One question that constantly confronts Indonesia’s Investment Coordinating Board (BKPM) is whether or how to use fiscal incentives to encourage investment. While a broad array of options are at BKPM’s disposal, such as accelerated depreciation, matching grants and payments in kind, the most contentious have invariably been the provision of tax holidays.
The fire and fury that tax holidays ignite in the public discourse, especially in developing countries, stems from the relative complexity of their proper administration and the resulting foregone income to the state treasury if the need for precision is compromised. In Indonesia usually large tax losses could be construed as an act of treason.
It is hardly surprising then how expedient it would be for some to oppose tax holidays on purportedly nationalistic grounds. The thrust of this argument is that tax holidays lead to an erosion of the tax base and motivate firms to find imaginative ways to qualify for the incentive, undermining policies designed to offer it only in cases where benefits outweigh costs and thereby shrinking tax revenue even further.
But the experiences of China and Vietnam, two of Asia’s rapidly expanding economies, demonstrate that tax holidays can be a useful tool in economic policymaking. China has been offering them for the past 20 years to spur investment to the record levels where it stands today and Vietnam has been following suit essentially over the same period.
Both countries have included tax holidays in their long-term development strategies, with an eye to easing the way for investors wary of their command and control governance structure and of their rhetorical critique of private capital ownership. Their use was in part to send a signal of welcome to otherwise hesitant investors.
But the larger question as to the size of tax revenue gained from additional investment that had offset upfront tax losses has received mixed reviews and is a hot topic for empirical research.
However, evidence is emerging that suggests tax holidays can change the distribution of investment in a geographic region or a common market, providing that countries under consideration by investors are roughly equal on more pertinent factors, such as the size of the market, breadth and depth of natural resource advantages, quality of infrastructure, flexibility of labor laws, and transparency and stability of the investment climate.
This suggests that, in Southeast Asia or the ASEAN-China free trade area, tax holidays could shift the balance of competition for investment in Indonesia’s favor. Investment flows are lumpy and highly erratic. Because of the rapid integration of the region and the finalizing of steps towards a common market, investors can, for example, establish head office facilities in the most competitive regional business environment and then service neighboring markets from that base of operations. Indonesia should therefore judiciously offer tax holidays, among other fiscal and non-fiscal incentives, to compete in this arena.
Given that Indonesia aims to channel investment into priority sectors such as manufacturing, which is oriented towards exports and has been demonstrated to be responsive to tax holidays because it is very sensitive to cost structure, the adoption of tax holidays should therefore become a policy option for consideration. Capturing more investment in this sector will create jobs and induce transfers of know-how and technology, moving Indonesia along its path towards industrialization in a global competitive context.
In addition, the provision of tax holidays for pioneer sectors such as renewable energy, where this added sweetener has been shown to get investors to take on higher risks and intensive capital requirements, should be weighed carefully. Developing this sector and diversifying Indonesia’s energy mix, especially with respect to its vast geothermal reserves, remains a key consideration for national energy security.
Yet tax holidays fall in and out of favor in Indonesia. Whenever they have been repealed, it was said that they were costly, both fiscally and administratively, and distortive, in that they seemed to encourage short-term projects and gambling by less scrupulous firms.
The solution to these challenges is not, as scholars advise, to strike an agreement to place regional
limits on tax holidays, a proposition akin to a prisoner’s dilemma which has been repeatedly shot down, but rather to appreciate the role of tax holidays in the formulation of policy. Keeping an option off the table simply because it may have, if not implemented properly, unintended consequences is not only restrictive but also naïve.
For tax holidays to produce a positive impact on Indonesia’s development goals, discretionary regulation is supremely critical and must be applied on two separate fronts.
First, examining tax holidays in the region would allow Indonesia to set reasonable parameters for what it in turn should offer. This also would inform Indonesia for which sectors it should provide tax holidays. Tax holidays should be used as an instrument of industrial policy to help Indonesia target sectors where its comparative advantages remain untapped or under-leveraged.
Second, the benefits and costs of tax holidays must be estimated and evaluated in both quantitative and qualitative terms. Targets for how much tax revenue should be collected and new jobs created from the additional investment, if any, after a certain period of time following their introduction. This standardization would promote transparency and accountability and reduce tension arising from any lack of clarity regarding the timing of economic gains, government agency coordination and ownership, and any disparities in foreign-domestic investor treatment.
Faithfully executing these tasks, in cooperation with relevant technical ministries, will furnish a roadmap on how to use tax holidays to usher the right kind of investors into the sectors that need investment the most to become globally competitive as well as criterion for measuring how cost effective these incentives can be, which can point to other policy options, if any, that may be more optimal in achieving the same impacts.
As with any aspect of far-reaching economic policy, care must be invested in implementation. If wielded wisely, tax holidays can help pierce the bamboo curtain obstructing a larger share of investment flows into the region and which could be diverted to Indonesia.
The writer is chairman of the Investment Coordinating Board. This column will appear regularly every two weeks.