Abstract
The Selected Issues paper discusses Cambodia’s poverty and growth, private sector development, public financial management reform, and debt sustainability. It summarizes the Poverty Assessment and describes the regime of tax incentives, costs, and limits for private investment. It also summarizes the assessment of Cambodia’s Public Expenditure Management system and Public Financial Management Reform Program. It highlights the key reform priorities, and provides historical background on Cambodia’s external and domestic debt. It also includes a statistical appendix and a summary of the tax system.
III. Investment Incentives in Cambodia: A Comparison With Neighboring Countries7
A. Introduction
17. A recurring policy issue in Cambodia is whether its investment incentives are sufficient to compete with its larger neighboring countries in attracting investment. Cambodia needs to ensure that a sufficient number of new jobs are created each year to absorb the large inflow of new job seekers into the labor market. This requires sufficient investment, including from FDI, which requires a sound investment climate especially because Cambodia's domestic market is small compared to its neighbors.8 In addition to being magnets for investment due to their size and more developed economies, Vietnam and Thailand also offer investment incentives to firms. This chapter addresses the following issues:
Are Cambodia’s tax incentives presently attractive compared to those offered by its neighbors?
Are Cambodia’s tax incentives sufficiently transparent and cost effective?
B. Comparing the Generosity of Incentives
18. Comparing investment incentives across countries is difficult because they are provided along many dimensions. Incentives can consist of, for example, tax holidays, exemptions or reduced rates. In the end, however, what matters is the marginal effective tax rate on the investment’s return, which is the outcome of all taxes and incentives combined. As such, the generosity of incentives should really be evaluated by comparing individual firms’ after-tax profits with and without incentives over a prolonged period. It is also important to note that comparing tax and incentive policies across different countries should not form the basis of one-upping neighboring countries; such policies can only invite harmful tax competition and lead to significant fiscal costs with little beneficial impact on attracting investment.
19. In terms of duration of the tax holiday and terms of eligibility for direct and indirect tax exemptions, investment incentives in Cambodia appear to be broadly as generous as those provided in neighboring countries.9 Table 1 compares the coverage, duration of the holiday period, as well as the incentives provided in Cambodia to those provided in Lao P.D.R., Thailand, and Vietnam:
Investment Incentives in Cambodia, Lao P.D.R., Thailand, and Vietnam
Investment Incentives in Cambodia, Lao P.D.R., Thailand, and Vietnam
| Cambodia | Lao P.D.R. | Thailand | Vietnam | |||
|---|---|---|---|---|---|---|
| 1994 Lol | 2003 Lol | |||||
| I. Profit Tax | ||||||
| 1. Standard CIT (for legal persons) |
• 20% | • 20% | • 35% | • Generally 30%, but progressive rate for small businesses (with paid-up capital below 5 million baht) or company registered a Stock Exchange of Thailand from 20% to 25% to 30%. |
• 28% | |
| 2. Other income taxes (personal income tax) |
• Progressive rate from 0–20 percent depending on amount of taxable profits | • Progressive rate from 0–45 percent depending on amount of taxable profits | • Progressive rate from 0–37 percent depending on amount of taxable profits | • Progressive rate from 0–40 percent depending on amount of taxable profits | ||
| II. Tax Incentives | ||||||
| 1. Sectors, geographical areas, and labor qualified for incentives | Pioneer or high-tech, job creation, export tourism, agro −and processing, infrastructure, energy, rural development, environment, and Special Economic Zones (SEZ). |
Pioneer or high-tech, job creation, export, tourism, agro-and processing, infrastructure, energy, rural development, environment, and SEZ. | Regions 1, 2, and 3 (see below) | Technology, use domestic sources, job creation, basic and support industry; earn foreign exchange; growth outside BKK; infrastructure, energy conservation and environment protection. | Forestall on, infrastructure construction, mass-transit, export production and trading, offshore fishing, agricultural processing, research and services of science and technology, plant variety production, and animal breeding. |
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| 2. Tax holidays |
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3 to 7-years from the commencement of operations:
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| 3. Reduced CIT after tax holiday period or incentives provided instead of a tax holiday |
After tax holiday:
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After tax holiday:
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After tax holiday:
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| 4. Import duties and VAT exemptions |
100% on inputs for qualified sectors under II. 1. |
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Duty and taxes on import of:
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Exemptions and reduced import duty and VAT rates on inputs on exports and in certain sectors | Import duty exemptions:
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Investment Incentives in Cambodia, Lao P.D.R., Thailand, and Vietnam
| Cambodia | Lao P.D.R. | Thailand | Vietnam | |||
|---|---|---|---|---|---|---|
| 1994 Lol | 2003 Lol | |||||
| I. Profit Tax | ||||||
| 1. Standard CIT (for legal persons) |
• 20% | • 20% | • 35% | • Generally 30%, but progressive rate for small businesses (with paid-up capital below 5 million baht) or company registered a Stock Exchange of Thailand from 20% to 25% to 30%. |
• 28% | |
| 2. Other income taxes (personal income tax) |
• Progressive rate from 0–20 percent depending on amount of taxable profits | • Progressive rate from 0–45 percent depending on amount of taxable profits | • Progressive rate from 0–37 percent depending on amount of taxable profits | • Progressive rate from 0–40 percent depending on amount of taxable profits | ||
| II. Tax Incentives | ||||||
| 1. Sectors, geographical areas, and labor qualified for incentives | Pioneer or high-tech, job creation, export tourism, agro −and processing, infrastructure, energy, rural development, environment, and Special Economic Zones (SEZ). |
Pioneer or high-tech, job creation, export, tourism, agro-and processing, infrastructure, energy, rural development, environment, and SEZ. | Regions 1, 2, and 3 (see below) | Technology, use domestic sources, job creation, basic and support industry; earn foreign exchange; growth outside BKK; infrastructure, energy conservation and environment protection. | Forestall on, infrastructure construction, mass-transit, export production and trading, offshore fishing, agricultural processing, research and services of science and technology, plant variety production, and animal breeding. |
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| 2. Tax holidays |
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3 to 7-years from the commencement of operations:
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| 3. Reduced CIT after tax holiday period or incentives provided instead of a tax holiday |
After tax holiday:
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After tax holiday:
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After tax holiday:
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| 4. Import duties and VAT exemptions |
100% on inputs for qualified sectors under II. 1. |
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Duty and taxes on import of:
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Exemptions and reduced import duty and VAT rates on inputs on exports and in certain sectors | Import duty exemptions:
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Duration of the tax holiday period: comparing the duration of the tax holiday across countries is difficult because the start of the holiday is triggered by different factors. For example, in Lao P.D.R. and Thailand, the tax holiday starts after the project has commenced operations. In contrast, for Cambodia and Vietnam, a project’s commencement period does not trigger the start of the holiday. Instead, for Cambodia, a necessary condition to start the holiday is that a project results in sales, whereas for Vietnam it is the realization of taxable income.10 As a result, to compare the duration of the holiday period across these countries, one needs to look at different time profiles for the onset of sales and profit after the start of a project. In general, one can conclude that: (i) for projects generating profit soon after commencement, the average duration of the holiday period is similar in Cambodia, Lao P.D.R., and Thailand, and exceeds Vietnam’s; (ii) the length of the holiday in Cambodia and Vietnam exceeds the one in Lao P.D.R. and Thailand, for larger lengths of time between commencement of operations and the project’s first years of profits; and (iii) if profits are first posted 5 years or more after the first year of sales, Vietnam’s average holiday period is longer than Cambodia’s.
Reduced corporate income tax (CIT) rate: Lao P.D.R., Thailand, and Vietnam continue to provide reduced corporate income tax rates for a number of years after the holiday has ended. In Cambodia, this practice was discontinued after the passage of the amended Law on Investment (LoI) and its implementing subdecree, in September 2005, although there remains a 5 year transitional arrangement for firms under the old LoI with a reduced CIT (9 percent instead of 20 percent).11 From Table 1, it can also be observed that the standard corporate income tax rate (applicable once the period of incentives has ended) is lowest in Cambodia, an important fact in particular for projects with long-term operations.
Coverage of direct and indirect tax exemptions: The coverage of sectors and firms qualifying for incentives in Cambodia is wider than in the neighboring countries, with the possible exception of Vietnam. Regarding indirect incentives, Cambodia provides complete exemption of import duties and VAT for qualifying investment projects whose output is essentially for export, but also to firms operating in industries supplying to the garment and footwear sectors. Lao P.D.R., Thailand, and Vietnam use exemptions more selectively and tend to rely more on reduced rates rather than exemptions.
20. However, incentives related to profit taxes are less clear in Cambodia and made much less generous by the tax deferment provisions and withholding taxes. Cambodia does not provide a withholding tax exemption. The rate of withholding tax on dividend distributions—additional profit tax—is 20 percent, which is relatively high by international standards. As a result, profits are effectively taxed at 20 percent in case they are distributed, even if the firm enjoys a profit tax holiday.12 Furthermore, an additional 14 percent withholding tax applies if any resident taxpayer makes dividend payments to a non-resident taxpayer. Alternatively, if profits are reinvested, a firm pays either the withholding tax at a later year, or is eventually subject to the 20 percent profit tax once the holiday expires. This practice does create some uncertainty on the part of investors, with tax incentives appearing more generous than they really are. These provisions notwithstanding, firms qualifying for incentives generally prefer the profit tax exemption over the special depreciation allowance also provided as an option under the LoI.
21. Cambodia has recently begun establishing Special Economic Zones (SEZ) and Export Processing Zones (EPZ) whose fiscal regime is governed by the same incentives as those stipulated in the LoI. In this regard, Cambodia follows the international best practice of avoiding different tax incentives for firms located in SEZ/EPZ. Vietnam and Thailand, however, do not follow this practice, and provide some additional incentives in their promotion zones. As illustrated in Table 2, taking into account both the scope and duration of the holiday period offered in Cambodia’s SEZ/EPZ is broadly in line with those in the special zones in Thailand and Vietnam. For example, the duration of the tax holiday in Vietnam’s promotion zone is 2–4 years, except for high-tech zones for which it is 8 years. Thailand offers complete withholding tax exemption in its zones, while Vietnam provides for a reduced rate, essentially making the provision of direct incentives more favorable.
Investment Incentives in Promotion Zones in Cambodia, Thailand, and Vietnam
Incentives provided prior to 2004, repealed under new CIT legislation in 2004, and intended to be restored in new draft CIT legislation.
Investment Incentives in Promotion Zones in Cambodia, Thailand, and Vietnam
| Cambodia (amended LoI) | Thai EPZ/IE (industrial estate) | Vietnam EPZ/IE 1/ | |
|---|---|---|---|
| 1. Tax holidays |
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3 to 8-years tax holiday from the commencement of operations:
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Holiday not limited by commencement of operations Holiday not limited by sales taking place 1–8 years from the last day of the tax year immediately preceding the tax year in which profits are first derived:
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| 2. Reduced CIT |
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| 3. Other taxes |
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Incentives provided prior to 2004, repealed under new CIT legislation in 2004, and intended to be restored in new draft CIT legislation.
Investment Incentives in Promotion Zones in Cambodia, Thailand, and Vietnam
| Cambodia (amended LoI) | Thai EPZ/IE (industrial estate) | Vietnam EPZ/IE 1/ | |
|---|---|---|---|
| 1. Tax holidays |
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3 to 8-years tax holiday from the commencement of operations:
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Holiday not limited by commencement of operations Holiday not limited by sales taking place 1–8 years from the last day of the tax year immediately preceding the tax year in which profits are first derived:
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| 2. Reduced CIT |
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| 3. Other taxes |
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Incentives provided prior to 2004, repealed under new CIT legislation in 2004, and intended to be restored in new draft CIT legislation.
22. Further complicating comparisons with the regimes of its neighbors, Cambodia’s LoI also offers a choice of tax incentives between either a special depreciation allowance or a tax holiday. In practice most firms prefer the latter, which could be an indication that most investment is not very capital intensive, or that the accelerated depreciation option implies additional costs, for example costs of interacting with tax authorities. Put differently, the advantage of tax holidays—as opposed to other forms of tax subsidies—is that they provide benefits up front, thereby allaying the potential concern on the part of investors that their promised tax subsidies might never materialize. However, this argument in itself suggests that one of the underlying problems is that investors have little confidence in the government regarding tax matters, and this matter would be best addressed directly.
C. The Cost Effectiveness of Investment Incentives
23. Among tax incentives, tax holidays are generally regarded as a damaging form, posing significant dangers to the wider tax system:13
Tax holidays are not cost effective because profits are exempted regardless of their amount. The most profitable investments, which would have taken place in any event, benefit most.
Tax holidays have a tendency to matter most for footloose industries that tend to exit the country at the end of the holiday period. These industries are likely to bring the smallest benefit to the overall economy. Instead, firms investing in long-lived assets whose revenues may not fully recover costs during the period of the holiday, benefit least from tax holidays.
Tax holidays are open to abuse and provide many opportunities for tax avoidance. This is especially true for countries with weak revenue administrations. Thus, tax incentives present a risk to government revenue as their mere existence allows for potential abuse by investors not eligible to receive them.
24. The experience in other countries indicates that tax incentives have small effects on long-term investment relative to their fiscal cost. Recent empirical evidence suggests that the general level of corporate income taxation significantly affects the size and location of FDI in developed economies (see Gordon and Hines, 2002). In contrast, the evidence for the effect of tax incentives, especially tax holidays, at least for developing countries and emerging markets, has been more negative. For example, as noted in Guin-Siu (2004),
Malaysia (Boadway, Chua and Flatters, 1995): tax holidays failed to promote investment in desirable activities or assist infant industries and disadvantaged economic and social groups. A similar conclusion was reached for Thailand (Halvorsen, 1995), where corporate tax holidays were found to be ineffective as an investment incentive. The various incentives granted in several projects were unjustified, since their rate of return was so high that the investments would have taken place in any event regardless of the incentives.
Transition economies (OECD, 1995): on balance, tax incentives are unlikely to affect significantly the decision of investors to undertake FDI. Also, for Central Europe (Mintz and Tsipoulos, 1995), tax allowances and credits were found to be probably more cost effective than tax holidays in attracting FDI, without revenue losses.
Foreign investment decisions of Fortune 500 companies (Wunder, 2001): a survey of 75 such companies found that nontax factors were the main determinants of their location decisions.
Brazil (Estache and Gaspar, 1995): tax incentives, rather than being a decisive factor in the decision to invest, have in fact tended to reduce revenue without stimulating investment, and have significantly distorted the tax system.
Mexico, Pakistan, and Turkey (Bernstein and Shah, 1995): selective tax incentives, such as investment credits, investment allowances, and accelerated depreciation, are more cost effective in promoting investment than more general tax incentives, such as CIT rate reductions.
25. Cambodia could attract investment more cost effectively if incentives were provided in a more direct and clear manner. As a general principle, incentives that are directly conditioned on the undertaking of investments in targeted activities or locations are always more cost-effective than those that confer benefits on the outcome of such investments, such as holidays and reduced CIT rates. As a result, by changing the way incentives are provided towards investment allowances, tax credits, and accelerated depreciation, Cambodia could improve the effectiveness of incentives without expanding their scope. Tax credits in particular have the added advantage that they allow for a systematic analysis of the revenue impact of tax incentives. Indirect tax incentives, such as exemptions from import duties on goods used in the direct production of exports, are prone to abuse and their usage should be limited. Finally, the concept of a “priority period” in Cambodia is not fully transparent and creates unnecessary uncertainty for investors.
26. FDI to Cambodia would also benefit from negotiating bilateral tax treaties. First of all, tax treaties with countries that employ the world wide income approach (such as the United States) rather than the territorial approach, would allow Cambodia to tax corporate income without affecting the incentives to invest of their nationals. For example, corporate income taxes paid by a U.S. investor operating in Cambodia would be offset by a tax credit against its tax liability in the U.S. Second of all, Cambodia could benefit from entering “tax sparing” agreements with countries who entertain such agreements, such as Japan and to a lesser extent the U.K. Under tax-sparing agreements, even if a foreign investor does not pay profit tax in Cambodia because of a tax incentive (say a tax holiday), its home country ignores the incentive, calculates the Cambodian taxes that would have been paid in its absence, and grants a tax credit in that amount. Obviously, such an agreement is very attractive to both the developing country and to the investing firm, at the cost of the home country’s treasury. At the moment, Cambodia has no such “tax sparing” agreements.
27. Cambodia’s investment climate would also benefit from enhanced governance in the short run, and better infrastructure in the longer term. It is quite likely that the social rate of return from public good provision exceeds that from relying on tax incentives in Cambodia, suggesting that Cambodia’s investment climate could even be strengthened by higher revenue collection. A study comparing the cost for FDI in Asian nations finds that Cambodia’s cost of electricity is about three times higher per kwh than that in Thailand, China, and Vietnam.14 Lacking infrastructure is a major deterrent of both domestic and foreign investment. However, Cambodia’s competitiveness could be improved considerably in the short term as well. For example, a recent study by the World Bank (2004), finds that the costs of starting a business (relative to per capita gross national income) is much higher in Cambodia than in its immediate neighbors, being 19 times larger than in Vietnam, 29 times than in Lao P.D.R., and 76 times than in Thailand. In a study of the cost of corruption, Wei (2000) finds that reducing the level of corruption from that of Mexico to that of Singapore would have approximately the same effect on FDI as a reduction in the CIT tax rate of 30 percentage points. Thus, better governance and higher government revenue allocated in an efficient manner to strengthen both physical as well as human capital accumulation are likely to have large and long lasting positive effects on attracting investment and creating a competitive Cambodian economy.
D. Conclusions
The conclusions of this analysis can be summarized as follows:
Cambodia’s tax incentives appear broadly as generous as in Vietnam, Thailand, and Lao P.D.R., but withholding tax provisions make the profit tax holiday somewhat illusory and complex in reality.
Cambodia could attract investment more cost effectively if incentives were provided in a more direct and clear manner. Rather than expanding the scope of incentives, Cambodia could simplify the manner in which they are provided, for example by more directly targeting investment incentives in ways that are more transparent to investors, for example by providing tax credits.
FDI to Cambodia would benefit from negotiating bilateral tax treaties.
Cambodia’s investment climate would also benefit from enhanced governance in the short-run, and better infrastructure in the longer term.
References
Bernstein, Jeffrey I., and Anwar Shah, 1995, “Corporate Tax Structure and Production,” in A. Shah, Fiscal Incentives for Investment and Innovation, 503 –43 (New York: Oxford University Press).
Boadway, R., D. Chua, and F. Flatters, 1995, “Investment Incentives and the Corporate Income Tax in Malaysia,” in A. Shah, Fiscal Incentives for Investment and Innovation, 341 –73 (New York: Oxford University Press).
Coe, David, and II Houng Lee, et al., 2006, Cambodia: Rebuilding for a Challenging Future (Washington: International Monetary Fund).
Estache, A., and V. Gaspar, 1995, “Why Tax Incentives do not Promote Investment in Brazil,” in A. Shah, Fiscal Incentives for Investment and Innovation, 309 –40 (New York: Oxford University Press).
Gordon, Roger H., and James R. Hines Jr., 2002, “International Taxation,” in A.J. Auerbach and M. Feldstein, Handbook of Public Economics, 1935 –95 (Amsterdam: North-Holland).
Guin-Siu, Maria Teresa, 2004, “Tax Holidays,” FAD guidance note (Washington: International Monetary Fund).
Halvorsen, Robert, 1995, “Fiscal Incentives for Investment in Thailand,” in Shah, A. Fiscal Incentives for Investment and Innovation, 399 –436 (New York: Oxford University Press).
Mintz, Jack M., and Thomas Tsiopoulos, 1995, “Corporate Income Taxation and Foreign Direct Investment in Central and Eastern Europe,” in A. Shah, Fiscal Incentives for Investment and Innovation, 455 –80 (New York: Oxford University Press).
Organization for Economic Cooperation and Development, 1995, Taxation and Foreign Direct Investment: the Experience of the Economies in Transition (Paris: Organization for Economic Cooperation and Development).
Wei, Shang-Jin, 2000, “How Taxing is Corruption on International Investors?” Review of Economics and Statistics, Vol. 82, No. 1, 1 –11.
World Bank, 2004, Seizing the Global Opportunity: Investment Climate Assessment and Reform Strategy (Washington: World Bank).
Wunder, Haroldene, 2001, “The Effect of International Tax Policy on Business Location Decisions,” Tax Notes International, Vol. 24, 1331 –55.
Zee, Howell H., Janet G. Stotsky, and Eduardo Ley, 2002, “Tax Incentives for Business Investment: A Primer for Policymakers in Developing Countries,” World Development, Vol. 30, No. 9, 1497 –1516.
Prepared by Dennis Botman (FAD), Robert Hagemann (EUR), and Sodeth Ly (APD).
Investment incentives are provided under the Law on Investment (LoI) which was amended in 2003 to simplify the qualifying criteria for incentives and improve the consistency with the Law on Taxation (LoT). In general, the provision of tax incentives is not discretionary, but relatively clear and transparent eligibility criteria exist which should be enforced effectively and equitably.
In Cambodia, the duration of the “trigger period” ends either on the final day of the tax year preceding the first year of profits or after three years of sales. After the trigger period, a flat three years of exemption are automatically granted followed by the “priority period” with an additional holiday between 0 and 3 years, specified in the Financial Management Law (budget law) and depending on the economic sector.
In addition to the regular tax incentives applicable to all export industries, the garment industry has occasionally obtained special and ad hoc tax treatment, such as a 2-year extension of expiring tax holidays granted in June 2005 (the garment sector accounts for 15 percent of GDP in 2004).
In Cambodia, firms qualifying for investment incentives under the LoI are exempt from the minimum tax, which is applied as 1 percent of the annual taxpayer’s turnover and is due irrespective of the taxpayer’s profit or loss position. Although this tax does not conform to optimal tax policy, it is seen as essential for safeguarding revenue in light of still weak tax administration.
Much of the following material, including the international experience, is taken from Guin-Siu (2004). See also Zee, Stotsky, and Ley (2002).
See International Development Center of Japan, KRI International Corporation (2003), “The study on regional development of the Phnom Penh—Sihanoukville growth corridor in the Kingdom of Cambodia.