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Monday, 5 January 2009

On tax incentives...

Richard Bird's new paper on Tax challenges facing developing countries comfirms my own suspicions of fiscal incentives (and by extension MFEZs) :

Conventional wisdom also seems right about what should be done with virtually all tax incentives: eliminate them. Despite their continuing popularity almost everywhere, tax incentives are usually redundant and ineffective: they reduce revenue and complicate the fiscal system without achieving their stated objectives. Even to the limited extent that some incentives are effective in inducing investors to behave differently than they would have done in response to market signals the result is often inefficient, diverting scarce resources into less than optimal uses (McLure 1999).

The political (and sometimes even theoretical) appeal of twisting the tax system into a collection of clever gimmicks that seem to do something for any good cause of which one can think is obvious. So, alas, is the grim reality of the bad things that experience has again and again demonstrated tend to happened once one starts down the tempting road. Loading more and more objectives on the tax system through incentives opens the door to inefficiency and inequity and reduces the chances that the tax system can achieve its main objective of adequately funding essential public sector activities. Tax incentives improve economic performance only if government officials are better able to decide the best types and means of production than are private investors. Since observation suggests strongly that people are likely to spend ‘other people’s (taxpayers) money’ with considerably less care than they do their own, this proposition seems inherently implausible. Excessive use of tax incentives complicates administration, facilitates evasion and encourages corruption. Once created, concessions usually prove hard to remove and tend to be enlarged at the initiative of taxpayers who lobby for more concessions or simply redefine existing concessions in unforeseen and presumably undesired ways. Get rid of them.

If one cannot simply eliminate tax incentives, I have elsewhere suggested three simple rules to reduce the damage that may be caused by poorly-designed and implemented incentives: keep them simple, keep records, and evaluate the results (Bird 2000). Alas, very few developing countries have managed to follow even such basic rules as these: the political advantages of ambiguity seem always to outweigh the potential social gains from transparency.

This is also an opportunity to deal with the idea that "tax incentives" are there to attract cross border investment. I remain of the view that the best way to do that is not through huge incentives but through "across the board" reduction in things like corporate taxes as discussed on the blog - In praise of larger and larger firms...

I strongly recommend Bird's new paper - very accessible and a pleasure to read, though undoubtedly readers will find some bits they don't agree with ( I found at least two, I am curious to see if someone can spot them!).

2 comments:

  1. Cho,

    Tax incentives improve economic performance only if government officials are better able to decide the best types and means of production than are private investors. Since observation suggests strongly that people are likely to spend ‘other people’s (taxpayers) money’ with considerably less care than they do their own, this proposition seems inherently implausible. Excessive use of tax incentives complicates administration, facilitates evasion and encourages corruption. Once created, concessions usually prove hard to remove and tend to be enlarged at the initiative of taxpayers who lobby for more concessions or simply redefine existing concessions in unforeseen and presumably undesired ways. Get rid of them.

    If one cannot simply eliminate tax incentives, I have elsewhere suggested three simple rules to reduce the damage that may be caused by poorly-designed and implemented incentives: keep them simple, keep records, and evaluate the results (Bird 2000). Alas, very few developing countries have managed to follow even such basic rules as these: the political advantages of ambiguity seem always to outweigh the potential social gains from transparency.
    (p10)

    I think that I agree with this, and with the general conclusions in the paper, it is all very much in line with the direction the consensus here usually winds up with. There are a few places where I probably disagree with specifics, but rather than delve into that, I'd rather take the conclusions about the need to build institutional capacity and overcome political advantages of ambiguity, and apply performance based incentives to the situation.

    When I want to get the most out of someone, the first place I look is how they get compensated. Here in the "Silicon Forest" people are constantly trying unconventional ways of doing things, which is one reason I like living here, and I see many local examples of things I would encourage Zambian communities to try (and others that I wouldn't!). I think this is especially true for Tribal authorities, as resource management examples from Warm Springs, Quinault and others are highly transferable. One thing that is starting to take hold is application of service industry compensation patterns to other sectors.

    The first step is to imagine that the institution in question is selling a product, and that every individual is a salesman, no matter what their actual job description (i.e. a dishwasher is selling cleaned dishes to a chef via a restaurant, a licensing clerk is selling properly filed documents to properly vetted applicants via a government ministry). Instead of "working for" a company, they are "renting a premises" in which to sell their wares. Like any service industry operator, the success of their business will therefore depend on consistency in both volume and quality of outputs.

    The second step is to assign a fair value to the difference between the output (clean dishes) to the overhead rent of the premises (plumbing, water, soap, etc.), as well as a means of detecting and deducting fair value for low quality outputs (returned plates, breakage, water waste, etc.). This can be tricky since the "customer" and the "landlord" are often the same entity. Wherever possible, double blind or third party means of determining output quality should be employed. It can also be useful to assign customer status to the next person in the supply chain, e.g. dishwashers sell clean dishes to chefs who use clean dishes as one input in selling food to servers who use the food as one input in pleasing customers. Each person is also paying rent to the restaurant for enabling each transaction, with hourly wages as a hedge against poorly located, under-equipped or under-utilized premises.

    Chefs have direct incentive to watch dishwashers and make sure they do a good job, servers have a direct incentive to make sure that chefs are preparing good food, both dishwashers and chefs have direct incentive to make sure servers are delivering quality food on clean dishes in a manner that will please customers and produce return business. All three have direct incentive to make sure the restaurant is providing quality inputs, such as hot water, quality ingredients and equipment, and pleasant surroundings with competitive menu prices. In a well run restaurant, the hourly wage component is almost never an issue, just set it at or near the statutory minimum, with suitable increments for seniority and management (top tier managers still receive relatively low hourly wages, generally 150-200% of bottom tier wages). The majority of compensation for everyone is derived from volume of sales.

    So if I want to structure the compensation for a road inspector, I figure their key input is a quality stretch of roadway free of structural faults and completed on budget and on time. They sell their "stamp of approval" on the road, which certifies the quality (presumably "adding value" to the road thereby), to road users via the facilities of the Ministry of Transport. If the inspector is rewarded for certifying roads which are completed on budget, or on time, or which stand the test of time, or all three, then they have direct incentive to truly insure the quality of the road works and encourage conforming with budgets and timetables. In this specific case, I would overweight the importance of road longevity, since that is the factor most directly under the inspector's control. If the inspector's base wage is low enough to survive on but not thrive on, they are likely to view any project under their review which is over budget as a personal loss (rather than a lost opportunity for a relatively insignificant "bonus" which can be overcome with a bribe). They have to need that road to be of high enough quality to last at least as long as originally forecast, because each year it continues to adequately serve motorists is more money in the inspector's pocket.

    Once the roadway does require major works, the inspector can either be permitted to certify the next generation of the road, if it outlasting its forecast lifespan, or replaced with a new inspector, if it failed before its forecast due to structural fault (assuming some sort of natural disaster exception in place). Such an incentive structure is highly likely to make inspectors very hostile to construction companies who seek to skimp on quality, or transporters who overload trucks and damage otherwise serviceable roads. The bribes to overcome this hostility would have to be significantly larger than at present in order to be effective, and larger bribes are easier to detect. If their superiors are given similar incentives to deliver bundles of reliable inspections to Parliament, then they are unlikely to collude with inspectors to lower quality standards or otherwise overlook defects which require major works.

    ReplyDelete
  2. This is a great paper, and I would urge every one to read it. What is apparent, is that what Zambian politicians have missing from the entire MFEZ concept, is massive support for the SME sector, as a supplier to these zones. Also, the disemphasis on education and the introduction of fees reduced the number of students, when it should have been increased. However, the greatest objection I would see to this paper, is that it is completely directed toward manufacturing, while ignoring agriculture. In the Zambian context, agriculture (and infrastructure) is the big growth industry, not production of manufactured goods for foreign markets. Other than that, a lot of the policies outlined here could be introduced to at least increase the multiplier effect of the MFEZs.


    From the Japanese Institute of Developing Economies (IDE, 2008):

    Unlocking the Potential of Zambian Micro, Small and Medium Enterprises

    “Learning from the international best practices – the
    Southeast Asian Experience”

    Chibwe CHISALA*

    Some highlights - on the relevance of a 'supporting industry' of SMEs in attracting FDI:

    ***

    On the other hand, investors or large-scale firms, it be foreign or domestic, look at the reliability of the supporting industries before they make their investment decisions as they consider supporting industries (SMEs) to be a very important determinant for the success of their businesses. Perhaps this is why most Southeast Asian countries have concentrated much in developing their home grown enterprises which in turn have attracted more Foreign Direct Investments (FDI).

    For example Singapore, Korea and Malaysia which receive considerably high levels of FDI, have focused much on developing their SMEs sector, which was one of the strategies used for their industrial development. It is therefore, important that Zambia takes a leaf from these Southeast Asian countries that have succeeded in developing their SMEs during their process of industrialization and see whether it could replicate some of the programmes and policies as it strives to meet some of the Millennium Development Goals in particular halving its poverty levels by 2015.

    ***


    Astonishingly, according to Table 1, between 1993 and 2006, FDI only created a total of 199,410 jobs. Zambia has a labour force of 5,000,000 (5 million) people. These 200k jobs were created through inflow of $4,125,118,765 ($4.1 billion), I'm not impressed.

    If anyone still entertains it, the idea that FDI will 'bring jobs' should be let go of. Only developing agriculture and infrastructure in a people/farmer centered way is going to create the kind of employment that is needed.

    Now they tell us:


    ***

    But Zambia has remained behind in terms of economic development, while Malaysia is now one of the most industrialized countries actually, an upper middle income country which is targeting at becoming a fully developed country by the year 2020. One of the areas that were identified that contributed to the Malaysia’s success story is the way they supported their home grown industries, the SMEs.

    ***

    In other words, just attracting FDI without enabling and supporting Zambian SME's is pointles. However, taken a step further, if we are to develop Zambian SME's why attract FDI at all? Why not allow enough SME's to grow and become Zambia's own corporations?

    ***

    2.5 Constraints faced by Zambian SMEs

    (i) Inadequate Policy Frame Work

    The Zambia Development Agency (ZDA) Act of 2006, ... incentives are granted to only those investors with qualifying Assets of US$500,000 and above.

    It is evident through most economic policy documents, that the sector is not a
    focus area of most policy makers, and yet a lot of pronounced or documented
    socio-economic policies have direct or indirect effects on the SME sector.

    (ii) Difficulties in filling capacity Gaps for SMEs

    It is important to note that the biggest difficulty in entrepreneurship development
    is related to the “mindset” or poverty of the mind. This is translated into the
    following symptoms:

    * Poor work culture in public offices, organizations, households and in individual personal lives;
    * An attitude of dependency: always expecting government/donor to come up with packages;
    * Apathy, believing that we are poor, failing to see potentials that are waiting to be tapped;
    * Lack of commitment to desired mission (putting short sighted self interest first and;
    * Corruption.


    Analysis of the SME sector in Zambia (MCTI, 2003) indicates severe deficiencies in basic management and technical skills relating to the following fundamental areas:

    • Strategic management capacities i.e. the ability to manage entry into new
    markets and organizing labour and capital to respond to the changing markets,
    technologies and regulations. Such skills are usually acquired through family
    experience, or through formal education in business strategy development,
    followed by associated experience in modern firms;

    • Functional management skills i.e. skills required in production, finance,
    purchasing and marketing to improve production of capital, quality control etc;

    • Technical management skills i.e. the actual technical know how to achieve the
    required quality and quantity.


    In addition, there has been limited emphasis towards addressing the obvious bottlenecks that impede the development of SMEs, which include:

    • Ineffective and uncoordinated support schemes to effectively encourage SMEs to meet both local and export markets;

    • Inadequate information resources on trade, investment, technology, training and application of quality control etc;

    • Inaccessibility to finance/long-term credit: The MCTI survey (2003) revealed that only 7.2% of Zambian SMEs had access to credit while the majority used their personal savings to start up a business. Furthermore, due to high default rates by SMEs, commercial banks favor large firms as regards to credit lending.

    The government of Zambia through the Bank of Zambia has however, put in the place the Credit Reference Bureau that reduces the market imperfections such as asymmetric information between the borrowers and lenders as it tracks the credit culture of SMEs, but the problem comes to new SMEs who would want to enter the market without any records to track hence they still remain marginalized.

    These are somewhat “traditional constraints” that are faced by most SMEs not only in Africa but also in much developed countries. However, countries in Southeast Asia have directed most of their funding to the SME sector unlike the case of some African countries that mostly wait for the donor community to approach them and solve their problems.


    ***

    Offiong and Ero (2002) in their paper, identified policies that have to do with
    technological advancement as one of the policies that most Southeast Asian countries
    implemented in their process of industrialization which subsequently led to the East
    Asian Miracle. They agued that the technological capabilities were achieved through the
    support for education particularly engineering and science education which provided
    intellectual infrastructure that facilitated technological transfer.


    ***

    The technological development in these industrial parks trickled down to the suppliers mainly the SMEs. This transfer of technology to the SMEs made them become even more competitive that led them to graduate to larger enterprises. SMEs also benefited from the government subsidies mostly the cheap credit. Until now most Southeast Asian countries heavily subsidize their industries and provide different sorts of credit for their firms be it small or large.

    ***

    Something tells me there is going to be no 'trickle down' from the MFEZs.

    ***


    Figure 4: Phases of Development of Enterprises in Malaysia:

    1. Startup Stage
    * R&D Incubator
    * Adequate workforce
    * Market knowledge
    * Adequate raw material supply
    * Adequate infrastructure

    2. Growth
    * Certification/Standard
    * Technical assistance
    * Automatic Process
    * Tax benefit
    * Market Development

    3. Expansion
    * Technological capability
    * Management capability
    * ICT capability
    * Brand development
    * Venture Capital
    * Outsourcing
    * Distribution channels

    4. Maturity (Globally Competitive)
    * Design capability
    * Brand name promotion
    * Industry upgrading
    * Investment abroad

    The success of the SMEs sector in Malaysia is evidenced by the growth rates in SMEs sub-industries. In all the sub-industries, SMEs have been performing well mainly due to the earlier mentioned industrial policies and also due to the specific SME development programmes that will be discussed later in this paper.

    ***

    SME development programmes mentioned:

    ***

    The Vendor Development Programme

    The Vendor Development Programme (VDP) is aimed at developing SMEs as a dynamic supporting industry to local large industries or Multinational Corporations (MNCs). The programme is implemented through tripartite arrangement between the Ministry in charge of entrepreneur development (lead agency), large industries (anchor companies) and financial institutions. This programme will indeed promote industrial linkages between SMEs and large corporations.

    ***

    The Industrial Linkage Programme and Global Supplier Programme

    The Industrial Linkage Programme (ILP) aims to forge linkages between SMEs with large companies and MNCs. ... new machinery and equipment they acquire sometimes are “too productive” for limited needs i.e. they may have a market for 100 pieces but the new machinery now produces 500 pieces. ... (Solution:) selecting an industry group that has similar needs of machinery, but where the end products are different e.g.

    ***

    Loans: Fund for Small and Medium Industries and New Entrepreneur Fund

    These programmes were aimed at promoting SME activities in export and domestic oriented sector and also to help stimulate growth of SMEs. The maximum interest rates were 5% p.a. with a maximum tenure of 3 to 5 years.

    ***

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