As reported in The Jakarta Post on June 9, the government is now considering offering tax breaks for foreign investment in the automotive industry. The policy is obviously intended to help attract foreign direct investment.
The question is: Will tax breaks be effective in attracting FDI. Experience shows they may not be.
To attract FDI, such as foreign investment in the automotive industry, offering tax incentives has been popular in many developing countries. Association of Southeast Asian Nations countries, including Indonesia, are no exception. A survey by the United Nations Conference on Trade and Development (UNCTAD) shows that, to attract FDI, at sometime or another, ASEAN countries have offered various kinds of tax incentives, including tax breaks or tax holidays -- a temporary reduction or elimination of a tax.
In Indonesia, the policy of reducing or eliminating taxes for the purpose of attracting FDI is not new.In 1967, at the start of the New Order era, the Indonesian government welcomed new investors in certain sectors with five-year tax holidays. And after tax rates were reduced in 1984, tax holidays were reintroduced in 1996.
The main argument for tax incentives is that taxes affect the net return on capital and then influence the direction of capital movement across countries. Therefore, a more generous tax policy such as tax breaks attracts more investment. To remain competitive, a country should offer tax incentives if its neighboring countries offer tax incentives.
As the chairman of the Investment Coordinating Board (BKPM) asserted, tax incentives are needed to compete with other neighboring countries in attracting global auto giants to invest in Indonesia.
This argument sounds convincing. The problem is, it is based on the assumption that investment conditions across countries are similar. In reality, however, it is a shaky argument at best: political stability, economic stability, infrastructure, law enforcement and the cost and availability of labor differ from one country to another.
A competition in offering tax breaks among neighboring countries may only result in a "race to the bottom", meaning that all the competing countries in the region lose revenue without significant increase in investment. A recent study by the Organization for Economic Cooperation and Development (OECD) concluded that the estimates of costs incurred by tax incentives in ASEAN countries range from 0.5 to 2 percent of the gross domestic product. Yet the incentives do not significantly raise the investment in those countries.
True, tax breaks may increase investment if such an incentive is provided for tax-sensitive projects. However, as shown in many studies, instead of being provided for tax-sensitive projects, tax breaks are often granted for the most profitable projects, which would have been available even in the absence of tax breaks. And thus, the provision of tax breaks only results in the loss of tax revenue.
A study on the effectiveness of tax incentives in Indonesia carried out by Tonzi and Shome in 1992 showed that providing companies with tax breaks was not effective in raising investment. Studies in Thailand showed a similar experience, that is, the projects receiving tax breaks were the ones with a high rate of return, which would have occurred even without tax incentives.
The discriminative nature of tax breaks may create another problem. The experience of many countries shows the difficulty of identifying correctly which projects or industries should receive tax breaks. The implementation of such tax breaks often results in investment distortions: a diversion from higher return investments to lower return investments. Moreover, discriminative tax incentives may give policymakers opportunities to obtain kickbacks or political favors in exchange for the incentives granted.
Though providing tax incentives can give rise to problems, this does not mean tax policy has no bearing on FDI. But a simpler, more transparent and more predictable tax system is much more important.
After all, as many surveys have found, incentives are not the most important factor for multinational companies in deciding on investment locations. A better fundamental investment climate, incorporating political and economic stability, solid infrastructure and law enforcement and affordable and available labor is much more important
The writer holds a PhD in economics from the University of North Carolina in Chapel Hill, U.S. He is now an economist at Bank Indonesia. The views expressed are his personal views.
Find Article by Date