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Policymakers must ensure tax incentives are properly planned to attract investments and accelerate growth.
In brief
- Reductions in overall tax rates will be sweeteners of investment decisions.
- Tax incentives can be targeted to encourage investments in slow-moving sectors.
- Tax processes should be transparent, without cumbersome administration.
The million-dollar question that is being increasingly asked is – how effective is a nation’s tax incentives in attracting investments?
In the current globalized environment, where businesses operate in multiple jurisdictions and are constantly seeking greater efficiency, effective supply chain and cost reduction, countries are compelled to continuously look at ways to attract investments to accelerate economic growth that is both sustainable and equitable. Thus, the role of tax incentives has been and will continue to be an area of focus for policymakers around the world.
The downward trend of corporate tax rates
Corporate tax rates around the world have been on a declining trend over the last two decades, as countries respond to increased corporate tax competition and turn to transaction taxes such as Value Added Tax (VAT) or Goods and Services Tax (GST) to bolster government revenue. Malaysia’s corporate tax rate has gradually been lowered from 34% in the year of assessment 1993 to the current 24%. A study by the Tax Foundation, an independent non-profit tax research group based in the US, showed that the worldwide average statutory corporate income tax rate has consistently decreased since 1980, but the rate has levelled off in recent years. Around the region, corporate tax rates have continued to be on a declining trend, with Asia having the lowest average corporate tax rate of 19.52%. This is compared to the 23.57% average rate in the Organisation for Economic Co-Operation and Development (OECD) countries and 32% rate in the Group of Seven (G7) countries.
The corporate tax rate of a country is undoubtedly a key factor when it comes to investment decisions, but it is not the only consideration. Other factors such as political stability, fiscal framework, market size, availability of skilled labor , the supply chain ecosystem and infrastructure support are among other areas influencing investment decisions. That said, as countries continue to compete to attract much-needed investments, reductions in overall tax rates as well as the availability of tax incentives will be sweeteners for investment decisions. High corporate tax rates can sometimes lead to countries being eliminated from lists of potential investment destinations, even before other factors are considered. Additionally, driving down the cost of tax compliance, simplifying the tax system and providing certainty to taxpayers will also contribute to investment decisions. A study done by the OECD showed a clear correlation between the complexity, transparency and certainty of the tax system and the investment decisions by corporates.
Tax incentives to attract investments
One key characteristic of tax incentives such as tax holidays or investment allowances is that government funds are not needed upfront. Other forms of financial incentives to attract investments such as grants, or subsidies will require an upfront outflow of funds from government coffers. Regardless of the type of incentive granted, a monitoring mechanism should be implemented to estimate and confirm the outcome of the investment, to assist governments in evaluating the performance of the said investment and the multiplier benefits to the economy, and to allow governments to react quickly if it appears that the incentives offered are not producing the intended outcomes. Common conditions such as the use of local manpower, workforce training, technology and knowledge transfer and support of the vendor supply chain are typically imposed, and positive outcomes have been observed from such conditions.
Another key feature of tax incentives is that they can be targeted to encourage investments in activities or sectors that are lagging behind others, which are important to achieve desired social or environmental outcomes, or which are key to support the overall strategic growth of the economy. For example, in recent years, to encourage the use of green technology, companies undertaking green technology activities and providing green technology services are granted a Green Investment Tax Allowance (GITA) or Green Income Tax Exemption (GITE). Such measures will encourage companies to consider the quicker adoption of green technology in their businesses.
Design of tax incentive regimes
It is important for tax incentives to be transparent, without cumbersome administration. The conditions attached should be practical and achievable by businesses, whilst at the same time bringing about the desired results for the nation. The relevant investment promotion agency should provide end-to-end support to the investor, including assisting the investor in addressing queries from the tax authorities in respect of the tax incentives claimed, where relevant. Further, governments need to consider whether tax incentives should be restricted only to new investors in the country. Failure to support existing investors may result in them looking elsewhere, and it would be logical for governments to continue to incentivize existing investors who commit to expansion projects and additional investments in the country.
As long as we ensure that our tax incentives remain fit-for-purpose in light of changing investor demands and evolving international tax policies, there is no reason why we should not continue to be a location of choice for investors
Impact of the Base Erosion and Profit Shifting (BEPS) 2.0 Project on tax incentives
Pillar Two of the OECD’s BEPS 2.0 Project, which will apply in many countries from the year 2024, requires that corporate groups with group turnover of over EUR750 million pay a minimum effective tax rate (ETR) of at least 15% in each country in which they operate. Where the blended effective tax rate of all the group entities in any country is below 15%, a top-up tax will apply elsewhere, such as the jurisdiction in which the group’s ultimate parent entity is located.
Tax incentives will continue to be relevant even once Pillar Two becomes effective. For example, corporate groups which are below the EUR750 million revenue threshold will not be subject to the minimum tax rate, whilst larger groups with many entities operating in a country may still have an ETR of close to or more than 15% even if one or more of the entities are incentivized, as long as all the other entities are paying taxes at the prevailing corporate tax rate. Nonetheless, governments can expect that investors will increasingly be seeking bespoke tax incentive packages to suit their tax profiles, and larger groups may prefer grants or subsidies over tax holidays as these will have a lesser impact to their ETR.
Conclusion – to incentivize or not?
Capital is mobile and investors have many options when it comes to establishing manufacturing facilities, trading hubs or service hubs. Investors may make investment decisions based largely on the attractiveness of a country’s tax system and incentive packages, and hence tax incentives can be a powerful tool to attract investors and foster economic growth.
However, it is important to monitor the effectiveness of the tax incentives in attracting investments and bringing the desired benefits to the nation. Governments must be creative and must be prepared to modify the types of incentives offered if the incentives are not effective.
Further, countries need to move away from a “one size fits all” approach when it comes to incentives. There is an increasing need to ensure that tax incentives are tailored to the needs of the individual investor and to ensure that the incentives do not simply result in top-up taxes being paid in another jurisdiction.
Malaysia has many attractive factors that are favorable to investors, including a robust banking system, a strong logistics sector, a multi-lingual and multi-skilled workforce, abundant land and natural resources and seasoned investment promotion agencies. As long as we ensure that our tax incentives remain fit-for-purpose in light of changing investor demands and evolving international tax policies, there is no reason why we should not continue to be a location of choice for investors
Summary
Tax incentives that are agile in facing the changing environment will remain key to a nation’s growth.
The digital revolution, particularly with the internet of things, is transforming tax administrations around the world.
In brief
- Today, the tax administration systems place a heavy reliance on voluntary compliance.
- There are technology options now that provide opportunities for tax authorities to integrate the taxation processes into the systems used by taxpayers as part of their daily lives and businesses.
- The future in tax administration systems is in increasingly embedding compliance by design outcomes as well as possible step-change reductions in compliance costs for taxpayers.
Since the start of the COVID-19 pandemic, Malaysia, as with many other nations, has had to spend billions on stimulus measures to save lives and livelihoods. There is now the need to increase the nation’s revenue to fund these measures, and one obvious option is tax.
There are many views on the best methods to increase tax revenue. In Malaysia, some of the widely mentioned and sometimes hotly debated options are the introduction of capital gains tax, moving to a worldwide scope of taxation (as opposed to our existing mainly territorial regime, where foreign-sourced income is generally tax-exempt), or reinstating other taxes such as the goods and services tax (GST) and inheritance tax. Each of these options has its pros and cons.
The bigger opportunity, in my view, is not so much in introducing new taxes, rather it is in rethinking and redesigning the tax administration systems.
Today, the tax administration systems place a heavy reliance on voluntary compliance. While tax is not voluntary, the term “voluntary compliance” recognizes that in many aspects of the current tax system, taxpayers make their own choices on the reporting, calculation and payment of tax. As long as these voluntary compliance choices remain, some of the choices made will inevitably result in certain amounts of tax not being paid. This could be deliberate, or due to a lack of reasonable care or genuine mistakes made on the part of the taxpayer.
In Malaysia, it is estimated that the shadow economy accounted for 18% of our gross domestic product (GDP) in 2019. In today’s terms, this roughly translates to RM250 billion. Malaysia’s shadow economy is largely formed by non-registered businesses, the under-reporting of business income, unreported sources of income and illicit trafficking. Imagine the increase in tax revenue if we could bring these activities into the tax fold.
With the digital revolution, there are now technology options that provide opportunities for the authorities to integrate the taxation processes into the systems used by taxpayers as part of their daily lives and businesses, i.e., making tax just happen.
The bigger opportunity, in my view, is not so much in introducing new taxes, rather it is in rethinking and redesigning the tax administration systems.
To use an analogy from the OECD Tax Administration 3.0 report, this would be akin to the development of automated, self-driving cars. Today, car safety is a combination of set requirements, such as vision standards, driving tests, traffic rules and speed limits, coupled with enforcement processes such as the installation of cameras to detect speeding and other moving violations, patrolling by the traffic police and the imposition of parking fines. Despite these set conditions and controls, in essence, there is still an expectation that drivers will voluntarily exhibit responsible behavior and comply with the relevant rules.
In a world of driverless cars, however, the vehicle is an integral part of a wider system which builds-in safety through the use of algorithms and features for the vehicle to make complex decisions such as sensors picking up information from road conditions and other cars. As such, driving will be largely based on compliance by-design systems with drivers freed-up to undertake other activities.
Similarly, the future in tax administration systems is in increasingly embedding compliance by design outcomes as well as possible step-change reductions in compliance costs for taxpayers.
The core features of digital tax administration systems are:
1. Tax will be embedded within taxpayer natural systems, such that paying taxes will become a more seamless and automated experience over time, integrated into daily life and business activities
2. Many digital platforms will become “agents” of the tax authorities carrying out tax administration processes within their systems, and
3. Tax authorities will no longer be the single point of data processing and tax assessment. Instead, tax administration is conducted within a resilient network of seamlessly interacting trusted actors without one single point of reliance. The tax administration processes will therefore be increasingly in real-time or close to real-time
The use of technology has the potential to address various areas and identify players within the shadow economy, therefore creating the opportunity to recover lost tax revenue, improve taxpayer morale, and restore trust in the system. At full capacity, technology solutions can significantly drive down the level of informal activity and revolutionize the operations and organization of the tax authorities, and their interaction and relationships with taxpayers. Mandatory e-invoicing and the increase in the use of electronic payments are just two digitization options that can help to curb the loss of tax revenue arising from the shadow economy.
What has been described above is not an imaginary future state. It is already taking place. The digital revolution, particularly with the internet of things, is already transforming tax administrations around the world. In Russia, data from many checkout terminals feeds directly into the country’s Federal Tax Service. The Russian tax authorities have a comprehensive view of the entire Russian economy. With minimal human involvement, their system tracks and matches transaction data from buyers and sellers across the country. They receive the receipts of every transaction in Russia within 90 seconds. The information has exposed errors, evasion and fraud in the collection of its consumption tax, VAT, which has allowed the Government to raise revenues more quickly than the general Russian economic performance.
Russia is just one example, and perhaps the most advanced. Many other jurisdictions such as Mexico, India, Brazil, to name just a few, have also gone digital. These countries have all introduced some form of digital tax administration, such as e-invoicing, that results in transactional data being posted to the tax authorities almost in real-time.
This is the future of tax administration — digital, in real-time and with probably no tax returns even needing to be submitted. In other words, remove the “voluntary” aspects and make tax just happen.
Summary
There are many views on the best methods to increase tax revenue. The bigger opportunity is not so much in introducing new taxes, rather it is in rethinking and redesigning the tax administration systems. In Malaysia, it is estimated that the shadow economy accounted for 18% of our gross domestic product (GDP) in 2019. In today’s terms, this roughly translates to RM250 billion. The use of technology has the potential to address various areas and identify players within the shadow economy, therefore creating the opportunity to recover lost tax revenue, improve taxpayer morale, and restore trust in the system.
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