An important function of the state is to create an effective delivery system for the implementation of public policies, a tool that can effectively deliver the benefit of incentives and facilities to the public in general and businesses in particular. Obviously a government can make decent and popular decisions to attract investment but where the benefits of incentives are not extended and are denied the purpose of the government policies in this regard stands defeated.
Economic incentives are usually given to businesses, industry and investors to usher in growth, attract investment and create jobs in the market; the incentives so offered by the government are regulated through regulatory procedures. The key to success of these incentives thus lies in the hands of the delivery system which can contribute in positive terms by assisting the beneficiaries; since the purpose of policy can be distorted by denying it to the intending investors. The incentives can thus be made ineffective or denied to its intending beneficiary by those who are authorised to disperse the incentives. In this perspective, the incentives relating to taxes are much more important as these affect economic growth and labour market.
Tax incentives are intended to encourage investment in certain sectors or geographic regions and are rarely provided without specific conditions. Very often countries design special incentive regimes that detail the tax benefits as well as the key restrictions. For instance, these regimes may require that a facility be established in a certain region by having a specified turnover, require the transfer of technology from abroad or employ a certain number of individuals. For example, China offers foreign firms which make investment in China a tax refund of 40 percent on profits that are reinvested to increase the capital of the firm or launch another business. The earned profit is required to be reinvested for at least five years. Where the reinvested amounts are withdrawn in less than five years, the firm has to pay the taxes; India, similarly, offers a tax exemption on profits of firms engaged in tourism or travel, provided their earnings are received in convertible foreign currency.
While tax incentives are enunciated in the tax code, quite often their administration is carried out by different government agencies. For example, tax deductions or allowances on employee training may be administered by the labour department, duty exemptions by the customs department and income and profit tax exemptions by the income tax department. Such diversity of agencies dealing with tax incentives tends to increase the inconvenience of doing business. It is generally recognised that investors prefer to deal with one government agency and that they like to be able to determine from the start the total package of incentives available.
All other things being equal, the more transparent the incentives system, the more easy it is to administer and making it easier for investors to comprehend. For example, it is better to list the provinces or states in which the incentives will be granted than to refer vaguely to "less developed regions". If the rationale for an incentive is to increase labour absorption, then it may be preferable to target incentives at specified labour-intensive industry sectors (eg footwear, garments, and handicrafts), rather than simply referring to "labour intensive" projects. The general reference would raise the question of how "labour intensive" is defined and operationalized. Similarly, for the sake of clarity and transparency, it may be better to specify the high-tech industries that qualify for incentives rather than simply stating "high-technology projects", as the latter would give rise to the question of what constitutes high-technology.
A related issue involved in the design and administration of an incentives system is the discretionary power of officials granting the incentives. Administrative discretion can be reduced if the enabling legislation clearly defines the incentives package and the criteria under which incentives may be granted. This reduces the opportunity for inappropriate administrative behaviour.1
In a developing country, an incentive regime went to the other extreme by developing a very transparent, but complex system. Industries were divided into four groups: Tourism, hotels, food processing, manufacturing, and agriculture/crops. For each of these broad sectors, it developed a matrix of activities and characteristics and awarded points for performance-based criteria. In manufacturing, for example, points were awarded to a project based on the amount of the investment (larger investments gained more points),employment, export intensity, domestic value added percentage, use of local resources, training and hiring, location, employment of women and employment of the disabled. The government granted tax holidays based on the number of points achieved. The system proved to be so complex that the organisation with the mandate to determine the incentives to be granted was paralysed and incentives were only granted if "higher authorities" mandated them.
A balanced explanation of the issues to stakeholder would be advisable as they may better understand the conditions under which tax incentive programmes are likely to succeed or fail. It may be kept in mind that some of the tools used in economic policy work; the advantages and disadvantages of alternative tax instruments for stimulating investment; and the problem of harmful tax completion should also be reviewed.
The general conclusions are as follows:
1. Non-tax factors are far more important than tax incentives in determining the level and quality of investment flows. Non tax factors include the stability of the political system, the macroeconomic policy environment, the skills of the labour force, the condition of the infrastructure, the legal and judicial framework, and the efficiency of the banking system,
2. The effect of incentives on productivity and efficiency is at least as important as the effect on the amount of investment. Productivity growth accounts for much of the difference in economic growth performance across countries. Modern theories of competitiveness emphasise the importance of policies in fostering productivity growth. Hence, productivity effects should be a central concern in any assessment of tax incentive policies.
3. Investment tax incentives work well in some countries and poorly in others. The effectiveness and impact of any package of incentives depends on local economic and fiscal conditions, characteristics of the incoming investment projects, details of the tax code, and political judgements about trade-offs among competing policy objectives. Thus, decisions about tax incentives must be clear and specific.
4. The benefits of investment tax incentives are widely exaggerated, while the costs are widely underestimated. This bias arises partly from weaknesses in tax policy analysis, and partly from political pressures that inherently favour special interests. By implication, it is advisable to err on the side of caution in establishing tax incentive policies, so as to avoid the risk of revenue losses and economic distortions. This is especially so in countries with stringent revenue constraints and problems with tax administration.
5. Capacity building to strengthen tax policy analysis should be a central priority. All can benefit from developing stronger capacity to analyse the effectiveness and impact of investment tax incentive programmes.
(The writer is an advocate and is currently working as an associate with Azim-ud-Din Law Associates Karachi)
1. Leaving some discretion to officials, however, has the advantage of increasing their flexibility to adjust incentives to specific situations, as in the case of a large TNC in the detergents industry, which approached the government of a developing country concerning investment in a major project. Although the detergents industry was not on the list of promoted industries, the Government wanted the project. It was, therefore placed in the awkward position of having to justify incentives on the basis that the project introduced a product or process new to the country.
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