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Fiscal Incentives for SEZs International Best Practice

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1 Fiscal Incentives for SEZs International Best Practice
Jean-Paul Gauthier Special Economic Zones Policy and Bill Validation Workshop October 28-30, 2012 Serena Beach Resort, Mombasa

2 MoF Views on Fiscal Incentives in the Bill
The Bill relies heavily on fiscal incentives to drive SEZ development and the MOF “need[s] to understand why this is the case before [it] can recommend more fiscal incentives.” More specifically: the legal framework is not sufficiently geared toward supporting the development of specific clusters EPZs in Africa have primarily failed due to infrastructure, planning and governance constraints, both inside and outside of the EPZs, rather than due to the lack of incentives the fiscal incentives are distortionary, could lead to tax evasion, and will likely require expensive administrative mitigation measures the fiscal incentives could result in net negative economic impacts The MoT accepts that these points merit consideration

3 International Corroboration
In the 1990s, zone development in Kenya was slow, and EPZ contribution to exports and employment were below expectations: Zone exports reached just 3.5% of tot. mfg. exports The 25 % ave. ann. growth of EPZ exports in was just slightly higher than overall mfg. exports growth (22%). EPZs employed 2,855 workers in 1997, accounting for just over 1% of tot. mfg. employment While in part a reflection of Kenya’s overall economic decline over the period, performance remained relatively poor during the subsequent period of economic reforms and renewal While the EPZ programme grew dramatically over the next 6 years, it continued to account for only a small share of the Kenyan economy: EPZ exports account for approx.12% of tot. mfg .exports, equivalent to the EPZs share of manufacturing output. EPZs account for only 3.4% of tot. private sector employment Success of the EPZ programme is largely restricted to AGOA, which is at risk The OECD stated in 2007 that this showed “that incentive loaded EPZs are not automatically successful.” FIAS/World Bank, Background materials for “Assessment of the Performance of Export Processing Zones” (Unpublished, September 2004); Kagira B., Rolfe R., Woodward D., Footloose and Tax Free: Incentive Preferences in Kenyan Export Processing Zones, Biennial Conference of the Economic Society of South Africa, South Africa (September 2003); and OECD Trade Committee, Export Processing Zones: Past and Future Role in Trade And Development, TD/TC/WP(2006)39/REV1, JT (March 2007)

4 KAM Views on SEZ Bill’s Fiscal Incentives
Zone Enterprises’ permission to sell up to 100% of their goods in the domestic market distorts playing field, due to fiscal incentives -- therefore adversely affecting domestic non-SEZ enterprises [In fact, the question is whether you want the competition to come from abroad or zones. Sunk costs, locational advantages, mean relocation is unlikely] Propose assessments be carried out first to determine the impact of SEZ incentives on domestic business and, in the meantime, to limit access to the domestic market to 20% of annual production, as per the Protocol on the establishment of EAC Customs Union


6 Survey Findings If a firm would have invested in the absence of incentives, they represents a drain on government revenues. If the incentives induce investment in desirable projects, they yield long-run returns to government revenues greater than the initial revenue foregone Tax holidays reward founding a company rather than re-investment. Tax holidays thus primarily benefit short-term investments, in so-called footloose industries such as garments manufacturing The impact of these incentives on investment decisions is generally higher on small, export-oriented companies than those seeking the domestic market or location-specific advantages. One study found that for 48% of export-oriented firms, tax incentives were important to investment Many other types of investments are not profitable in the initial years. Thus, the firms would normally not owe any taxes in this period even in the absence of the tax holiday. Firms that are making a profit and repatriating dividends to their home country often remain liable in the home country for the difference in taxes paid abroad. For these firms, therefore, tax holidays see a net drain of taxes from the Kenyan to foreign treasury Barlow and Wender (1955) found that just 10% of companies listed tax concessions as a condition for FDI. Robinson (1961), Aharoni (1966), JETRO (1995), Ernst & Young (1994) corroborate these findings. The Group of 30 (1984) found that among 19 factors influencing FDI, tax incentives ranked 7th. In a Fortune/Deloitte & Touche survey (1997), taxes ranked 13th out of 26 factors Padovano & Galli, cited in Scott Jacobs, “The importance of institutions in determining the investment environment,” FIAS South Asia FDI Roundtable, Maldives (2003). Root and Ahmed (1978), Agodo (1978), Shah and Toye (1978), and Lim (1983). Reuber (1973); Guisinger (1985); Wells (1996); and Coyne (1994). Jacques Morisset and Neda Pirnia, How Tax Policy and Incentives Affect Foreign Direct Investment: A Review, FIAS (2002)

7 Econometric Time-Series
Econometric time-series estimations of the responsiveness of FDI to variations in tax rates are revealing Agodo, who analyzed US firms with manufacturing investment in 20 African countries, found tax concessions marginal as a determinant of FDI compared to infrastructure, worker training, and hassle-free bureaucracy Root & Ahmed however found that corporate tax rates are an effective investment discriminator but that tax holidays are not. Marginal rate of taxation negatively correlated with economic growth because the marginal tax rate acts as a disincentive to produce and generate income. Lower overall tax rates reduce the cost of business and induce firms to allocate capital to economically desirable projects The simplicity of a tax system may attract further investors and increase the tax base in the longer run

8 Competitive General Equilibrium (CGE) Models
CGE models taking endogenous effects of incentives into account indicate that reductions in corporate tax rates yield greater capital formation than an increase in investment or employment tax credits CGE models have also found that very high taxes deter FDI, and that a tax regime must have a competitive corporate tax regime to attract labor-intensive manufacturing investment –there is thus a need for a competitive tax rate to attract FDI The attractiveness of a fiscal incentive to an individual firm depends on the firm’s home country taxation levels Effectiveness of fiscal incentives is also greater where they make a difference between competing jurisdictions where the basic, more important conditions are more or less equivalent Shah & Baffes found that targeted incentives cause positive changes in investment in machinery and equipment, and in R&D. Accelerated depreciation policies are thus key to firms in the ICT and financial services sectors Mintz and Tsiopoulos, “Corporate Income Taxation and Foreign Direct Investment in Central and Eastern Europe,” in Fiscal Incentives for Investment and Innovation (Anwar Shah, ed.), Oxford University Press (1995) Feltenstein and Shah, “Corporate Tax Structure and Production,” in Shah (1995) Shah and Baffes, in Shah (1995) Bond and Samuelson (1986); Ernst & Young (1994) Forsyth (1972); Ondrich and Wasylenko (1993); Swensson (1994); Devereux and Griffith (1998); Morisset and Pirnia (2002)


10 Article 38(1) Duties and Excise Tax Exemptions: All licensed special economic zone enterprises, developers, operators shall be granted exemption from all existing and future taxes and duties payable under the Customs and Excise Act, East African Community Customs Management Act and Value Added Tax Act, on all special economic zone transactions subject to the limitations on goods specified in the Second Schedule to this Act and its regulations [Good practice]

11 Income Tax Exemptions: Uncompetitive –Investment Detracting-Complex
Article 38(2)b) Income Tax Exemptions: special economic zone developers and operators- for the first ten years from the date of completion of the development, except that the income tax rate shall be limited to twenty per cent for the ten years following the expiry of the exemption… [Then what? 30%] special economic zones business incubators for the first ten years from the date of the first sale except that the income tax shall be limited to twenty per cent for the next ten years…. [Then what? 30%] export processing zones export manufacturing and Export Service enterprises- For the first ten years from the date of the first sale, except that the income tax rate shall be limited to twenty per cent for the next ten years.[Then what?] 30% special economic zones technology park enterprises- For the first ten years from the date of the first sale, except that the income tax shall be limited to twenty per cent thereafter for the life of the enterprise, provided that this exemption shall not apply in respect of industrial parks, agricultural free zone enterprises and tourism and recreational enterprises and regional headquarters enterprises who shall pay income tax rate at twenty per cent. Uncompetitive –Investment Detracting-Complex

12 [No fundamental issue]
Article 38(2)c) WHT Exemptions: Exemption from the payment of withholding tax on dividends and any other payments made to non-residents during the period that the special economic zone enterprise is exempted from payment of income tax under paragraphs (a) and (b) [No fundamental issue]

13 Article 38(2)d) Stamp Duty Exemptions::
Exemption from stamp duty on the execution of any instrument relating to the business activities of special economic zone enterprise; except for Agricultural Free Zone enterprises, Regional headquarters and Industrial Park Enterprises who shall be entitled to a fifty per cent reduction of stamp duty payable; [Unecessarily complex and serving no economic rationale]

14 Local Tax Exemptions::
Article 38(2)j) Local Tax Exemptions:: Exemption from the payment of advertisement fees and Business service permit fees Good Practice


16 SEZ Tax Incentives Best Practices
Simplified incentives Automatic incentives Reduction in the number of taxes Elimination of indirect taxes Zero-rating Simplified tax administration Unified forms Reduced audits AEO status Incentives for private sector zone development National treatment Duty deferral Free transit between zones In situ administration Paper-based, selective, risk-based, inventory control Customs inspections

17 Best Practice Approach to the SEZ Fiscal Regime
The optimal tax rate for Kenyan SEZs would be one that does not unnecessarily erode the tax base, but is still attractive to both domestic and foreign investors choosing amongst various regimes. This means a rate in line with those found in the more interesting tax regimes in investors’ home countries outside of SEZs, and at least as competitive as the rates in competing tax jurisdictions in the region Based on Kenya’s solid economic assets and market advantages, a “race to the bottom”, for instance to equal Rwanda’s permanent EPZ tax holiday, is neither fiscally responsible, nor necessary The tax regime in the SEZs should be simple. In this regard, the SEZ Bill could reduce the overall tax burden on corporations through a low flat tax A number of countries in Eastern Europe, Asia, and Africa have implemented flat corporate income rates –many at levels in the 10-20% range. Some of Kenya’s key investors similarly have actual rates which may be lower still (viz., China at 5.9%, Taiwan at 13.7%, Pakistan at 17.9%) “The case for flat taxes,” The Economist (22 April 2005); Doing Business in 2013

18 Investor Country of Origin Actual Corporate Tax Rate (%)
Corporate Income Tax / Profit Tax Rates in Kenya EPZ Investor Countries Investor Country of Origin Actual Corporate Tax Rate (%) Luxemburg 4.1 Belgium 5.2 China 5.9 Singapore 6.5 Switzerland 8.9 Canada 9.3 Qatar 10.4 Croatia 11.5 UAE 12.0 Taiwan 13.7 Panama South Korea 15.1 Pakistan 17.9 Germany 19.0 Seychelles 19.9 Tanzania 20.1 Netherlands 20.9 Israel 22.8 UK 23.1 South Africa 24.4 India 24.7 Australia 26.0 Sri Lanka 26.6 USA 27.6 Kenya 33.1 PwC/IFC, Doing Business in 2012, To determine actual tax rates, a case study is used in which a company: Has a turnover of 1,050 times income per capita; makes a loss in the first year of operation; has a gross pretax margin of 20%; and distributes 50% of its net profits as dividends to the owners at the end of the second year.

19 Tax Rates in the Region Foreign branches in Uganda are taxed at a rate of 15% Newly listed companies under Kenya’s CMA are taxed at 20% Large companies in Rwanda are taxed at a rate of 23% Any rates set above these benchmarks within the Kenyan SEZ regime will encourage jurisdiction shopping within the region, and indeed within Kenya itself PwC, EAC Tax Guide (2011

20 Optimal Tax Incentive and Range to attract FDI
A Flat SEZ Tax in the 5-25% range (given the rates in the home jurisdictions of Kenya’s investors and the strong component of East Asian investment), rather than the current complex regime, based on tax holidays, followed by differentiated rebates and periods of abatement for different sectors

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