Do fiscal incentives truly promote change?

By Fara G. Vargas-Pagaran

First Published in Business World (11/4/2012)

There are two versions of a bill currently pending in Congress that seek to change the system of investment incentives in the Philippines. Both House and Senate versions seek to rationalize the current fiscal incentives and streamline their administration.

The House version proposes, among others, two major changes: (1) the adoption of a 25-year sunset provision; and (2) the inclusion of a 50% reduction in corporate income tax for a period of 25 years for export enterprises, and 15 years for domestic enterprises.

On the other hand, the Senate version proposes, among other things, a 10-year cap on the enjoyment of incentives. It also proposes complete removal of the income tax holiday (ITH) and value-added tax (VAT) exemptions, because of their alleged negative impact on government revenues. However, it extends incentives to firms that locate in any of the 30 poorest provinces, invest at least P500 million, and generate at least 200 jobs. Proposed incentives to these firms include a reduced income tax rate of 15% and extended net operating loss carryover (NOLCO) and accelerated depreciation. In addition, the Senate version recommends the establishment of a Trust Liability Account by the Bureau of Treasury to facilitate the refund of VAT on the importation of capital equipment and raw materials.

As expected, reactions to the proposed rationalization of our fiscal incentives, particularly the move to abolish the ITH incentive, have been as varied as the many interests that are involved. The main issue to consider, however, is the overall effect on the investments climate in the Philippines.

Do we lose more than we gain?

Data from the Bangko Sentral ng Pilipinas (BSP) show that Foreign Direct Investment (FDI) inflows surged 154% to $850 million in the first two months of the year from $335 million a year earlier. Many factors may have contributed to such an increase, such as a renewed confidence in governance, a positive outlook on the economy, and improving infrastructure.

In a letter to Senator Ralph Recto, the Joint Foreign Chambers of the Philippines commented that removing the ITH may negatively impact the Philippines’ competitiveness as an investment destination within the region. They pointed out that our neighboring countries in Southeast Asia continue to offer very attractive incentives, including the ITH. The proposal to end the ITH could therefore handicap the Philippines’ ability to attract manufacturers and other businesses that are looking for alternative investment locations.

Revenue loss has been the main argument for the removal of the ITH. Conceptually though, if the long term social and economic gains from the investments attracted or induced by these fiscal incentives heavily outweigh the short-term costs, then there are strong reasons for providing incentives.

Is change good?

On the other hand, there are those that favor and push for the rationalization of incentives. For instance, the World Bank expects a 4.2% growth in the Philippine economy in 2012 if key measures like the tobacco and alcohol excise bill and the fiscal incentives rationalization bill are enacted into law, and public spending improves.

Some experts believe that there is no direct correlation between incentives and attracting domestic or foreign investments. Dr. Renato Reside, in his publication entitled Towards Rational Fiscal Incentives: Good Investments or Wasted Gifts? (2006), said: “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. Incentives have very limited power to induce investments. Rather, incentives are of secondary importance compared to other more potent inducers of investment.”

In the Position Paper on the Rationalization of Fiscal Incentives published by the Action for Economic Reform, other experts state that the granting of incentives is only needed when investors are not willing to invest, such as in areas where they are discouraged from investing because the return is too low or the risk too high, and where the social return for their investment is too low. Offering incentives to attract foreign investors should not be a substitute for pursuing policy measures that create a sound investment environment for domestic and foreign investors, they added.

According to those who support the removal of ITH, fiscal incentives alone, without an improved investment climate in the Philippines, will be a bigger financial burden to the country than it will be of assistance.

Moving Forward
Despite the varied viewpoints on this matter, two points are quite clear.
First is that there must be an effort to harmonize fiscal incentives and consolidate numerous incentive-giving laws such as the Omnibus Investments Code, special laws for economic zones and other similar statutes. Such a move would ease administration and simplify the incentive scheme for the benefit of investors.

Second, our fiscal incentives scheme will only be effective in the context of a robust and stable investment climate in the Philippines. A good investment climate encourages domestic and foreign firms to invest productively, create jobs and expand. These firms are the main source of tax revenues which contribute to public funding for better infrastructure, health, education and other services, the primordial concerns of our government. This means that managing the tension between creating attractive fiscal incentives for domestic and foreign investors and achieving social and economic goals will continue to be a major challenge for the government.

Today, the Philippines is well-positioned for an economic take-off. Decisions with respect to policy design and administration must be well-studied to create a fiscal incentive scheme that will create a favorable investment climate for investors.

Fara G. Vargas-Pagaran is a Senior Tax Director of SGV & Co.

This article is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinion expressed above are those of the author and do not necessarily represent the views of SGV & Co.