FISCAL INCENTIVES RATIONALIZATION IN THE ASEAN REGION FILOMENO STA. ANA III A CTION FOR E CONOMIC R EFORMS

O UTLINE I. Overview of Incentives (FI) in the ASEAN region II. The Prisoner’s Dilemma III. Cost of Fiscal Incentives IV. Rationalizing Fiscal Incentives V. Need for Collective Action in the ASEAN

Fiscal Incentives (FI) in the ASEAN region o Countries in ASEAN region offer incentives that are similar in range, objectives, and nature of investments targeted. o In a regional context, governments use fiscal incentives to gain competitive edge against neighboring countries with similar characteristics. In doing so, all countries end up in scenario where no one gains a competitive advantage from the incentive alone. o Despite increasing call to rationalize incentives, and despite the potential gain from doing so, these countries continue to offer incentives.

Similarity of the FI Regimes of ASEAN countries Tax Holiday Reduced Corporate Income Tax (CIT) Investment Allowance/ CreditIndirect Tax Exemptions Indonesia5-10 yrs. 30% deduction of qualified investment 5% import duty on imported capital goods and raw material Malaysia5-10 yrs. 5-10% on incremental qualifying income % deduction of qualified expenditure duty free import of raw materials and spare parts Philippines3-8 yrs. 5% on gross income in lieu of national and local taxes 100% deduction on infrastructure spending in least developed areas exemption for importation of raw materials, machineries, equipments and spare parts Singapore3-15 yrs % deduction of qualified expenditure exemption from GST on imports Thailand3-8 yrs50% reduction of CIT 50% deduction of investment in designated zones exemptions and reduced import duty and VAT on inputs on exports Vietnam2-4 yrs.50% reduction of CIT VAT and import duty exemptions for certain imported goods, machineries and raw materials

C RITIQUE OF F ISCAL I NCENTIVES (FI) o Foregone Revenues—In the Philippines, foregone revenue of incentives was estimated at 1 percent of the GDP (2004). In Vietnam, the estimated foregone revenue is equivalent to about 0.7 percent of the GDP (2001). o Redundancy—Incentives are granted to enterprises that would have been made anyway in absence of the incentives (e.g. extractive industries which choose to invest in a country for its abundant natural resources). As a rule of thumb, incentives for resource-seeking and market-seeking (domestic markets already exist and are profitable) investments are redundant. o Lack of Transparency—Lack of transparency invites corruption and rent-seeking opportunities. It also prevents assessment on effectiveness and cost of the policy.

P RISONER’S D ILEMMA o Consider two countries with similar characteristics, both imposing tax rate of 20%. Suppose investors are indifferent between the two countries, and are likely to divide the investment equally between the two. To gain advantage against the other, one can offer incentive to attract higher investment. o Suppose the return to the total amount of available investment is 100 million. If investment is divided between the two countries, the return of investment is 50 million for each country, respectively.

P RISONER’S D ILEMMA o If both countries do not offer incentive, both receive a respective payoff of 55 million (equal to the 40 million return to investment, 10 million tax revenue from the 20% tax rate, and amount of 5 million returns to government spending for public infrastructure and social services). o If both countries offer incentive, both receive a respective payoff of 50 million (equal to 50 million return to investment, and zero tax revenue, and hence zero returns to public spending). o If only one country offers the incentive, that country receives all investment and its return.

P RISONER’S D ILEMMA o For a country seeking to attain the highest payoff, the dominant strategy is to offer the incentive. Since the case is true for the two countries, we end up in a situation where both countries opt to offer the incentives, resulting in a split in investments and thus a lower payoff. o But in the alternative scenario where both countries do not offer FI is higher, the total payoff is higher than the scenario where both countries offer the FI. Hence, both countries have more to gain by cooperating and scaling back FI.

The Payoff: Cooperation is Best B not offeroffer A not offer 55, 550, 100 offer100, 050, 50

P ROPER W AY OF D OING FI o Institutionalization of eligibility criteria to identify which sectors are qualified for fiscal incentives. o Incentives to be constrained by the country’s industrial policy (IP). A vertical, not horizontal approach, to meeting IP objectives. o Institutionalization of transparency. Public disclosure of actual investments, types of incentives, actual amount of incentives, and cost-benefit studies. Treatment of tax incentives as tax expenditures.

o Adoption of performance-bound criteria and disciplining mechanisms on investments receiving incentives. Use of performance threshold for preferred investments. (e.g. income tax holiday applied on pre-specified rate of return, and above which profits will be taxed). Incentives based on the actual delivery of proposed investments. P ROPER W AY OF D OING FI

C OLLECTIVE A CTION IN ASEAN o Experience with liberalization shows how ASEAN country members expanded use of incentives to compete for investment. o Tax competition as part of locational competition is bound to intensify in light of the ASEAN Free Trade Agreement in end o Countries have disincentives to rationalize of FI in a regional context (as seen in the Prisoner’s Dilemma case). This necessitates a regional agreement among the members of ASEAN to move towards rationalization of FI in their respective countries.

C OLLECTIVE A CTION IN ASEAN o Regional rules related to FI must address, among other things: Harmonization of rules in granting incentives (preferably tied to IP), without sacrificing flexibility. Transparency and accountability mechanisms, and sharing of information (which is also necessary to address transfer-pricing). How to address the economic unevenness within ASEAN, which will result in exacerbating the inequality in the distribution of gains. Thus, asking what policy and institutional covers for potential losers can ASEAN agree to.