The public debates over the role of tax holidays in attracting investment that Chairman of the Investment Coordinating Board (BKPM) Muhammad Lutfi revived last week could distract the government from the real reforms needed to reinvigorate the economy.
After a limited Cabinet meeting last Wednesday on economic policies chaired by Boediono, Lutfi told reporters the many investors in capital-intensive industries might flee Indonesia to Singapore or Malaysia because the latter two countries offered tax holiday facilities. Lutfi was quoted by Kompas daily as saying a bio-diesel producer in Riau was considering moving its plant to Singapore, which offered a 15-year tax holiday.
Boediono asserted the next day the government had no plan to provide tax-holiday incentives to investors, arguing that such a facility was not the main factor considered by businesspeople in making investment decisions.
Boediono said most investors looked primarily at the quality of the investment climate -- the political and macroeconomic stability, policy predictability and legal certainty.
He said the government, therefore, was still focusing its reforms on developing good governance practices in areas such as tax administration, customs service, licensing bureaucracy and other components of regulatory and legal frameworks.
Tax incentives, Boediono added, were now limited to tax allowances offered to particular investment ventures in the form of a deduction from taxable income -- up to 30 percent of the investment amount -- and accelerated depreciation of fixed assets.
He said the tax holiday offered during the 1980s failed to significantly attract the kind of investment the government wanted to promote in designated sectors and locations.
In fact, many investors, in collusion with BKPM and tax officials, had misused the tax holiday facility by manipulating the dates of the start-up of commercial production, thereby extending the period of the tax relief.
Indeed, the tax holiday incentive has never ranked prominently in the list of grievances aired by domestic and foreign investors in opinion surveys. Their main considerations for investment decisions covered the main factors Boediono cited above.
After all, tax is paid from profit or income. And most companies lose money anyway in the first year of operation.
Investors in the country often complain about tax issues relating to inefficient and corrupt tax administration and taxation regulations that put taxpayers at a disadvantage vis-a-vis tax officials.
The tax holiday incentive has a negligible impact on investors' decisions when such basic issues as the effectiveness of the judiciary and the ability to uphold and enforce contracts still rest on uncertain ground as they do in Indonesia.
It is these non-economic factors, in addition to excessive red tape, not tax policies, that have been the main reasons behind the lack of foreign direct investment in the country.
Reform measures in tax administration, customs services, labor regulations and strong law enforcement -- currently the main target areas of government reforms -- will have a much larger impact on attracting investment.
Low corporate income tax rates contribute significantly to attracting investment. The 30 percent tax allowance incentive the government recently gave to 52 companies could also help direct investment to particular locations or business areas.
But even such tax incentives would be meaningless if the tax administration is largely inefficient and corrupt.
The government is well advised to realize that special incentives, such as tax allowances for investment, are not substitutes for good governance and sound macroeconomic policies.
Unfortunately, Indonesia is still ranked very low in most of the key building blocks for good investment climate.
The World Bank 2008 Doing Business report, which rated 178 countries according to their performance in 11 areas relating to ease in doing business, ranked Indonesia in 123rd place. Even among ASEAN countries, Indonesia's performance was among the worst, better only than the Philippines.
Investors prefer good governance because this factor reduces the costs and risks of doing business and minimizes barriers to sound competition. The rationale is that strong and consistent law enforcement is key to minimizing government policy-related costs and risks as those regarding regulations on taxation, customs, labor, local autonomy and basic infrastructures.
Strong legal certainty in turn helps build the credibility and certainty of government policies, which is important for both domestic and foreign investors because direct (not portfolio) investment is basically forward-looking or long-term in nature.
Investors expect risks associated with changes in such factors as market competition and customer behavior but the government can offset these risks by helping maintain a stable and secure regulatory environment for doing business. Not by granting tax-holiday incentives.
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