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Do fiscal incentives predict foreign direct investments?

do fiscal incentives predict foreign direct investments 816x476 - Do fiscal incentives predict foreign direct investments?

The prolonged trade war between the US and China, the world’s two largest economies, is hurting both countries and it is thus seen as a threat to the global economy. Yet for developing countries, especially in Southeast Asia, the ugly trade war is an opportunity, for this economic war translates into a redirection of trade and investments. Indeed, having been affected by the trade war, many companies with global value chains based in China have moved out or are seriously considering their exit.

A survey done by the Nikkei Asian Review in early September and reported on Oct. 4 says that at least a fourth of Japanese companies with a supply chain centered on China, are considering the reduction of their “China footprint.” This spells trouble for China, but this is welcome news to other emerging economies. Will this be the new version of a Japanese wave of investments in Southeast Asia?

So far, the main beneficiaries of new investments, Japanese or not, resulting from the exit of companies in China are Vietnam, Thailand, and Cambodia.

The question is: Will the Philippines be able to capture a hefty share of investments leaving China?

What seems odd is that the Philippines — despite its good economic performance, accentuated by stunning economic reforms leading to an investors’ vote of confidence through a credit upgrade (a notch below A grade) — has not been able to attract the exiting investments from China.

Is it because the investors are repelled by Rodrigo Duterte’s authoritarianism? But then the countries that they are attracted to — Vietnam, Thailand, and Cambodia — are likewise authoritarian. Vietnam and Cambodia are one-party states. Thailand is run by a military junta.

On the other hand, Indonesia, which arguably is now the freest country in the region (despite the rise in religious fundamentalism), has not been on the radar of investors moving out of China.

The type of rule or government is secondary to investors. Their main concern is certainty, ceteris paribus.

In this context, for the Philippines, the delay in the resolution of the reform on fiscal incentives does cause uncertainty. The existing and potential investors do not know what the final design and features will be. The intense lobby against the reform, principally coming from the Philippine Economic Zone Authority (PEZA), and the attendant fearmongering fuel the uncertainty.

The main question in the debate is whether fiscal incentives — and in the Philippines, the incentives are perpetual! — are a predictor or a significant determinant of foreign direct investments (FDIs)?

The survey of the literature says it is not a significant variable of FDI stock or inflow. I limit my citations to studies done by the multilateral organizations.

FDI 100719 - Do fiscal incentives predict foreign direct investments?

A working paper of the International Monetary Fund (IMF) written by James Walsh and Jiangyan Yu titled “Determinants of Foreign Direct Investment: A Sectoral and Institutional Approach” (2010) analyzes the various macroeconomic, developmental and institutional/qualitative determinants, using a sample of both developed and emerging economies. The co-authors state that investments in manufacturing and services are affected by income levels, exchange rate valuation, financial depth, school enrollment, judicial independence, and labor market flexibility.

A World Bank policy research working paper written by Harinder Singh and Kwang W. Jun titled “Some New Evidence on Determinants of Foreign Direct Investment in Developing Countries” (1995) empirically analyzes political risk, business conditions, and macroeconomic variables that influence direct investment flows to developing countries. The significant determinants are: a.) sociopolitical instability (work hours lost in labor disputes, as proxy), b.) business operation conditions, c.) tariff and non-tariff barriers, and d.) export orientation.

Another paper from the World Bank authored by Maria R. Andersen, Benjamin R. Kett, and Eric von Uexkull titled “Corporate Tax Incentives in Developing Countries” in the Global Investment/Competitiveness Report 2017/2018 states: “Tax incentives are generally not cost-effective. The costs include fiscal losses (tax expenditure), rent-seeking, tax evasion, economic distortions, and retaliation from tax competition. Further the effectiveness of tax incentives is seen when applied to efficiency-seeking sectors (as against market-seeking and resource-seeking sectors).

The Asian Development Bank’s Asian Economic Integration Report, 2016 points out the major factors that attract global chain value (GCV) FDI. These are: labor abundance, low trade barriers (specifically, expedited trading procedures and low costs of exporting and importing), and existing network of domestic firms with input-output relations. Good governance and quality of institutions also matter.

A 2019 working paper from the Organization for Economic Cooperation and Development (OECD) authored by Fernando Mistura and Caroline Roulette titled “The Determinants of Foreign Direct Investment: Do statutory restrictions matter?” offers an interesting perspective. In gist, it says that easing restrictions by 10%, measured by a certain index, can increase the FDI stock for manufacturing and services by 2.1%.

The point is, there are better ways to attract FDI like easing restrictions. And given the determination of the leadership, this is not difficult. In the Philippine case, we have seen the passage of several significant laws that lower investment barriers and make doing business easier. A landmark bill that has become priority legislation is the amendment of the antiquated Public Service Law, which will ease or lift the nationality restriction on power generation and supply, transportation, telecommunication, and broadcasting, among other things.

The long and short of it is that fiscal incentives are not a significant determinant of FDI. Recent Philippine figures confirm this. The graph mentioned from the Department of Finance illustrates this fact. Total FDIs (black curve) have risen since 2010 (black line), but the pledged (not even actual) FDIs in PEZA (red curve), which is obsessed with fiscal incentives, have followed a downward slope since 2012. The FDIs approved by Board of Investments (BoI), represented by the blue curve, registered a slight increase in 2018, even outperforming PEZA. The takeaway from this figure is that FDIs in the Philippines are not dependent on fiscal incentives.

To be sure. the Philippine level of FDIs, despite the rise, is still low in comparison to our counterparts in the region. But it is not fiscal incentives that will mainly attract new investors. The World Economic Forum’s Global Competitiveness Report 2017-2018 says that the main concerns of businessmen in the Philippines are the inefficient bureaucracy (20% of respondents), inadequate infrastructure (18%), corruption (14%), tax regulation (11%), tax rates (9%) and political instability (8%).

Note the lower ranking for tax-related issues, but even here, reforms are forthcoming. The bill on rationalizing fiscal incentives goes hand in hand with a gradual lowering of the corporate income tax rates from the current 30% to 20% (given certain reasonable conditions on tax effort and national government deficit).

To summarize, fiscal incentives cannot be the main instrument for FDI promotion. The country has to focus on the significant determinants. In this regard, government has to pay attention to managing the macroeconomy well, like having a competitive exchange rate, price stability, and fiscal space and to providing public goods like infrastructure and human development.

At the same time, government must support winning sectors, which it is doing through its investment priority plan, through various means, including the prudent use of fiscal incentives.

Suffice it to say that these issues have been addressed through laws or are in the process of being resolved.

Fiscal incentives still play a role, albeit they have to be rationalized to curb abuses and reduce tax leakage. Such fiscal incentives address market failure and must be aligned with the government’s investment priority plan or its industrial or technology policy. The menu of incentives must be responsive to the specific needs of the sector or the firm. This suggests that the incentives are not mainly about tax incentives.

Tax incentives must be performance-based, time-bound, and transparent. Government can steer incentives towards addressing job creation and technological innovation (e.g., tax deductibility on additional labor costs, human development costs and research and development costs).

We want to modernize our fiscal incentive regime. Ultimately, once it becomes certain, we can expect that together with the other reforms, it will contribute to the promotion of FDIs, job creation, and prosperity.


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

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