How taxation policy helps in a nation’s economic growth and recovery

Taxation policy should revolve around labor productivity and growth in sectors.

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. 

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