Incentives for Investment in Developing Countries Are tax concessions offered by developing countries successful in at- tracting capital?

George E. Lent

EVELOPING COUNTRIES offer tax con- terprises. Once established or expanded, the D cessions of many different types to at- business that has been helped in this way can tract foreign and domestic capital. If their be expected to support the government by pay- governments are anxious to enhance the profit- ment of regular . ability of a newly established business, or expansion of an existing business, that will QUALIFYING FACTORS help the country's economic advance, they are likely to offer tax benefits of a kind that will Most industrial development laws are proba- help to channel new investment into these en- bly designed to attract new industries. Devel- oping countries generally want to produce within their own borders the goods they would Israel's law is a classic statement of the objectives of tax incentives for investment: otherwise have to import, thereby achieving greater national self-sufficiency. In particular, ". . . to attract capital to Israel and to encour- age economic initiative and investments for countries heavily dependent on the of foreign and local capital with a view to: primary products have promoted industri- "(a) the development of the productive ca- alization. In Latin America this policy has pacity of the national economy, the efficient been greatly influenced by the thesis of Raul utilization of its resources and economic poten- Prebisch, long-time Director of the Economic tial, and the full utilization of the productive Commission for Latin America, that the devel- capacity of existing enterprises; opment of manufacturing must be promoted in "(b) the improvement of the balance of pay- ments of the state, the reduction of imports, order to redress the adverse terms of ex- and the increase of ; perienced by primary producing nations vis-a- "(c) the absorption of immigration, the vis industrial nations. planned distribution of the population over the area of the state, and the creation of new Some countries—especially in Africa and sources of employment." Asia—tend to favor industries that will produce exports rather than import substitutes.

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These different objectives, of course, reflect benefits to so-called pioneer industries. A differences in economic circumstances. The pioneer industry generally is regarded as one domestic market of some countries is small, that does not already exist in the country, or and the greatest opportunities lie in increased one that does not produce enough to meet cur- production and processing of agricultural prod- rent or expected domestic requirements. Many ucts for export or in promoting tourism. In countries—Nigeria is one—have lists of others, the domestic market is large, and there pioneer industries; in others such industries are are better opportunities to realize economies determined administratively upon application. of scale. The pioneer status granted to a firm gives it a preferred position in getting established, usual- Consistent with their objectives of diversify- ly through exemption from duties on needed ing and broadening the manufacturing base of imports and income taxes as well as through their economy, many countries restrict tax other tax concessions. It may also be protected by high tariffs on competing imports. But helping pioneer industries is too small a target for most countries; what they are really concerned about is exploiting to the full the natural resources of the country. A few coun- tries, indeed, make no distinction between pioneer and established businesses but grant tax benefits to all new firms that qualify under statutory criteria. India and other countries have adopted a system of investment allow- ances (or grants) which are generally applica- ble to all new investment in machinery and equipment, as well as to other specified invest- ment. This policy neither imposes any limita- tions with respect to industrial capacity nor puts any company in a privileged position.

George E. Lent, Chief of the Some countries set a lower limit on the size Division of the Fund, formerly served as as- of a firm that can qualify for tax and other sistant director of the tax analysis staff, U.S. benefits; others graduate the benefits according Treasury Department; as a consultant with the to the size of assets or some other measure. A Organization of American States; and as a re- search associate at the National Bureau of "priority" investment in Senegal can qualify if Economic Research, New York. A graduate of it submits plans for an investment of at least Rensselaer Polytechnic Institute and Columbia CFAF 40 million (about $162,000) to be car- University, he was on the faculties of the Uni- ried out in three years, or creates at least 40 versity of North Carolina and of Dartmouth jobs for Senegalese supervisory employees. Pak- College before joining the Fund staff in 1964. istan requires a paid-up capital of not less than Rs 50,000 (about $10,400), and Ceylon

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©International Monetary Fund. Not for Redistribution Tax Incentives specifies a minimum employment of 25 per- including the duties on imported construction sons. Among others, Madagascar, Malaysia, materials, machinery, raw materials and sup- Nigeria, and Togo vary the number of years of plies, and the rates of income taxes and taxes exemption with the amount of expenditures on on property, sales, and business activity. fixed assets. Clearly, the higher the taxes, the greater the scope for temporary relief. As Senegal has shown, an important crite- rion for awarding incentive contracts is the In general, investment laws provide prima- amount of employment that is expected to be rily for tax relief of both imports and income. generated. If full employment is achieved this Some laws extend the benefits to include taxes of course changes; in earlier years, Israel ap- on property, sales, exports, and various busi- proved enterprises that assured employment ness privileges and transactions. The extent and for immigrants, but with full employment em- duration—that is, the total expected value of phasis has shifted to production of exports and the exemptions—varies widely from country to import substitutes. Mexico requires not only country and may even vary considerably within that 60 per cent of the direct costs of materi- a country, depending on the nature and size of als, supplies, and components be of national the business, its location, and other factors. origin but also that 10 per cent of the value be added to this from domestic labor and earn- Import Duties ings. As a general rule, remission of import duties A number of countries also consider a com- is thought to help manufacturers more than in- pany's policy for employing local labor. Libya come tax concessions. The exemption of con- requires that at least 90 per cent of the total struction materials, machinery, and equipment number employed in any enterprise be nation- is important in lowering the fixed costs of a als. In Trinidad and Tobago no approved firm new enterprise and in placing it on a more may, without prior approval, employ a person competitive basis. It reduces the capital re- not ordinarily a resident of the Caribbean ter- quirements of the business and thereby facili- ritory. tates its financing. Virtually all countries ac- cordingly provide for full or partial exemption NATURE AND EXTENT OF TAX of duties on such imports when they are needed BENEFITS for the building and installation of a new facility. Tax concessions are intended to induce the establishment of new businesses that otherwise Countries differ much more, however, con- would not be established; their nature, extent, cerning imports of raw materials, semifinished and duration therefore depend on a variety of materials, and components which go into the considerations. Many factors influence new in- finished product. Typically, an exemption vestment: the size of the market; protective from and fiscal duties is provided for tariffs; cost and skills of the labor supply; cost a period of years. However, some discretion and availability of materials; transportation may be retained; Nigeria provides for partial and power; and the general level of taxation, or complete exemption for a period up to ten

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©International Monetary Fund. Not for Redistribution Finance and Development years; exemption may also be partial, as in Al- clusively on these techniques as an inducement geria, the Malagasy Republic, and Morocco. In to new investment. In addition to the exemp- Central America a twofold classification is fol- tion of profits on net income not exceeding 6 lowed by some countries, such as Honduras, per cent of capital employed, India, since whereby "basic," "necessary," and "useful" in- 1955/56, has provided for a "development re- dustries are entitled to exemption from duties bate." This was initially equal to 25 per cent varying from ten to three years, depending on of the cost of new plant and machinery, and whether they are "new" or "established." later (1962) was reduced to a standard 20 per cent, with 35 per cent for selected industries; Deferral and Exemption provision is made for an eight-year carry-over Investment incentive laws are perhaps most of any unused rebate. Other countries have typically associated with relief from income schemes that are similar in principle. taxes. These laws take many forms, but they The investment allowance has recently are of two major classes, with each classifica- evolved into an outright grant in Canada, Mo- tion subject to further differentiation. These rocco, and the United Kingdom. Although in are: Investment allowances (or grants), which principle similar to the allowance, the grant is provide for a write-off of depreciable plant payable whether or not the firm has taxable and/or equipment in excess of ordinary depre- income. The early availability of benefits ciation allowances; and partial or complete tax makes the grant system particularly interesting holidays for a period of years. to new businesses with limited capital which are not immediately profitable. Grants have Investment Allowances the effect of reducing capital costs (and imme- Many techniques have been developed in re- diate capital requirements) by as much as 20 cent years to accelerate the tax-free recovery per cent in Morocco, 33V& per cent in Canada, of a capital investment by cutting or postpon- and 25-45 per cent in the United Kingdom. ing income tax. If the income tax of a com- pany is cut (or postponed), the cash flow from Tax Holidays operations is speeded up, and more funds are Partial or complete exemption from income available to finance current capital require- taxes is the most common type of income tax ments. By the same token, the rate of return inducement. Such "tax holidays" take a variety on investment is enhanced. A clear distinction of forms, the most common being outright ex- should be made between accelerated deprecia- emption for from two to five years, as in Ma- tion, which simply defers tax payments, and laysia (2-5 years), Nigeria (2-5 years), Ivory investment allowances (or grants), which per- Coast (5 years), and Sierra Leone (5 years). mit deductions in excess of the cost of depre- Other countries provide exemption for a ciable assets to be taken in the early years, longer period, e.g., 15 years in Congo (Braz- thereby arbitrarily reducing income tax liabili- zaville ). The period allowed may vary with the ties. size of capital investment, as in Malaysia, Ni- Several countries, mostly members of the geria, and Togo; with the region of the country British Commonwealth, have relied almost ex- in which the investment is made, as in Ecua-

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©International Monetary Fund. Not for Redistribution Tax Incentives dor and Pakistan; or with other factors, such whereas the investment-allowance approach as the class of industry and degree of priority usually makes no distinction between invest- of the investment. ment in new and in established firms. Many In some countries only partial income tax governments have favored tax holidays be- exemption is granted. For example, Costa Rica cause they have been particularly concewied provides for full exemption for the first half of with the establishment of new business enter- the period, and 50 per cent exemption for the prises. However, it can be argued that the ex- second half; Ecuador's exemptions vary with tension of benefits to established firms, as well the priority of the new business: 100 per cent as to new firms, is a positive advantage of the for the Special Class and 75 per cent for Class investment allowance approach on the grounds "A," no income being allowed that the expansion of established firms tends to for the "B" category. Similar differentiation is make the best use of scarce managerial talents in effect in Central America. There are, how- and capital. ever, almost as many variants of tax holidays An investment allowance probably is also as there are countries that employ the device. administratively more feasible than a tax holi- day and lends itself better to investment incen- Comparative Merits tives of general rather than selective appli- A tax holiday providing full income tax ex- cation. The simplicity of the investment emption for a period of years is likely to be at allowance, however, is obtained at the expense least equal in attraction to an investment al- of selectivity, and may, therefore, be consid- lowance; within the exemption period it will ered inconsistent with other objectives. The always give at least as much benefit as the al- use of an investment allowance also makes it lowance, since the latter can do no more than unnecessary to distinguish between the invest- wipe out the income tax liability. The only ment of a new business and that of an estab- possibility for greater benefit from an invest- lished business. If expansion of an existing ment allowance arises out of a carry forward project warranted special incentives, the in- of an unused investment allowance (or operat- vestment allowances could be applied more ing loss) to years beyond the period that simply than tax exemption, without the need to would be covered by the tax-holiday alterna- distinguish between the earnings of the old and tive. This may occur if profits during the holi- new business. The use of a tax holiday in these day period are too small to absorb the allow- circumstances presents formidable accounting ance. In general, however, most investors and enforcement problems in allocating earn- probably base their plans on the expectation of ings to the additional assets. a fairly prompt flow of profits at a rate high In favor of tax holidays, it is argued that enough to reach a cumulative total greater they are neutral between capital-intensive and than 40-50 per cent of investment—a liberal labor-intensive types of business, whereas in- investment allowance figure—in the first three vestment allowances are biased in favor of the to five years. former. As capital is ordinarily scarcer than la- The tax-holiday approach concentrates on bor in the less developed countries, an incen- new firms and directs its benefits to them, tive scheme offering special inducements to the

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©International Monetary Fund. Not for Redistribution Finance and Development use of capital-intensive methods is question- a primary domestic source of capital for new able. Tax holidays may be more suitable than investment, many countries provide special in- investment allowances in countries with sur- centives for the reinvestment of earnings. Such plus labor, especially where handicraft-type in- a policy may be employed to supplement tax- dustries offer good prospects for export, as in incentive laws through general legislation, or Jamaica and in Trinidad and Tobago. Alterna- to follow on the tax-exemption period when tively, it has been suggested that labor surplus expansion is considered. countries might appropriately offer subsidies Unless carefully controlled and limited, such based on the number of workers employed exemption is likely to entail substantial loss of rather than on investment. revenue. Proper enforcement, on the other Agricultural enterprises may derive little hand, is apt to be expensive in administration benefit from investment allowances because and compliance costs. This is so because it is the investment is less in depreciable property not enough to verify that earnings have been than in the form of land or intangible develop- retained, but it is also advisable to see that ment costs. A tax holiday may be better they are properly invested within the specified adapted to the encouragement of agricultural period. Moreover, since the funds available for development, but may be less suitable when business investment flow not only from net there is a long gestation period as there is with profits but from other internal and external tree crops. sources as well, such a provision clearly raises The tax benefit to investors and the revenue a problem of identifying the source of the loss to the state are specifically limited in an funds being invested. investment allowance; under a tax holiday, EFFECTIVENESS OF PLANS they depend on the amount of profits realized. Hence the tax holiday is subject to a greater It is not possible to determine conclusively risk of providing windfalls for enterprises that the "success" or "failure" of any country's in- are already making a great deal of money. vestment incentive program since we do not This "open-ended" feature of a tax holiday know what the record would have been in its can be avoided by limiting the tax exemption absence. Such agreement as has been reached to earnings that bear some fixed ratio to the on the weight that should be attached to tax investment. For example, Senegal restricts ex- incentives, derived from surveys in several empt earnings to 100 per cent of approved in- countries, suggests that their role in'promoting vestment, and Liberia's new code sets a limit new industry has often been overestimated. of 150 per cent. Some countries—Ecuador, In- The amount of investment may be taken as dia, Iraq, and the Sudan—limit the exemption one measure of the importance of the tax in- to earnings that are less than a specified per- centive program. Data for several countries in- centage of invested capital, and others suspend dicate that approved firms account for up to benefits if earnings are excessive. 10-12 per cent or so of gross private invest- ment. This appears to be a respectable propor- Reinvested Earnings tion when it is considered that the incentives Because profits of established businesses are cover substantially only one segment of total

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©International Monetary Fund. Not for Redistribution Tax Incentives investment—manufacturing, and sometimes ho- not even taken into account. Nevertheless, a tels. In some countries an appreciable contri- number of firms reported that the exemption bution also appears to be made to employment. had been "very helpful" or "helpful," only one Against these "benefits" must be weighed stating that it had not helped. Similar surveys the "costs." The major measurable costs are in in Argentina, Costa Rica, Jamaica, and the terms of the gross tax revenues that are United States support this view and confirm sacrificed, which range from 2 per cent to the limited role of tax considerations. about 10 per cent of total tax revenues for the So we are led by the available evidence to- countries covered. These data can be mislead- ward a general view that developing countries ing, however, because they do not take ac- need not be concerned about matching the tax count of other tax revenues generated by the benefits of other countries in order to attract new ventures. Moreover, this revenue would foreign capital for new industries. Of course not be "lost" if the venture were not formed in there are exceptions to so general a rule. One the absence of the tax concession. This is most of these is where a large region can be eco- clearly true of import duties, which account nomically served by an industry, especially for most of the loss, since many export and where there are good transportation facilities import substitute industries could not survive and no significant trade barriers. For industries without exemptions from duties on raw materi- in which efficient plant size is large relative to als, components, and supplies. the market of individual countries—for exam- Apart from all these difficulties of measure- ple, automobile assembly, oil refining, and cer- ment, there is much concern over possible un- tain chemicals—there may be good opportuni- desirable consequences of competition among ties for export to neighboring countries, and countries in offering tax inducements to foreign the tax advantages offered may have a investors. When one country offers unusually significant marginal effect on the choice of a liberal tax benefits, other countries may outbid site. it by even more generous measures. This situa- tion can lead to greater sacrifices of revenue In these circumstances voluntary adherence without commensurably increasing the flow of by the countries of the region to reasonable capital to the developing countries. standards may be sufficient to limit unhealthy The weight of the evidence also indicates competition; such standards could be enforced that tax considerations are far less influential through international agreements or conven- than are other economic and political factors tions. Harmonization is especially desirable in the location of industry. This conclusion is among members of a common market (or free supported by numerous questionnaire surveys trade) area. Workable agreements have been taken both in capital-exporting and capital- negotiated in several such trading areas, as in importing countries. According to a survey Central America and West Africa, which not based on experience in Mexico before 1959, only standardize tax benefits but also provide there was no instance in which tax exemption for the uniform implementation and adminis- was a decisive factor, and in most cases it was tration of investment laws.

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