Position Paper on the Rationalization of Fiscal Incentives

As part of AER’s tax policy, we are supporting legislation that aims to phase out redundant tax incentives that cost billions of pesos in lost revenues and to put in place a well-targeted and a performance-based fiscal incentives system. While fiscal incentives, in their current design, administration, and context, may have proven to be of little value when it comes to encouraging investments, the notion of providing effective subsidies to worthy investors should not altogether be abandoned.

 

Redundancy of Incentives

 

There have been efforts to consolidate and rationalize the various investment incentive schemes in the Philippines. Numerous studies have been conducted with such an aim, one of which is a paper by Dr. Renato Reside entitled Towards Rational Fiscal Incentives:  Good Investments or Wasted Gifts? (2006). The Reside paper is by far the most comprehensive and exhaustive study conducted on the current structure of Philippine fiscal incentives.  This paper has served as guide to many discussions on and debates about investment policy reforms in the Legislative Department. Reside’s analysis confirms that “a large amount of incentives being provided are redundant – they are given to many firms that would have invested anyway without them.” In his conclusion, he maintains that “the provision of fiscal incentives is very costly, yet in spite of the fact that they continue to be provided, there is limited evidence of their efficacy in inducing investment across countries.” “Even within the country, incentives have very limited power to induce investment. The power of incentives is of secondary importance relative to other, more potent inducers of investment.”

One such example of redundant incentives is those given to the extractive industries. Listed as a preferred area of investment,[1] large-scale mining enterprises are entitled to various fiscal incentives under the Omnibus Investment Code of 1987, provided that they register with the Board of Investments (BOI). There are also additional incentives granted by the Philippine Mining Act of 1995 (Republic Act No. 7942). Given the abundance of resources that the Philippines has, mining companies’ incentive to invest is the resources themselves. Hence, investors will be interested to invest in mining operations in the country regardless of whether or not incentives will be given to them. But more than the redundancy of incentives, the fact is that the mining industry has very small contribution to taxes, because of the incentives themselves. As a result, the cost of allowing the operation of extractive industries is very high relative to the return they give to the economy. This is in addition to the environmental costs that are being done by those who do not rehabilitate the areas they mine on.

The rationale behind the granting of incentives is that they are only needed when investors are not willing invest; i.e., in areas where they are discouraged from investing because the return is too low or the risk is too high, and where the social return for their investment is high. Such is not the case in the extractive industries, along with other areas of investments where incentives are no longer needed.

Fiscal Incentive Design, Administration, and Context

According to the paper, Philippine Fiscal Incentives: A Note on Design, Administration, and Context by AER’s Cristina Morales-Alikpala (2010), there are three aspects we need to address in the rationalization of fiscal incentives: incentive design, the administration of incentives, and context.

  1. Incentive Design

 

One aspect of incentive design that needs to be evaluates is the policy of granting income tax holidays. Although they may factor into investors’ decision-making, income tax holidays only serve to benefit investments that are already profitable in the first place, and investments with higher profitability serve to gain more from such absolute income tax holidays. However, Alikpala contends that the complete elimination of income tax holidays could prove to be even more costly than in its current design because the country would miss out on those new investments. One possibility then is to impose a performance threshold for preferred investments.  Another suggestion is for the income tax holiday to apply to a pre-specified rate of return, above which profits will be taxed.

 

Another aspect that needs evaluation is those given to non-exporting investments. Reside (2006) concluded that non-exporting investments are not as sensitive to fiscal incentives relative to exporting investments. Therefore, the elimination of incentives for non-exporting producers should also be seriously considered. In Dr. Felipe Medalla’s paper, On the Rationalization of Fiscal Incentives (2006), he also has the same recommendation. “Incentives to non-exporters should be removed since the incentives are likely to be either redundant (if the firms are efficient, they are already getting a very good deal because of the tariff protection) or inconsistent with economic efficiency (that the incentives are not redundant is actually bad news since it means that the firms that are being given protection are inefficient).” Medalla proposes that the duty and tax incentives on raw materials and capital goods used by exporters be retained, since the incentives are, strictly speaking, not really incentives but are partial removal of cost penalties on them arising from the country’s protectionist trade policy. Alikpala adds that duty-free importation of raw materials and capital goods for exporters this raises the effective rate of protection for exports and helps them become more competitive in export markets. However, Medalla proposes that safeguards be put in place to prevent the use of and tax and duty free import privileges as avenues for smuggling and the expansion of incentives to areas not intended by congress.

 

Another important recommendation of many economists is that investment incentives be consolidated under a single law. Such a move will provide ease of understanding and administration of the incentive scheme in the country.  Alikpala also suggests that a periodic review of incentives granted to investments should be a built-in provision in the law which can allow for a more dynamic policy environment that will be responsive to new challenges in the economic landscape.

 

  1. Administration of Fiscal Incentives

 

Reside proposes that there be a greater coordination between the investment promotion agencies (IPA) and the Bureau of Internal Revenue (BIR) in monitoring IPA-registered firms. According to Alikpala, “(t)he key to successful investment promotion is an IPA’s ability to recognize the investors’ stage of decision-making and to tailor its campaign accordingly, since different promotional activities are more effective at different stages of the investment decision-making process. As potential investors first show signs of awareness and interest, building a positive reputation for the local investment climate must be the priority. Then, as the interest narrows down to specific ventures, the IPA can focus on investment projects attraction in order to trigger the actual investment action.  Once the investors have made a positive and definite decision, the IPA should facilitate both the entry requirements and the longer-term stay.[2]

 

Alikpala also emphasizes on one core IPA function, aftercare services. “The notion of aftercare emphasizes that IPAs should be tasked with, among others, ensuring that investment promises are delivered upon, and incentives such as income tax holidays should be made conditional on delivering on such promises.  This means that IPAs should be tasked and authorized to monitor investors even after they have entered the country.” “Aftercare activities are becoming more and more important in the context of already-established FDIs who might be looking to reinvest their earnings, make new investments to increase capacities (sequential investments), and / or whose suppliers are looking to invest in a location in close proximity to their client (associated investments).”

 

  1. Context

 

Alikpala asserts that offering financial and other incentives to attract foreign investors is not a substitute for pursuing policy measures that create a sound investment environment for domestic and foreign investors.  There are several economic aspects we need to reform in an effort to improve the overall economic context within which investment incentives operate. She cites a 2007 publication entitled “Philippines: Critical Development Constraints,” by the Asian Development Bank. In the publication, ADB identified that uncertainty in the private appropriability of returns to investments is one of the most crucial reason why investments have remained so low in the country.[3] The absence of sufficient and good was also identified as a critical constraint to growth.

 

Focusing on the policy context, Alikpala proposes the contextualization of fiscal incentives in a larger framework that promotes investments, employment, industry, structural change, learning, technological absorption, and all the other nice things we hope to get from foreign direct investments. “At the outset,” Alikpala states, “it must be stated clearly and plainly that investment promotion is industrial policy. “ A strategic industrial promotion strategy should be able to anticipate human resource needs, correct market failures, promote and create linkages, and provide targeted assistance to SMEs.

 

Conclusion

 

AER agrees with all the points raised by Alikpala (2010) in her paper. We thus adopt the conclusion in full:

 

“Corruption and administrative abuse have long stumped economists who advocate for a more active government presence within the economy, and have served as ammunition for those who insist on limited governments and profess unwavering faith in free markets.  However, to shy away from using a potentially important tool for development simply because that tool is open to abuse is to be shortsighted at best, irresponsible at worst.  Corruption is a fact of Philippine policy life, and the only way to rid the country of it is not to abandon all policies and regulation that are susceptible to it[4], but rather to punish offenders and to do so consistently and severely.

 

The fact is that we are only still learning best practice lessons from around the world, and there is much room for innovation in policy design and administration.  The Philippines needs to commit itself to a more a strategic and proactive approach to investment promotion.  Fiscal incentives to investments are costly and have a significant failure rate.  However, without the proper context of improving the investment climate and a broader framework for industrial promotion, fiscal incentives have less hope to achieve what they were designed to do and will be a bigger financial burden to the country.”

 

 



[1] Section 17 of Executive Order No. 226, the Omnibus Investment Code of 1987

[2] Obviously, IPAs will not be dealing with investors that are all at the same investment decision stage. The most successful IPAs are those which effectively utilize their resources to focus on the activity corresponding to the decision-making stage of the majority of their potential “customers”.

[3] Since the 90s, Philippine investment rate has lagged behind its neighbors.  In 2006, the share of gross domestic investment in GDP was at its lowest level since the East Asian Crisis of 1997.

[4] Is there any sort of regulation impervious to greed and abuse?  This argument is raised in every discussion of any new regulatory instrument proposed in Philippine policy circles.  We abandon regulation because we do not have the capacity to administer it properly, but the capacity to administer proper regulation is never built up because existing policies do not justify the need to do so.  It then becomes a vicious cycle of regulatory atrophy.  When markets run amuck or development goals do not materialize, we blame corruption.

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