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Tax incentives to attract investments: Time to rethink?

13 May 2013 - {{hitsCtrl.values.hits}}

By Anushka Wijesinha
This article draws from a new Research Working Paper by the Institute of Policy Studies of Sri Lanka (IPS) titled ‘Incentivizing Foreign Investment in Sri Lanka and the Role of Tax Incentives’ by Anushka Wijesinha, Raveen Ekanayake and Gajen Mahendra. The publication is now available at IPS and leading bookstores.

As post-war Sri Lanka gears itself towards a faster growth trajectory and reach upper-middle income status, the importance of attracting greater investment from abroad – Foreign Direct Investment (FDI) – has risen to the fore. Although Sri Lanka has seen a steady inflow of foreign investment projects into the country over time, the record has been less than impressive when compared with many emerging economies. Sri Lanka attracted an annual average FDI of US$ 500 million (about 1.5 per cent of GDP) during the last decade while East Asian countries, for instance, attracted FDI inflows exceeding US$ 5 billion annually – close to 5 per cent of GDP.
With a GDP growth target of 8 per cent or higher, Sri Lanka would need to raise its annual rate of investment from the current level of approximately 26 per cent of GDP to at least 35 per cent. With public investment to be capped at around 6 per cent of GDP, this rise would need to come almost entirely from private investment. Within this, foreign private investment plays a critical role. In addition to helping bridge the domestic savings-investment gap, foreign investment brings other benefits as well – technology spillovers, management best practices, links to new markets, etc. Like many developing countries Sri Lanka has offered, and continues to offer, generous tax holidays and other tax-based incentives and exemptions to incentivize FDI inflows to the country. But it is widely acknowledged that they erode the government’s tax revenue base significantly.

Fiscal pressures in Sri Lanka are rising and the government is keen to curb the budget deficit at 6.2 percent, amidst a declining tax-to-GDP ratio. Meanwhile, concessionary foreign aid to the country is also rapidly shrinking owing to the country’s new lower-middle income status. This means that to finance Sri Lanka’s development needs domestic revenue mobilization, i.e., tax revenue, needs to be strengthened. A critical part of this effort is minimizing revenue leakages in the form of tax exemptions and holidays and ensuring that these incentives are effective in their intended purpose – attracting more and quality-wise better foreign investment.
So, the government is currently faced with a policy paradox – the need to minimize the use of fiscal incentives on the grounds of revenue whilst maintaining the stance of fiscal incentives to entice FDI.

History of tax incentives
Sri Lanka’s use of fiscal incentives to entice FDIs could be traced back to the 1960s during the heights of the import substitution industrialization era. From 1963 onwards, some tax holidays were offered in the areas of “pioneering industries”, export enterprises and tourism. These were granted under the Inland Revenue Act and administered by the Ministry of Finance under the Inland Revenue Department (IRD). With the shift in industrial policy orientation from an inward-looking one to a more outward-oriented export promotion strategy in 1977, the attraction of FDI became the cornerstone of national development policy.

At the outset, generous fiscal incentive packages encompassing tax holidays of 10 years or more and customs duty exemptions were offered to foreign investors engaged in export-oriented activities operating within specially designated Export Processing Zones operated by the Board of Investment (formerly known as the Greater Colombo Economic Commission). Gradually over time, successive governments increasingly recognizing the importance of FDI extended fiscal incentives to foreign-owned enterprises engaging in all forms of economic activities.

Fast forward to 2013, and Sri Lanka continues to grant tax incentives to varying degrees. Yet, in a significant streamlining move to correct the dichotomous structure that existed earlier of both the BOI and IRD offering tax incentives, all corporate income tax holidays were written in to the Inland Revenue Act in 2011.

Tax incentive effectiveness debated
The effectiveness of tax incentives in attracting FDI is widely debated among tax professionals, treasury officials and investment promotion officers. Some tax experts argue that tax incentives are not necessary for attracting investment, as investors will generally consider other factors that improve a country’s investment climate as more important. Despite insufficient evidence of their effectiveness, tax incentives are still an important part of the policy mix used by countries to increase their appeal to foreign investors.

Tax administrators as well as researchers often highlight the difficulty in measuring the effectiveness of tax incentives due to the absence of high quality firm-level datasets on investment in most countries. Sri Lanka is no different and this paper is also constrained by the same challenge. Estimating the costs vs. benefits of tax incentives is not easy and can be contentious, as widely acknowledged in the literature. Although this was one of the items specified in the mandate of the Presidential Commission on Taxation 2009, it is learned that the Final Report of the Commission has refrained from providing such a cost-benefit outlook. However, rough estimates suggest that, for 2010 the revenue foregone from tax incentives could amount to around Rs. 6.6 billion or close to 1 per cent of tax revenue. This number is likely to be less from 2011 onwards following the substantial cuts in tax rates introduced in the 2011 Budget. These are not new IPS calculations, but rather draw from existing literature.

Can Sri Lanka do away with tax incentives?
Some may argue that Sri Lanka had to grant generous incentives in the past because of the poor investment climate that existed on account of the armed conflict and now that the war is over we can do away with generous incentives. However, the security situation of a country is not the only factor that would impact an investor’s decision to locate. As this paper (the Research Working Paper referred to above) argues, other factors like the trade policy regime, openness to international markets, the investment policy regime, and institutional and governance set-up, are important as well.

In this post-war phase, where Sri Lanka has a new chance at attracting world-class foreign enterprises, the attractiveness of Sri Lanka as an FDI destination has to be preserved. This is important in order to keep the rate of investment high to generate faster growth, to help Sri Lanka further integrate with the global economy, and to provide more and better employment opportunities for the country’s people and raise living standards. Sri Lanka is continually competing with other FDI destinations in the South and South East Asian region, especially Malaysia, Thailand, and Indonesia and increasingly also Vietnam, Cambodia, Myanmar and Lao PDR.

Sri Lanka cannot completely do away tax incentives for FDI just yet – not only because the country does have to try everything available in its arsenal to attract investment at this crucial stage, but also because competitor destinations are still offering a fair amount of tax incentives as well. However, many of these countries have begun moving away from blanket tax holidays towards more targeted incentives of the type that is advocated in this paper; like accelerated depreciation, investment tax relief, minimum investment thresholds, and renewable certificate schemes. For instance, Malaysia and Brazil are using investment tax relief for investment in higher technology sectors; Vietnam is using accelerated depreciation allowances for investment in ‘difficult areas’; Brazil is introducing ‘minimum investment thresholds’ for investments in the IT sector; and Thailand is planning on introducing a ‘certification scheme’ to ensure better compliance.

Discussion in the paper
The paper reviews a wide range of international empirical evidence surrounding the use of tax incentives, as a whole, as well as specific types. The paper also provides a fairly comprehensive discussion on the host of types of tax incentives available and their relative merits and demerits. The paper embodies the principle that although economists have often been skeptical about tax incentives and have instead supported broad tax bases and lower rates, there is a continued popularity of tax incentives. With this as the point of departure, the paper puts forward some ideas on how to better design and better monitor tax incentives. On the design side, the paper discusses ideas of administration, better measures to ensure incentives help a government achieve investment targets, tightening qualifying criteria, improved targeting and categorization of incentives. On the monitoring and compliance side, the paper discusses the strengthening pre-approval assessment, tax registration, compliance certification, and closer information sharing among agencies.

Meanwhile, the paper does acknowledge the valuable point that tax incentives are only part of the story – the importance of non-tax factors that determine the investment attractiveness of a FDI-host country cannot be overlooked or compensated for using incentives. Elements of this investment climate include a progressive trade policy, investment policy, and labour market regime.

Accountability of tax incentives is a crucial part of the discussion that is often overlooked, and this paper argues for a comprehensive and formal mechanism for recording tax concessions granted and possibly an estimate of the revenue foregone as a result and for this to be tabled in Parliament. A ‘Tax Expenditure Statement’ or ‘Statement of Revenue Foregone’ of this kind is not unusual, and in fact has been recently introduced rather successfully in India. It enhances the accountability and transparency of the incentives granted as well as the agencies involved in granting them.

Due to severe data limitations, this paper has not undertaken a comprehensive econometric analysis of costs vs. the effectiveness of tax incentives. Rather, it provides a critical overview of the use of tax incentives in incentivizing investment, reviews some of the available tools, and presents an agenda for the way forward for the country. It draws extensively on international literature on the subject and aims to serve as a reference point for further research and policy analysis on this issue. The paper hopes to advance the knowledge that will help policy makers and administrators to develop, implement and monitor smarter tax incentives.

Conclusion
Overall, Sri Lanka must answer a key policy question and structure its incentives accordingly – ‘what kind of foreign investment does the country desire to attract?’. Like Singapore did, FDI strategy must fit in to broader industrial strategy, which gives investors a credible and stable signal on the government’s direction. FDI promotion cannot sit in isolation from other policies relating to trade and industry.

In concluding, while the paper does acknowledge that tax incentives are not the only factor in determining the foreign investment attractiveness of the country, that tax incentives violate the equity principle of taxation, that the evidence supporting the effectiveness of tax incentives is often contentious, and concessions and exemptions are a drain on the country’s exchequer, it also acknowledges that Sri Lanka would need to maintain some form of tax incentives regime to remain competitive in attracting FDI. But this tax regime must be designed, implemented, and monitored in a smarter and more cost-effective way so that the impact on revenue is minimized while the desired economic policy objectives of higher investment are realized.

(Courtesy Talking Economics)
(Anushka Wijesinha is currently a Research Economist at the IPS, in the Industry, State Enterprise Reform and Regulatory Policy Unit. His key areas of research include industrial development strategy, SME policy, economic governance, and public-private partnerships. He was previously seconded as the Research Officer to the Presidential Commission on Taxation. He earlier worked as the Assistant Director, Economic Affairs, at the Government Peace Secretariat. He has also worked as a short term consultant at the World Bank, Sri Lanka, in the South Asia Finance and Private Sector Development section. Anushka holds a BSc (Hons.) in Economics from the University College London, UK, and a MA in Economics and Development from the University of Leeds Business School, UK. (Talk with Anushka - [email protected])

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Tax incentives to attract investments: Time to rethink?

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