Also, projects with long gestation periods

* With an investment tax allowance, the com- suffer in comparison with those that begin earn-pany receives the benefit of lower corporate taxes ing income quickly.only if it makes an investment. The incentive is * When inflation is high, the allowance aggra-correctly targeted at the desired activity (i.e., ad- vates the tax system's uneven impact on the in-ditional investment, rather than formation of a vestment behavior of companies. Companies, innew company). high-inflation countries will benefit more if they

* The investment tax allowance, if targeted borrow to finance capital, because tax deductionstoward long-lived capital such as structures and for capital expenditures are more valuable. This ismachinery, encourages investments that are ex- the reverse of the tax holiday and of lower corpo-

tnachery,encoraee mvetmens tht ar ex- rate tax rates, which reduce the advantages of in-pected to be profitable for many years. It encour- rterta cost dedctionsufo thaxvpurpoes duringages companies to take a long-term view when high inflation.planning investments.

* The investment allowance costs the govern- Like any other tax incentive, the investment al-ment less than alternatives such as tax holidays lowance reduces the government's revenue. Butand reduced corporate tax rates. By targeting cur- the allowance probably is the most cost-effectiverent capital spending, the allowance causes less approach, because it is targeted more preciselyrevenue leakage than would a tax holiday, and it toward the type of activity wanted-i.e. acldi-promotes new investment instead of giving a tions to productive capacity. It can also be madewindfall gain to owners of old capital, as does a refundable, allowing the government to share thereduction in corporate tax rates. investment costs and risks with the foreign entre-

preneur.

Table 7 Effective Tax Rates: NoTax Holidaysbut Investment Tax Allowance for Depreciable Conclusion

Assets Set at 20 percent Tables 6 and 7 illustrate how alternatives to tax

Country Manufacturing Services holidays can maintain tax competitiveness in theCEE countries. Either of the particular alterna-

Czechoslovakia 11.6 -35.9 tives chosen for the examples, a 20 percent statu-Poland -270.1 -361.4 tory rate or a 20 percent investment taxHungary -59.3 -358.4 allowance, would by themselves be sufficient for

Bulgaria 1977 182.5 Czechoslovakia, Hungary, and Poland. ForBulgaria and Romania, additional changes would

11

be necessary (e.g., allowing LIFO inventory ac- however, especially those that arise with international transactionscounting). and incentives for tax evasion when other countries continue to levy

income taxes. See Mintz and Seade (1991) for a discussion of theGiven the strengths and weaknesses of the var- implementation problems associated with both income and cash

ious incentives discussed here, we suggest that flow taxation.

the CEE countries seriously consider reducing or 4. Note that we do not analyze whether the government would

completely eliminating tax holidays, and main- gain or lose corporate tax revenue under a 20 percent corporate taxtaining their tax competitiveness with some kind rate compared with the current tax holiday system.

of investment credit or allowance (as well as per- 5. The international linkages undermine the ability of a CEEmitting LIFO and liberal loss-carry-forward country to pursue a cash flow tax when other governments rely onrules, a topic not analyzed in this paper). The income taxation. For example, multinational companies can take ad-

vantage of both the expensing of capital and interest by financing in-same tax rules should apply to all private enter- vestment undertaken in the country with the cash flow tax with debt

prises, regardless of the nationalities of the own- raised by the parent. See Mintz and Seade (1991) for further discus-

ers. Such changes would leave the countries as sion.

much or even more attractive to FDI as they are 6. See De Long and Summers (1991).

now, and would be more cost-effective in induc- 7. A refundable investment allowance would imply that the gov-ing more additional investment per uinit revenue enment gives the company a refund, or its equivalent, equal to theloss to their treasuries. tax value of the incentive. For example, suppose that a comupany in-

vests $100 and faces a corporate tax rate of 40 percent. If fully used,the investment allowance tax benefit is $40. If the credit is refund-

Notes able, the govenmment would give a $40 rebate or grant if the compa-ny has no tax payable during the year. Altematively, the government

1. See Leechor and Mintz (1991) for a lengthy discussion of the could allow the company to carry back deductions or credits againstprinciples involved in the tax treatment of foreign investment in a taxes paid in previous years or carry forward deductions at an inter-developing country context. est rate to preserve their value over time.

2. As noted previously, this statement is true only if companies 8. The investment tax allowance would allow a company to writemust write down assets for tax depreciation purposes during the tax off 20 percent of qualifying investment expenditures from taxableholiday. If they can delay depreciation until afterward, the holiday income. This also assumes that annual tax depreciation allowancesprovides a significant benefit to depreciable long-lived capital. would not be affected. If the corporate tax rate is 40 percent, the 20

3. For developing economies, McLure and others (1989) advo- percent investment tax allowance is equivalent to an 8 percent in-cate a cash flow tax that would require expensing capital instead of vestment tax credit.deducting depreciation and interest at the corporate and personal 9. These results reflect the effect of high inflation rates in Poland,level. The cash flow base has a number of very attractive features, Hungary, and Bulgaria. The negative effective tax rates imply that theparticularly its simple treatment of depreciation and financial in- investments would be subsidized, although the subsidy would be re-come. There are a number of complexities with cash flow taxation, duced if inflation is much lower or companies use less debt finance.

12

Table 8 Summary of Input Data Percentages

Czechoslovakia Poland Hungary Bulgaria Romania Portugal Greece LISA

Statutory Corporate 40.0 40.0 40.0 50.0 39.0 39.00 46.00 38.0Income Tax Rate

Inflation 10.0 55.0 20.4 36.0 15.0 10.34 15.90 4.2

Interest Rate 14.1 59.1 24.5 40.1 19.1 14.45 20.01 8.3

Dividend Withholding 25.0 5.0 0.0 15.0 10.0 25.00 2.00 n.a.Tax-USA

Annual Depreciation 2.3 2.5 2.0 1.5 1.5 4.00 5.00 2.2Allowance - Structures

Annual Depreciation 12.5 15 13.0 7.0 7.0 14.00 15.00 9.3Allowance - Machinery

Tax Holiday Duration 3 years 5 years 10 years 5 years 5 years 0.00 0.00 0.0

Inventory Valuation LIFO LIFO LIFO FIFO FIFO LIFO LIFO LI:FOSystem

Debt to Total Asset 38 38 38 38 38 38 38 29Ratio

n.a. Not applicable.

13

Appendix

Calculating the Effective Tax Rates domestic market interest rate for a country is de-termined by international trading of currencies.

This appendix supplements the report with addi- Furthermore, the analysis throughout this re-tional details of the methodology, assumptions, port explicitly deals with those investments ofand data sources used to calculate the effective multinational corporations whose home countrytax rates. The methodology is based on the open is the United States of America. While the Unitedeconomy analysis of Boadway, Bruce, and Mintz States is the capital-exporting country,(1984, 1987). The work is similar to that of King Czechoslovakia, Poland, Hungary, Romania,and Fullerton (1984), Andersson (1991) and the Bulgaria, Greece, and Portugal are the host or cap-OECD (1991). The main differences in the meth- ital-importing countries.odology used here and that of the OECD, for ex- The effective tax rates were estimated for twoample, is that actual interest rates and inflation different tax incentive schemes (tax holidays andrates are used to measure the effective tax rates. post-tax-holiday regimes) and under three differ-Also, risk is incorporated in the analysis follow- ent simulations (actual inflation, 3 percent infla-ing Bulow and Summers (1984) and McKenzie tion for all countries, and three different debt-and Mintz (1990). asset ratios, 40 percent, 20 percent, and 0 percent).

The methodology used to estimate the effective The calculations of rn, the net-of-tax return re-tax rates rests on a number of assumptions. To quired to compensate savers for their savings, re-start, companies are assumed to maximize prof- mains the same for each industry and within eachits, implying that they invest in capital to the country and across the two tax incentive schLemes.point where the return on capital equals the cost However, formulating and estimating the effec-of capital. It is also assumed that companies tive tax rates requires considerable modificationchoose the level of debt and equity needed to when moving across the different tax incentives.minimize their cost of finance. Cost minimization The multinational is assumed to finance capitalof financing implies that companies issue debt in the host country using three sources of money.until the tax benefits from additional debt equals The first is debt raised in the host country. Thethe bankruptcy and agency costs associated with second is equity invested by the multinationalincremental debt. In addition, the seven host parent in the subsidiary operating in the hostcountries of this study, Czechoslovakia, Poland, country. In turn, the multinational finances equi-Hungary, Romania, Bulgaria, Greece, and ty acquired in the subsidiary with equity andPortugal are treated as small open economies. In debt raised in the home country. The mathemati-a small open economy, corporations have the op- cal expression for the net-of-tax, risk adjusted,tion of acquiring financing from domestic and in- rate of return on capital, for each industry is:ternational markets while, at the same time, the rn= {f3i'(1-u')+(1-IO)g'-p'}(1-Y)+y(i-p) (a.1)

14

All home (capital-exporting) country variables change in the consumer price index was used asare denoted by the ' symbol. Those characters the inflation rate. Both variables, for all countrieswithout the' symbol represent host (capital-im- were collected from the IMF International Finan-porting) country variables. The term i is the nom- cial Statistics. The rates used for each country areinal interest rate; B is the portion of multinational presented in Tables A-1 and A-2.parent's capital financed by debt in the home The data used for the debt-to-total-assets ratiocountry, while y represents that portion of the (fg), the debt-to-asset-ratio of the multinatiorLalmultinational subsidiary's investment financed company's investment within the host countryby debt in the host country; g' is the nominal (y), and the economic depreciation rates (O) werehome country cost of equity finance; and p' is the estimated from World Bank project data for allexpected rate of inflation of the home country (p countries except for the United States. The U.S.is also the inflation rate of the host country). The statistics are based on estimates obtained byrate of return on capital held by the owners of the McKenzie and Mintz (1990). The components ofmultinational parent, as formulated above, is es- the debt data included debentures and loansentially a weighted average of the rate of return stocks, loans from financial institutions, loansavailable to owners of debt,7(i-p), and owners of and advancements from headquarters and sub-equity, IX1-Og'+1i'(1-u')-p'L The host country sidiaries, short-term borrowing, and other credi-rate of return on capital from holding equity is it- tors. The debt/asset ratio was estimated for eakchself a weighted average of both home country eq- of the three industries. The debt-to-asset and eco-uity, (1-if)g', and the rate of return on corporate nomic depreciation parameters used are sumnna-bonds in the home country, lgi'(1-u'). rized in Table A-1:

It is assumed that international interest ratesare determined in the long run by arbitrage in in- Table A-1 Debt-to-Asset and Economicternational markets. Assuming purchasing pow- Depreciation Parameterser parity to hold in the long run to determine thehost country's interest rate relative to the home Manufacturing Services

country, the following equation is assumed tohold: B 29 44

7 ~38 soi = i - ( p' - p) (a.2) 8-Bldg 3 4

6 - Mach 14 22

The owner of a multinational parent is as-sumed to be a typical G-7 country investor. Theinvestor is assumed to face a weighted average of The statutory annual depreciation rates mndtax rates imposed at the personal level across the relevant tax rates, such as the corporate, income,G-7 countries. It is important to note that the net- and dividend tax rates, were obtained from theof-personal tax rate of return earned on bonds is International Bureau of Fiscal Documentation, 1990assumed to equal the rate return earned on equity edition, various supplements. Actual rates uLsedheld by the .marginal investor in the U.S. parent. are provided in Tables A-1 and A-2.This relationship between the rate of returnearned by bonds and equity implies the following Absence of Incentives / Postholiday Periodexpression:

g' = i'(1-m') / (I(1-0 (a3) For a profit-maximizing company, capital is ac-= i'(l-m') / (1-0') (a.3) quired until the return on capital, gross of taxes,

The variable, m', is the personal income tax and depreciation equals the rental price of capi-paid on interest (the rate used was 31 percent). tal. The rental price of capital, for buildings andThe variable, 0', is the tax on equity income for machinery, is mathematically defined as,the average OECD investor. This tax rate is as- F' = (8+r+h)(l-A)/(1-u), (a.4)sumed to be a weighted average of personal taxrates on dividends and capital gains and found to where F' represents the return per dollar of capi-equal 13.6 percent. tal (gross of depreciation and taxes), h the risk

The nominal interest rate is operationally de- premium on capital, and 8 the economic depreci-fined as the 1990 lending rate, while the annual ation rate. The term A is the tax value of initial

15

and annual depreciation allowances per dollar of As stated previously, the host country economiccapital expenditure: depreciation rate used, 3, for buildings and ma-

chinery was derived from World Bank projectA = u[al +(l-a1f)a 2/(a2 +R-(p'-p))1, (a.5) data and McKenzie and Mintz (1990) for the Unit-

where a, is the initial write-off of capital and a2 is ed States. The risk premium, h, was set at 4.5 per-the annual declining balance (or equivalent) de- cent for all countries, based on the estimates usedpreciation rate. The variable f captures the pro- by McKenzie and Mintz (1990).portion of the initial allowance written off thecapital cost base; f was assumed to be zero for all Tax Holidayscountries. The term R is the company's net-of-tax omial cst f fiancng, hic is Of the tax incentive schemes analyzed, tax holi-corporate a days complicate the analysis because the method-

ology must explicitly account for the time, before

R = (l-y){i'(1-u')+ (1-1)g'1/(l-x)+y{i(1-u)+p'-p) the tax holiday expires, when the investment wasand r = R -P' (a.6) ~undertaken.and r = R - p' (a.6) Without deriving the methodology underlying

The cost of finance is similar to the net-of-tax re- the tax holiday cost of capital and effective taxturnonna.1) except for two rates, the final-form equations will be considered

terms. The first incorporates the interest deduct- (otherwise, see Mintz [1990]). Assuming rLo de-ibility of debt in the host country er-u. The sec- ferral of depreciation allowances until after theondibnlotyofadebts the host countr which Thpresec tax holiday period expires, the cost of capital andond incorporates the term x, which represents the efctvtartswresimedbednth

weigted verge hst ounty wihhodingtax effective tax rates were estimated based on theweighted average host country withholding tax flo~ omlsand r is the real cost of financing.

For inventories, the user cost of capital, assum- F' = 15+ro+h][1-At]/(0-u0) +ing a FIFO system, is comprised of the cost of fi- (l+ro)(At-At_1 )/(1-u 0) (a.12)nancing and the additional corporate taxes that where;apply to the inflationary appreciation of a com-pany's inventories adjusted for the interest de- At = uOai+[uoZo(l-Yt) +ductibility of the cost of borrowing. The user cost uIZ1(1-E0)/(1-Eo)YtI (a.13)of capital for inventories is defined as:

for t*-t>O.Finv = (r + up@) / (1 - u) (a.7) Zt = (1 - fal)(1 + Rt-(p'-p))a 2

such that 0=1 for FIFO and 0=0 for LIFO. da2 + Rt-(P'-P)) (a.14)and,Finally, eliminating physical depreciation and Yt = [(1 - a2)/(1 + Ro-(p'-p))]t*-t (a.15)

tax depreciation allowances, the user cost of cap-ital for land is expressed as follows: The term uo represents the corporate tax rate

for the tax holiday period (t*-t>O), which is set toF'Land = r / (1 - u). (a.8) zero. The variable f represents the proportion of

the initial allowance written off the undeprecia-The effective corporate tax rate (U), defined as ble capital cost base (which is set equalto zero). Rt

the difference between the risk-adjusted cost of is the nominal weighted average net-of-corporatecapital, net of economic depreciation, rg, and the tax cost of equity and debt financing at each pointnet-of-tax rate of return required to compensate of time. The expression At represents the presentsavers for their savings that are to be invested in value of the tax depreciation allowances and Ytthe company's particular capital, is for the pur- captures the value of the depreciation deductionpose of this study defined as after the holiday; the earlier the investment, the

lower the depreciation deduction (Yt > Yt-1)U=(rg-rn)/rg1 (a.9) The tax holiday user cost of capital, equation

where rg = F - 6 - h, (a.10) (a.12), is essentially comprised of two terms. Thefirst expression represents the real cost of holding a

and rn= (1-y){Ili'(1-u')+(1-O)g'-p'}+y(i-p). (a.11) unit of capital: composed of economic depreciation

16

and financing cost adjusted for tax value of invest- Table A-2 Capital Stock Weightsment and depreciation allowances at time t* (l-At).The second expression captures the loss in depreci- Manufacturing Servicesation deductions by investing in period t-1 ratherthan period t. Land 4.51 2.86

The net-of-tax rate of return on capital for Buildings 22.54 6.36

holidays is identical to the post-holiday net-of-tax Inventories 23.16 0.89

rate of return, except that the host country level ofdebt is lower during the tax holiday period, given Total 83.49 16.51

the reduced tax benefits of interest deductionstaken during the holiday. For the study the taxholiday host country debt-asset ratio, yo, was re- Notesduced by one-third of the postholiday host coun-try debt/asset ratio (y), based on empirical results 1. The effective tax rate is modified slightly forthose CEEcoln-

of Bartholdy, Fisher, and Mintz (1987). tries having high inflation rates (Poland, Hungary, and Bulgaria) to

Estimation of effective tax rates for all tax holi- the following formula:

day situations followed the same set of equations U'=(rg-rn)/rn (a.9')used in the absence of incentive case.

For those three countries, equation (a.9') was preferred to (a.9) to

Aggregation avoid a technical complexity associated with a negative cost of cap-ital. The gross return to capital (rg) for many assets was negative andwith equation (a.9) the effective tax rate would turn out positive,

The aggregation of the effective tax rates for each when it should be negative.

industry for each country involved the individualweighting of rg and rn by the corresponding cap-ital stock weight (shown in Table A-2), then usingequation (a.9) to determine the effective tax rates.The aggregation of the effective tax rates can bemore formally expressed as:

U'ij= [-ij(rgijcswij)-Yij(rniijcswij)I /1ii(rgiicswii),

where i represents the three industries and j thecapital stocks. The capital stock data used for theUnited States and Germany for each industrywere obtained from McKenzie and Mintz (1990).The capital stock weights used for the CEE coun-tries were derived from World Bank project data.

17

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tional Capital Flows. Paris.

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The Foreign Investment Advisory Service (FIAS), ajoint venture of the International Finance 8Corporation (IFC), the World Bank, and theMultilateral Investment Guarantee Agency (MIGA),was established to help member governments that 0belong to the IFC, the World Bank, and MIGA review Hand adjust policies, institutions, and programs thataffect foreign direct investment. FL4S advises onprocedures for the promotion, regulation, and 0

monitoring of foreign direct investment. The ultimate Jpurpose of FIAS is to assist member governments in :Lattracting beneficial foreign private capital, 0technology, and managerial expertise.

HAS Occasional Papers report the results of researchon practical issues which the staff of FHAS identify inthe course of their work. The research has either beencarried out or sponsored by FIAS. The Papers will beissued as research findings become available.

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ISBN 0-8213-2301-6 z