Advancing fiscal incentive reform

Yellow Pad

 

THE rationalization of fiscal incentives is a long-overdue reform. It is a necessary reform for several reasons.

The current regime of incentives has resulted in the loss of huge potential revenues every year. In 2016 alone, the foregone revenues amounted to P178.56 billion.

The Philippines has been too generous in granting incentives and that a significant part of these incentives are unnecessary or unwarranted. The term used is redundancy. The investments would have happened even without the tax incentives.

Furthermore, several hundreds of firms enjoying the incentives have them in perpetuity. For example, they pay a tax rate of five percent of gross income earned (GIE) for the rest of their corporate life. This is most unfair. The overwhelming majority of corporations pay a much higher corporate income tax rate, currently at 30%. Most unfair.

It goes without saying that tax incentives can be a tool to attract investments. But two basic conditions must exist for tax incentives to be given.

First, the social benefits are high — greater than the private benefits — for the activity that the incentives will cover. The social benefits include the generation of direct and indirect employment, the creation of forward as well as backward linkages, the introduction and diffusion of new knowledge and technology, etc.

Second, the profit-motivated private sector shies away from such economic activity because of unprofitability. Hence, the incentives are necessary to attract the private sector investment in the missing market.

These two conditions go together. Essentially, tax or fiscal incentives are justifiable when there is market failure.

The truth is, all political administrations agree to the principle of rationalizing fiscal incentives. Previous administrations that wanted this reform failed to obtain it because of the powerful lobby of vested interests and the resistance of politicians who had their own interests to protect. It did not help, either, that in previous episodes of attempting to reform fiscal incentives, the Cabinet was split. The Department of Finance (DoF) and the Department of Trade and Industry (DTI) had sharply contradicting positions.

But the situation has changed. We still have the same set of politicians, which is a point against reform. But the economic managers, the technocracy in and out of government, and a part of civil society have created a strong current on the comprehensive tax reform. This current continues to move forward, despite the opposition to the reform. And never in the history of reforming tax incentives have we seen the DoF and DTI solidly united in the present initiative.

An indicator of advancing the reform tax incentives is the approval by the ways and means committee of a substitute bill. This bill is ready for second reading in the House of Representatives.

The substitute bill contains the essential features for reform. What are the principal features? I highlight the following:

• Tax incentives will become time-bound. Income incentives will be limited to five years at the maximum. The bill also has sunset provisions for corporations that currently avail themselves of the incentives. The bill will remove the perpetual low rate of 5% of GIE and will gradually move the tax rate of these favored corporations closer to the rate that normal corporations pay (in which the corporate income tax will likewise be reduced significantly).

• Rationalization means that only industries that are listed in the Strategic Investments Priority Plan (SIPP) can qualify for the tax incentives.

• Rationalization also means improving the governance and institutions in granting tax incentives. Institutional strengthening is about making the tax incentives time-bound, performance-bound, and transparent. Organizationally, the Fiscal Incentives Review Board (FIRB) will be strengthened. The FIRB, to be co-haired by the DoF and DTI, will exercise oversight functions over the investment promotion agencies (IPAs). The FIRB will exercise the power to grant incentives, which principally resides in the IPAs, only under two conditions. The first: when the “projects or activities pose risk to the environment, health, and economic stability.” The second: when the IPA decision to grant incentives faces a deadlock.

• A menu of fiscal incentives is listed to make the incentives responsive or suitable to the concrete needs of qualified firms. The menu covers income tax holiday; depreciation allowance for capital expenditure; net operating loss carry-over (NOLCO); and tax deduction at significant levels for training and research, labor expense, infrastructure development, and reinvestment allowance.

But wait. The substitute bill also constitutes problematic if not dangerous provisions. I cite a couple of provisions.

The first pertains to Section 301 of the substitute bill, which gives power to the President (any President) to grant incentives. The power is not arbitrary, for the bill puts in places the qualifiers or conditions. But I am afraid of the unintended consequences. Given our history of presidents captured by vested interests, this provision is an opening for abuse and arbitrariness. This creates a more powerful presidency. The lobby groups that want to extract privileges will shift their rent seeking activities from Congress to the Presidency.

At any rate, this provision is redundant because the FIRB is composed of the President’s men. But the IPAs and FIRB have the superior advantage of having disciplinary and transparent mechanisms.

The second dangerous provision, which is indirectly related to fiscal incentive rationalization, is the radical reduction of the corporate income tax or CIT (Section 6). The bill states that the CIT will be reduced in a phased manner, from the current rate of 30% to the rate of 20% by 2029.

What is wrong with this?

True, reducing CIT is justified on the basis of having fairness, easing tax compliance, and safeguarding competitiveness. The DoF recognizes such, but having a significantly lower CIT is contingent on the successful outcome of fiscal incentive rationalization. The reform package must at least be revenue-neutral. It must not result in huge revenue loss. Our calculation is that a drop of every percentage point in corporate income tax can translate into a loss of up to P30 billion in revenue.

Sadly, the substitute bill is not informed by evidence in proposing a radical and unconditional drop in corporate income tax.

Can we expect the House of Representatives to scrap the bad provisions and retain the good ones during the second reading? We must exert pressure. Whatever the outcome will be in the House, the reformers must convince the Senate to come out with a better bill. Remember, the reformers have the momentum.

 

Filomeno S. Sta. Ana III coordinates the Action for Economic Reforms.

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