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Investment Policy, Tax Incentives and the Enabling Environment

David Ray VNCI - Vietnam Competitiveness Initiative

Introduction to VNCI
New USAID project implemented by Development Alternatives Inc (DAI) VNCIs policy component implemented by The Asia 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)

Focus on Investment Policy


Assumption for todays presentation: Possible extension of the Enterprise Law (EL) to govern corporate behaviour and entry for all business entities (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 not worth the costs. Developing country governments should instead focus on improving the enabling environment. Tax incentives represent a useful policy tool to promote and direct investment flows.

Policy makers and investment agencies:

Key reasons why governments use investment incentives


To correct for market failures

Promoting more externality generating investment: 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 of incentives and so have no effect on their investment decision. The result: For investing firms: lower tax liability results in windfall gains. For host governments: losses in scarce tax 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 developing countries to richer OECD countries) 6

Subsidy Equivalent of a 5-Year Tax Holiday, a 10% Discount rate, and a 35% Tax Rate
Rate of Return on Assets
Redundancy rate 20% 30% 40% 50% 60% 70% 80% 90% 10% 3% 5% 7% 11% 16% 25% 43% 98% 20% 5% 9% 14% 22% 33% 51% 87% 196% 25% 7% 12% 18% 27% 41% 63% 109% 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)

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 a negative, 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 the enabling environment.

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. Business prefer to stay small with separate multiple units hence local suppliers less efficient.

Major Constraint on the development of a mutual funds 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, but comprise income forgone. Easy to implement: much easier to cut taxes rather than take the more difficult and more important step of improving the enabling environment (cutting red tape, streamlining government procedures and regulations) Investor interests: Individual investors will always insist on tax cuts, whether they influence their investment decision or 10 not.

BIAC position on incentives


But the business community as a whole do not support 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 is sufficiently robust and supportive. The most important factor in creating favourable conditions is good governance, i.e. clear, stable and business-friendly legislation and economic policies, 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, no special incentives are needed to attract foreign, or indeed domestic direct investment Source: Business and Advisory Committee to the OECD (comprising the key employer and business associations in the OECD). Investment - BIAC Position on Incentives

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BIAC position on incentives (contd)


..incentives are not necessarily undesirable. [But] it is important to assess the value and effect of incentives... There are often more powerful factors [that can be used] by aspirant 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..
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Building business confidence is job number one!

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 where investment incentives were abandoned in the mid 1980s. Despite use of aggressive incentive policies in other ASEAN countries, flows of FDI remained robust in the late 1980s/early 1990s and Indonesias regional share of FDI 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. 2.

results are preliminary and unpublished, and used with the kind permission of TAF and VCCI. 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
11 10 9 8 7 6 5 4 3 2 2 4 6 8 10 12
Same as Central Law Total Population Insuffcient info. Greater than Central Law

Investment Incentive

Total score on provincial policies and planning


Statistical Handbook, 2003 The Asia Foundation-VCCI Economic Governance Survey
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Relationship between Implemented FDI and the Sum of All Provincial Governance Scores
11 10 9 8 7 6 5 4 3 2 60 70 80 90 100 110 120
Same as Central Law Total Population Insufficient Info. Greater than Central Law

Investment Incentive

Total sum of all economic governance scores


Statistical Handbook, 2003 The Asia Foundation-VCCI Economic Governance Survey
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Relationship between Private Registered Capital and The Efficiency of Provincial Registration Procedures
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7 Investment Incentive
Insufficient Info.

Greater than Central Law

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Same as Central Law

3 4 5 6 7 8 9 10 11 12

Total Population

Total score on the efficiency of registration procedures


CIEM, 2004 The Asia Foundation-VCCI Economic Governance Survey
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Relationship between Non-State Investment and Firm Perceptions of Transaction Costs


10.5 10.0 9.5 9.0 8.5 8.0 7.5 7.0 6.5 6 8 10 12 14 16 18 Investment Incentive
Insufficient Info. Greater than Central Law Same as Central Law Total Population

Total score on firm perceptions of transaction costs


Statistical Handbook, 2003 The Asia Foundation-VCCI Economic Governance Survey
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Interpretation of results
Important caveats: Difficult to determine direction of causation. Red provinces may not need to aggressively use incentives The analysis of incentives comes from the regulations voluntarily submitted by the provinces. There may be incentives being used which the province do not 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 do not use local incentives) Some provinces are using locally initiated investment incentives (i.e. beyond that outlined in central laws) but record low scores on governance quality. This suggests a need to re-order policy priorities to focus on the enabling environment. 19

Shares of Total Foreign Investment in Five ASEAN Countries (%)


Indonesia Philippines Thailand Singapore Malaysia Total

Avg 1970-84 Avg 1985-90 Avg 1991-96

10.8 9.2 19.8

2.6 6.9 6.5

7.7 17.0 11.7

46.4 49.3 33.8

32.5 17.6 28.1

100.0 100.0 100.0

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


1200 800
Incentives stopped

400
1975 1977 1979 1981 1983 1985 1987 1989 1991 1993
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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 have invested even without the tax incentive) N = No. of years of tax holiday I = Total investment
Source: Tax holidays to attract FDI: Lessons from two experiments Louis Wells 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 xTx N The 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 extra investment) 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


Tien Giang No. of firms receiving CIT incentives Yes Response to Q1 No. of firms % Implied redundancy rate 9 69.2% 69.2% Agree Response to Q2 No. of firms % Implied redundancy rate Average redundancy rate 10 76.9% 76.9% 73.1% Binh Duong HCMC Whole Sample

13 No 1 7.7% Don't know 3 23.1% Yes

20 No 2 10.0% Don't know 2 10.0% Yes

37 No 1 2.7% Don't know 2 5.4% Yes

70 No 5 7.1% Don't know 7 10.0%

16 80.0% 80.0% Agree 16 80.0% 80.0% 80.0%

34 91.9% 91.9% Agree 31 83.8% 83.8% 87.8%

59 84.3% 84.3%

Disagree No opinion 0 0.0% 3 23.1%

Disagree 3 15.0%

No opinion 1 5.0%

Disagree 3 8.1%

No opinion 3 8.1%

Agree Disagre No e opinion 57 81.4% 81.4% 82.9% 6 8.6% 7 10.0%

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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% for following 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 Redundancy rate Subsidy equivalent Tax rate = 32% Years of tax holidays = 4 60% 65% 70% 75% 80% 85% 90% 95% Subsidy equivalent Tax rate = 28% Years of tax holidays = 4

3.0% 5.8% 7.1% 9.0% 11.5% 15.4% 21.8% 34.6% 73.0%

5.0% 9.6% 11.9% 14.9% 19.2% 25.6% 36.3% 57.6% 121.6%

7.0% 13.4% 16.6% 20.9% 26.9% 35.8% 50.8% 80.6% 170.2%

9.0% 17.3% 21.4% 26.9% 34.6% 46.1% 65.3% 103.7% 218.9%

11.0% 21.1% 26.1% 32.9% 42.2% 56.3% 79.8% 126.7% 267.5%

13.0% 25.0% 30.9% 38.8% 49.9% 66.6% 94.3% 149.8% 316.2%

15.0% 28.8% 35.7% 44.8% 57.6% 76.8% 108.8% 172.8% 364.8%

17.0% 32.6% 40.4% 50.8% 65.3% 87.0% 123.3% 195.8% 413.4%

19.0% 36.5% 45.2% 56.7% 73.0% 97.3% 137.8% 218.9% 462.1%

21.0% 40.3% 49.9% 62.7% 80.6% 107.5% 152.3% 241.9% 510.7%

60% 65% 70% 75% 80% 85% 90% 95%

5.0% 6.2% 7.8% 10.1% 13.4% 19.0% 30.2% 63.8%

8.4% 10.4% 13.1% 16.8% 22.4% 31.7% 50.4% 106.4%

11.8% 14.6% 18.3% 23.5% 31.4% 44.4% 70.6% 149.0%

15.1% 18.7% 23.5% 30.2% 40.3% 57.1% 90.7% 191.5%

18.5% 22.9% 28.7% 37.0% 49.3% 69.8% 110.9% 234.1%

21.8% 27.0% 34.0% 43.7% 58.2% 82.5% 131.0% 276.6%

25.2% 31.2% 39.2% 50.4% 67.2% 95.2% 151.2% 319.2%

32.6% 40.4% 50.8% 65.3% 87.0% 123.3% 195.8% 413.4%

36.5% 45.2% 56.7% 73.0% 97.3% 137.8% 218.9% 462.1%

40.3% 49.9% 62.7% 80.6% 107.5% 152.3% 241.9% 510.7%

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Subsidy Equivalent (disc)


Discounted 7% ROA Redundancy rate Subsidy equivalent Tax rate = 32% Years of tax holidays = 3.29 60% 65% 70% 75% 80% 85% 90% 95% Subsidy equivalent Tax rate = 28% Years of tax holidays = 3.29

3.0% 4.7% 5.9% 7.4% 9.5% 12.6% 17.9% 28.4% 60.0%

5.0% 7.9% 9.8% 12.3% 15.8% 21.0% 29.8% 47.3% 99.9%

7.0% 11.0% 13.7% 17.2% 22.1% 29.5% 41.7% 66.3% 139.9%

9.0% 14.2% 17.6% 22.1% 28.4% 37.9% 53.6% 85.2% 179.9%

11.0% 17.4% 21.5% 27.0% 34.7% 46.3% 65.6% 104.1% 219.9%

13.0% 20.5% 25.4% 31.9% 41.0% 54.7% 77.5% 123.1% 259.8%

15.0% 23.7% 29.3% 36.8% 47.3% 63.1% 89.4% 142.0% 299.8%

17.0% 26.8% 33.2% 41.7% 53.6% 71.5% 101.3% 160.9% 339.8%

19.0% 30.0% 37.1% 46.6% 60.0% 79.9% 113.3% 179.9% 379.7%

21.0% 33.1% 41.0% 51.5% 66.3% 88.4% 125.2% 198.8% 419.7%

60% 65% 70% 75% 80% 85% 90% 95%

4.1% 5.1% 6.4% 8.3% 11.0% 15.6% 24.9% 52.5%

6.9% 8.5% 10.7% 13.8% 18.4% 26.1% 41.4% 87.4%

9.7% 12.0% 15.0% 19.3% 25.8% 36.5% 58.0% 122.4%

12.4% 15.4% 19.3% 24.9% 33.1% 46.9% 74.6% 157.4%

15.2% 18.8% 23.6% 30.4% 40.5% 57.4% 91.1% 192.4%

17.9% 22.2% 27.9% 35.9% 47.9% 67.8% 107.7% 227.3%

20.7% 25.6% 32.2% 41.4% 55.2% 78.2% 124.3% 262.3%

23.5% 29.1% 36.5% 46.9% 62.6% 88.7% 140.8% 297.3%

26.2% 32.5% 40.8% 52.5% 70.0% 99.1% 157.4% 332.3%

29.0% 35.9% 45.1% 58.0% 77.3% 109.5% 174.0% 367.3%

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Estimated Subsidy equivalent


Tax rate 32% Non-discounted 4 Discounted 3.29 28% Non-discounted 4 Discounted 3.29

Equivalent years of tax holiday Whole Sample (70) ROA Redundancy rate Effective public subsidy Binh Duong (20) ROA Redundancy rate Effective public subsidy HCMC (37) ROA Redundancy rate Effective public subsidy Tien Giang (13) ROA Redundancy rate Effective public subsidy

13.8% 82.9% 85.4% 82.9% 70.2% 82.9% 74.7%

13.8% 82.9% 61.5%

19.6% 80.0% 100.4% 80.0% 82.5% 80.0% 87.8%

19.6% 80.0% 72.2%

12.4% 87.8% 114.4% 87.8% 94.1% 87.8% 100.1%

12.4% 87.8% 82.3%

4.0% 73.1% 13.8% 73.1% 11.3% 73.1% 12.1%

4.0% 73.1% 9.9%

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Conclusions
The current fiscal incentive regime for domestic investment is not incentivizing investment Redundancy rate of 83% suggests fiscal incentives not a primary factor motivating investment This translates into an effective public subsidy of around 70% Thus for $10 million dollars of investment qualifying for fiscal incentives, the national government must surrender $7 million in scarce revenue required for service delivery.
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