Investment Policy Tax Incentives and the Enabling Environment

8/3/2019 Investment Policy Tax Incentives and the Enabling Environment

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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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5

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



Total sum of all economic governance scores

12011010090807060

11

10

9

8

7

6

5

4

3

2


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


Total score on the efficiency of registration procedures

121110987654

8

7

6

5

4

3


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



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


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%


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%


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%


HCMC (37)

ROA 12.4% 12.4%

Redundancy rate 87.8% 87.8% 87.8% 87.8%


Tien Giang (13)

ROA 4.0% 4.0%

Redundancy rate 73.1% 73.1% 73.1% 73.1%



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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.

Investment Policy Tax Incentives and the Enabling Environment

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