Governments looking to revamp their tax incentives system to attract foreign direct investments (FDI) should align these perks with the country’s long-term development plan, according to Southeast Asian think tank Asean+3 Macroeconomic Research Office (AMRO).
A paper released by the think- tank that supports regional integration in Southeast Asia titled “Policy Considerations in Using Tax Incentives for Foreign Investment” said efforts to attract FDIs should cover various policy measures, including tax incentives and non-tax measures.
“All available policy options should be assessed for their relative strength and weakness in attracting FDI, and their impact on all related stakeholders should be examined carefully to facilitate the implementation of the strategy,” it said.
Tax incentives should be strategic, promoting certain priority sectors, encouraging activities that promote “positive externalities,” like spurring research and development, human resource development, or developing certain areas like Special Economic Zones, it added.
“A full assessment of the country’s strengths and constraints, including endowments, economic and business structure, and administrative capacity, will help the government set the strategic targets under the national development plan,” AMRO said.
“This will also help identify appropriate policy measures, but constantly evolving economic and policy environments require the government to regularly review the tax incentives for their continued relevance and effectiveness. The tax incentives should be examined and revised in this context, advancing to a more effective and efficient system by incorporating generally accepted good practices,” it added.
According to AMRO, existing studies and international best practices show that tax incentives are more effective for efficiency-seeking FDIs and in attracting greenfield FDI.
For countries eyeing to attract multiple types of FDI, tax incentives should focus more on efficiency-seeking FDI than market- and resource-seeking FDIs.
“For example, a country that seeks to host both efficiency- and resource-seeking FDI may concentrate tax incentives on the former, while granting less tax incentives but more non-tax measures, such as an exclusive concession, for the latter,” it said.
“However, market- and resource-seeking FDI could also be responsive to tax incentives under certain circumstances. For example, suppose the host country competes with other countries with similar investment environments. In that case, tax incentives can provide an additional comparative advantage in inducing FDI that would have otherwise invested in competing countries,” it added.
“Similarly, if M&A FDI requires sizeable additional investment to reshape or expand the existing production capacity, tax incentives can help the host country attract additional investment. In such a case, tax incentives should target the incremental investment that would not have occurred without the tax benefits,” AMRO also said.
The think tank, however, recommended that countries with a weak tax administration capacity should first start with simple instruments, before adopting a more complex but effective instruments over time.
Eligibility criteria for tax incentives “should be clearly defined to reduce the rent-seeking behavior of investors and the corrupt behavior of public officials,” AMRO added.
This should be “explicitly stipulated in the law, providing a clear and reliable interpretation to potential investors, limiting ad hoc changes or discretionary implementation,” it said.
“Also, the scope of eligibility should be carefully set to avoid unnecessary revenue losses while effectively attracting strategically targeted FDI and activities. Clearly defined and well-scoped eligibility criteria will help the responsible government agency to manage the tax incentives efficiently, reducing the risks of corruption and abuse of tax benefits,” AMRO said.
AMRO noted many countries presently facing two potentially conflicting policy priorities — supporting economic recovery and rebuilding policy space — after the coronavirus pandemic.
“Strong investment is essential to boosting the recovery momentum, but generous fiscal incentives to attract FDI could hamper the government’s efforts to rebuild fiscal policy space,” it said.
Coupled with the ongoing discussion on global tax reforms, governments will be forced by the authorities to revisit their tax incentive system, it said. – Ruelle Castro
