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Finance & Development, March 1982
Article

Narrowing regional disparities by fiscal incentives: A cost-benefit analysis in designing incentives could improve their effectiveness

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
March 1982
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Jitendra R. Modi

Variations in the endowment of natural resources inevitably create regional disparities within a country. For both developed and developing countries these disparities can be so severe and their socioeconomic costs so high that responsible governments can ill-afford to ignore them. Moderating regional disparities is, in any case, often desirable to promote national unity or to enhance national security.

To alleviate such disparities, policymakers have at their disposal a wide variety of instruments: fiscal incentives (or disincentives), comprehensive national and regional planning; foreign exchange and import licenses; control of the location of economic activities; and provision of basic infrastructure and budgetary grants-in-aid. The choice of appropriate instruments depends, among other factors, on the country’s economic system, the stage of development, the constitutional structure, and the extent and duration of the regional disparities.

In practice, policymakers tend to apply a combination of the available instruments, though priorities will differ with circumstances. In a free enterprise system, such as exists in most North American and European countries, prior certification of the location of an enterprise will be relatively unimportant, while fiscal incentives play a major role. In a centrally planned economy, such as Romania or Yugoslavia, control of location of the enterprise may be an important instrument, even though it may be supplemented by budgetary redistribution or fiscal incentives (such as import duty rebates in Yugoslavia). In federally constituted countries, such as India and Nigeria, grants-in-aid to regional budgets may be a major instrument for moderating regional disparities. In most developing countries, comprehensive national and regional development plans are an important adjunct to the formulation of regional development policies, including regional fiscal incentives.

This article looks specifically at fiscal incentives since they are the most prevalent means used to narrow regional disparities—being employed both in a large number of countries and within a great variety of economic and political systems. It discusses the main features of existing fiscal incentives and, through the experience of a few selected countries, examines both the intent and the actual impact of these incentives. Finally, to redress the shortcomings in output and employment generation that have persisted despite current incentives, this article proposes the application of an alternative means of extending incentives that would allow countries to use their resources more effectively and to maximize the net social benefits from these incentives.

Current fiscal incentives

The intent of regional fiscal incentives is to attract economic activity to specific regions and thereby increase the area’s output and employment. This can be done by subsidizing, as a minimum, the additional cost of locating the plant in a developing region, so that the present value of the project would be at least equal to, if not greater than, its value in any other part of the country.

Regional fiscal incentives are currently applied in some 60 (about 40 per cent) of the Bank’s and Fund’s member countries. As the table indicates, these incentives fall into five main categories: (1) tax incentives on inputs; (2) tax incentives on output; (3) tax incentives on profits; (4) expenditure incentives; and (5) miscellaneous incentives.

Regional fiscal incentives prevalent in various countries
Tax incentives on inputsTax incentives

on output
Tax incentives

on profits
Expenditure

incentives
Miscellaneous

incentives
CapitalLaborOther
ArgentinaIsraelAustriaChileBahamas 1BelgiumAustria 2
AustraliaMexicoBahamas 1China 10BoliviaCanadaBelgium 2
AustriaBelgiumGermany, Fed. Rep. ofBrazilChileBrazil 7
BelgiumBoliviaGreeceChileDenmarkDenmark 2
BoliviaBrazil 1IndonesiaChina 10FinlandFinland 8
BotswanaChileNetherlandsColumbiaFranceFrance 2
CanadaColombiaAntillesFranceGreeceGreece 2
ChileEcuadorPhilippines 1Germany, Fed. Rep. ofIrelandIreland 1, 3
DenmarkFranceSpainGreeceIsraelIsrael 2
FinlandGreeceSri Lanka 1GuatemalaItalyItaly 2
FranceGuatemalaThailandHondurasNetherlandsJapan 2, 3
Germany, Fed. Rep. ofHondurasUruguay 1IndiaSouth AfricaKorea 3
GreeceIndonesiaWestern SamoaIndonesiaSpainMorocco 2
IndonesiaKoreaIranSwedenNetherlands
IranNetherlandsIsraelAntilles 3
IrelandAntilles 1ItalyParaguay 1
IsraelParaguayMalaysiaPeru 2
ItalyPeruMoroccoPhilippines 1, 3
JapanPhilippines 1Netherlands Antilles 1South Africa 1, 4, 5, 6
KenyaSpainNigeriaSpain 2
KoreaSri Lanka 1PakistanSweden 2
LuxembourgThailandPanamaTanzania 2, 3
MalaysiaUruguayParaguayUruguay 1, 2, 3
MexicoYugoslavia 9PeruWestern Samoa 1
NetherlandsSpainYugoslavia 12
New ZealandSri Lanka 1
NorwayThailand
Panama 1Venezuela
Papua New GuineaYugoslavia 11
Philippines 1
Portugal
Singapore
South Africa
Spain
Sweden
Switzerland
Turkey
United Kingdom
United States
Western Samoa
Sources: Price Waterhouse (U.K.), Information Guide for various countries; Her Majesty’s Stationery Office (U.K.), Income Taxes Outside the United Kingdom, 1979; Touche and Ross (U.S.A.), International Business Study for various countries; George Kopits, International Comparison of Tax Depreciation Practices, 1975; Tax Management International (U.K.), Tax Planning International Review (for Mexico), 1979; Korean Ministry of Finance, Korean Taxation, 1979; International Bureau for Fiscal Documentation (Netherlands), Supplementary Service to European Taxation; Zaikel Shosho Sha (Japan), Japanese Taxes, 1979-80; Kesselman and Kesselman (Israel), Summary Information on Business Organization, Accounting Taxation and Investments, 1979; Her Majesty’s Stationery Office, (U.K.), Alan Whiting, Economics of Industrial Subsidies, 1976; World Bank, Thailand: Toward a Development Strategy of Full Participation, 1980, and Yugoslavia: Self-Management Socialism and Challenges of Development, 1978.

Free trade zones.

Subsidized loans.

Subsidized industrial estates.

Provision of basic industrial infrastructure (water, power, transport, etc.).

Preferential utility tariffs.

Price preferences on government contracts.

Government guarantee on loans to enterprises in developing regions.

Technical assistance by government institutions in preparing feasibility study and training of employees.

Exemption from import duties on equipment and partial rebate from import tax.

Exemption from agricultural tax in “handicapped” areas and from profits tax to industrial and commercial companies in frontier areas.

Preferential treatment of foreign partners in joint ventures.

Selective credits and institutional borrowing from abroad.

Sources: Price Waterhouse (U.K.), Information Guide for various countries; Her Majesty’s Stationery Office (U.K.), Income Taxes Outside the United Kingdom, 1979; Touche and Ross (U.S.A.), International Business Study for various countries; George Kopits, International Comparison of Tax Depreciation Practices, 1975; Tax Management International (U.K.), Tax Planning International Review (for Mexico), 1979; Korean Ministry of Finance, Korean Taxation, 1979; International Bureau for Fiscal Documentation (Netherlands), Supplementary Service to European Taxation; Zaikel Shosho Sha (Japan), Japanese Taxes, 1979-80; Kesselman and Kesselman (Israel), Summary Information on Business Organization, Accounting Taxation and Investments, 1979; Her Majesty’s Stationery Office, (U.K.), Alan Whiting, Economics of Industrial Subsidies, 1976; World Bank, Thailand: Toward a Development Strategy of Full Participation, 1980, and Yugoslavia: Self-Management Socialism and Challenges of Development, 1978.

Free trade zones.

Subsidized loans.

Subsidized industrial estates.

Provision of basic industrial infrastructure (water, power, transport, etc.).

Preferential utility tariffs.

Price preferences on government contracts.

Government guarantee on loans to enterprises in developing regions.

Technical assistance by government institutions in preparing feasibility study and training of employees.

Exemption from import duties on equipment and partial rebate from import tax.

Exemption from agricultural tax in “handicapped” areas and from profits tax to industrial and commercial companies in frontier areas.

Preferential treatment of foreign partners in joint ventures.

Selective credits and institutional borrowing from abroad.

Tax incentives on inputs commonly pertain to the purchase or modernization of fixed assets, though they may also apply to employment of labor, scientific research, technological development, and training labor or management. Fixed-asset incentives usually predominate; these commonly take the form of higher rates of depreciation and of investment or “initial” allowances (or the equivalent investment credits) than are applicable in the developed regions. Assets covered by such schemes consist mainly of plants, machinery, and industrial buildings. Incentives for the use of labor usually provide exemptions from payroll taxes or the equivalent amount of tax credit, while those for the remaining inputs provide exemptions from particular taxes such as exchange, property, and registration taxes, and stamp duties.

Tax incentives on output usually extend to free enterprise zones and offer varying degrees of exemption from such taxes on production as excise, turnover, value-added, or sales taxes. Incentives may also be applied to the income or profits of the enterprises. Such incentives are usually linked to the attraction of foreign investment and they accord “pioneering status” with attendant fiscal benefits.

Expenditure incentives consist of payments by government to enterprises equivalent to certain percentages of the cost of fixed assets, the wage bill, or outlays on training, research and development, or on relocation (from the developed to a developing region). Their impact differs from that of the tax incentives in that the benefits of tax incentives accrue when taxes fall due, while expenditure incentives usually improve the enterprises’ liquidity as soon as specified expenditures are incurred. The final—miscellaneous—category of incentives often includes the subsidization of such items as the interest rates on loans, rentals of industrial estates, and utility rates.

Selected country practices

To assess the impact of fiscal incentives in particular circumstances and in the context of their intentions, this article considers the experience of selected countries from different economic systems. These countries are Ireland and Italy from the developed market-oriented economies, Brazil and Malaysia from market-oriented developing countries, and Yugoslavia from the centrally planned economies. The first two are unitary, while the last three are federally constituted countries.

In Ireland, the underlying economic rationale for incentives has been to maximize expenditures on investment and related technological change so as to generate additional employment in the designated areas. Regional incentives include investment grants to small industries (employing less than 50 persons), re-equipment and readaptation grants, subsidized rentals for land and industrial estates, low interest loans, and the provision of free management and technical services.

Over the period 1952–77, grants amounting to some US$162 million were made to the designated areas. They generated investment of $982 million and employment of 63,000 persons as compared to grants of $310 million and investment generation of $2,516 million and employment creation of 101,200 persons in the nondesignated areas. Even though each dollar of grants generated a smaller amount of investment in the designated areas ($6) than in the nondesignated areas ($8), the level of investment in the designated areas would almost certainly have been much lower and the extent of regional disparities in output and unemployment greater in the absence of incentives.

In Italy, regional incentives are extended to enterprises located in the Mezzogiorno (developing regions of Southern Italy) to raise the aggregate level of demand and thus create employment opportunities and increase output. Incentives comprise cash grants on the purchase of fixed assets, the expansion and reactivation of the existing assets, the employment of young job seekers, the training of part-time employees, and reductions in corporation and local tax rates, including reductions more recently in the social security tax.

The available data suggest that over the period 1951–71 investment and national output in the Mezzogiorno rose much faster than the national average; employment in the manufacturing and services sectors, too, grew at a slightly higher rate than the national average. The limited evidence suggests that the impact of the incentives would have been higher but for the southern region’s high marginal propensity to “import” from the north, which reduced the multiplier impact of the additional investment by raising the overall level of aggregate demand.

In Brazil, incentives have been in operation since the early 1960s for stimulating private investment in the Northeast and Amazonia regions. The Northeast region has had a much lower level of development than the national average, while the Amazonia region has remained isolated from the rest of the country since the collapse of the rubber boom in earlier years. The intent of the incentives was to increase the levels of output and employment by stimulating investment and to integrate these regions (particularly Amazonia) in the development of the whole economy. The incentives essentially provide complete or partial exemptions from income tax on profits and from import duty and related taxes on plants and machinery purchased for the establishment of an enterprise in these regions. The Government requires that the proceeds of these tax exemptions be applied in government-approved investment projects in these regions. These funds may either be deposited with one of the Government’s regional development agencies, which in turn invests in appropriate projects, or be invested by enterprises in government-approved projects of their choice. Such projects usually entail the expansion, modernization, and diversification of operations of these enterprises, already well-established in the developed (usually southern) regions, into the developing areas.

The amount of income tax exemptions extended to all enterprises in Brazil during 1961–75 amounted to some $4.1 billion at 1975 constant prices and exchange rates. Available data suggest that over this period actual investment in Amazonia alone amounted to about $1.1 billion or about one and a half times the proceeds of income tax exemptions deposited with the Superin-tendency for the Development of Amazonia. Thus, the incentives had a fairly good measure of success in inducing additional investment to meet regional demand for goods and jobs. In the absence of necessary information, the actual impact of this increased investment on the levels of regional output and employment is difficult to quantify, although it would appear to have been positive. However, the high capital/labor ratios of investment projects implemented in these regions suggest that the impact of incentives on the generation of employment appears to have been lower than it would have been had more labor-intensive projects been favored.

In Malaysia, the intent of the incentives was to encourage both the growth of investment and employment in line with the level of aggregate demand. Incentives offer longer income tax holidays (up to eight years instead of the usual five) for companies locating their operations in the specified developing regions. Qualifying criteria for the tax holiday are either an investment of $100,000 or the employment of at least 100 persons.

It would appear from the limited amount of available data that these incentives could have induced some 9.5 per cent of the total projected employment and 17.5 per cent of the proposed investment in developing regions. Although the option of either investing in fixed assets or employing additional labor represented an improvement over the requirement to invest in fixed assets, the option did not act as a deterrent to the enterprises’ tendencies to favor capital-intensive methods of production. Consequently, while the incentives encouraged entrepreneurs to invest in more labor-intensive enterprises, such as electrical and electronic industries and wood products, they did not necessarily dissuade them from investing in capital-intensive projects such as chemicals and paper products.

In Yugoslavia, the intent of the incentives is to narrow the gap between the levels of regional per capita incomes and employment by raising the level of capital formation in the less developed regions. Regional incentives consist of the Federal Fund for the accelerated development of the less developed republics by means of interregional resource transfers, the joint venture system, and a host of other incentives. The developed regions contribute to the Federal Fund for redistribution to the developing regions. Under the joint venture system, enterprises in the developed regions pooling their resources for investment with enterprises in the developing regions may deduct these investments from their obligatory contributions to the Federal Fund. Other incentives include tax preferences to foreign partners in joint ventures, reduction of import duties, selective credits by the national banking system, and preferential treatment in institutional borrowing abroad.

The limited information available on the impact of these incentives suggests that the last category of incentives probably had only a marginal impact and, further, very few enterprises have invested in the developing regions in lieu of making compulsory contributions to the Federal Fund. During the period 1971–75, however, the Federal Fund collected from each region about 2 per cent of the social sector’s output in the form of compulsory loans from enterprises and redistributed it in the form of concessionary loans to the developing regions. This redistribution was equivalent to 10 per cent of the developing regions’ output in 1974 and the grant or incentive element of it constituted over 50 per cent of the loans extended to enterprises in the developing region. However, this incentive tended to favor capital-intensity in production with insufficient regard for the lack of technical know-how and the related lower productivity of labor in the developing regions. For a further significant narrowing of regional disparities, incentives that promote labor-intensive industries in the developing regions would be preferable. Furthermore, fiscal incentives would need to be oriented to the relative pricing of factor inputs (labor, technological know-how, and capital).

Improving present policies

This selected experience with fiscal incentives yields some broad inferences regarding their effectiveness in narrowing regional disparities. In making these incentives available, policymakers have tended to emphasize the generation of additional investment in fixed assets and have consequently assumed that there would be a positive impact on output and employment. While such incentives have generally stimulated some additional investment, however, they have only in exceptional instances generated significant additional output or employment. Even where policymakers have tied incentives to any one of the several factors of production, the actual impact of such “neutral” incentives on the generation of employment appears to have been rather limited because entrepreneurs have tended to favor capital-intensive methods of production. A number of fiscal policies that might have had a more pronounced impact on narrowing regional disparities—for example, the procurement of goods and services needed by government—were attempted only in isolated instances, such as in Italy.

At the planning and implementation stages, most regional policy decisions have focused much more on the supply side (namely, investment in developing regions) than on the demand side (that is, the generation of additional aggregate demand). In most cases, too, regional incentives appear to have been ad hoc exercises. It is not altogether clear whether the entrepreneurs made use of the incentives simply because they were available or whether the incentives, in fact, raised their profitability. In either case, there appears to be considerable scope for improving the present method of policymaking.

The existing methods of formulating incentives are subject to several shortcomings. First, policymakers do not appear to be sufficiently aware of the variety of available instruments and their relative efficacy. Second, policymakers do not always state in explicit terms the intent of the incentives or define concretely the specific regional disparities they are attempting to narrow. Third, they are not generally aware of the costs of the incentives to the national fisc and the alternative ways in which, for a given cost, they can maximize the benefits of extending equivalent incentives to the enterprise, to the regional economy, and to the national fisc. It is with the first shortcoming in mind that this article has reviewed the broad variety of regional incentives. The second and third shortcomings can be partly remedied by analyzing the possible incentives in terms of the standard cost-benefit analysis, which has recently been incorporated into regional economic analysis. It should enable the policymakers to identify the particular disparities that they are attempting to narrow and to maximize the benefits from given budgetary outlays on incentives.

In contrast to the usual considerations of private costs and benefits that enter into the decision of the entrepreneur to locate or not locate an enterprise in a developing region, the application of the social cost-benefit analysis entails ascertaining the costs and benefits of plant location to the society. If, for instance, labor in a developing region is likely to be unemployed (or underemployed), the employment (or full employment) of this labor and the consequent increase in output constitutes a social benefit. However, if the productivity of such labor is likely to be below the national average (if for no other reason than the lack of complementary infrastructure), it will most likely not yield as much return on capital as would be yielded elsewhere—an opportunity cost that becomes a social cost. In addition, the plant relocation gives rise to further social costs for the entrepreneur—in outlays for relocation—and to further social benefits—in the generation of incremental output, income, and taxes. As long as these aggregate social benefits exceed total social costs for the economy as a whole, the location of an enterprise in a developing region could well result in net social benefit to the regional as well as to the national economy. By subsidizing the cost of labor to an enterprise in a developing region (through fiscal incentives) and the outlay on relocation, the policymakers would be able to narrow the gap between the private and social benefit for the entrepreneur.

In extending incentives within the framework of such cost-benefit analysis, the policymakers would first decide the magnitude of incentives that would be feasible within the overall budgetary requirements. They would then examine each application for incentives to determine the “appropriate” level and to rank different applicants according to the overall net social benefit of their operations to the economy. By replacing the current blanket extension of incentives to all “eligible” enterprises, irrespective of their actual budgetary cost, with one in which limited incentives are extended on the basis of a ranking of applicants, policymakers would be able to ensure that for a given budgetary cost they could both generate additional revenue for the national fisc—from income and consumption taxes and savings in unemployment insurance payments in excess of the cost of the incentives—and maximize the net social benefits of these incentives to the economy.

Related reading

    HarryWard RichardsonRegional Economics: A Reader (New York, U.S.A.St. Martin’s Press1970).

    Birla Institute of Scientific ResearchThe Role of Fiscal Incentives in Reducing Regional Imbalances: Some Comparisons (New Delhi, India, BirlaInstitute of Scientific Research1978).

    ChristopherBlake“The Gains from Regional Policy” in JamesNathaniel WolfeeditorCost Benefit and Cost Effectiveness: Studies and Analysis (London, U.K.George Allen and Unwin1973).

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