This study discusses the Philippine output gap from three perspectives and evaluates the utility of the approaches for policymaking. Incentives in the Philippines appear broadly comparable with those in neighboring countries. The reform would also improve short- and especially medium-term revenue collection. The general tax provisions and investment incentives in seven east-Asian economies are compared. The analysis focuses on stocks of foreign assets and liabilities and adopts a cross-country perspective to help determine the Philippines’ position within a broader universe of emerging market economies.

Abstract

This study discusses the Philippine output gap from three perspectives and evaluates the utility of the approaches for policymaking. Incentives in the Philippines appear broadly comparable with those in neighboring countries. The reform would also improve short- and especially medium-term revenue collection. The general tax provisions and investment incentives in seven east-Asian economies are compared. The analysis focuses on stocks of foreign assets and liabilities and adopts a cross-country perspective to help determine the Philippines’ position within a broader universe of emerging market economies.

II. Investment Incentives and Effective Tax Rates in the Philippines: A Comparison with Neighboring Countries8

14. After the successful VAT reform, rationalization of tax incentives is the next major tax policy item on the legislative agenda in the Philippines. From 2002-05, substantial deficit reduction was achieved through expenditure compression. This changed in 2006 with the successful VAT reform that netted almost 1½ percent of GDP in additional revenue. The authorities recognize the need to increase revenue in the medium term, through tax administration reform, but also through reforming tax incentives. In particular, they aim to reduce redundancy; i.e. the provision of tax incentives for activities that would have been taken place anyway.

15. Unilateral reform of tax holidays is often hampered by tax competition. One consideration for introducing tax holidays in the Philippines, like in neighboring countries, was to remain regionally competitive. This need is frequently interpreted in the narrow sense of the length of a tax holiday, rather than low effective tax rates to encourage investment and attract firm-specific, internationally mobile capital. The same consideration makes it difficult to reform the incentives regime, despite the recognition in the Philippines and other countries that tax holidays may come at significant fiscal cost.

16. Rather than just the length of the tax holiday, the effects of the overall taxation regime on investment should be taken into account. In this context the paper asks the following questions:

  • What are the characteristics of business taxation in the Philippines relative to neighboring countries? We focus on the overall corporate income tax rate, tax incentives, as well as other provisions that affect incentives to invest such as depreciation methods and allowances, the profitability of an investment project, and whether it is financed through debt or equity.

  • What are the effects of tax holidays on incentives to invest? We review the theoretical and empirical literature, which suggests limited effectiveness of tax holidays in attracting additional, especially long-term, investment. Instead, a broader view of the tax system is stressed, with a focus on the general corporate income tax rate and depreciation allowances.

  • How do effective tax rates in the Philippines compare to those in neighboring countries? We extend the methodology by Devereux and Griffith (2003) to evaluate tax incentives and calculate the marginal effective tax rate (METR) and average effective tax rate (AETR) to assess the impact of the tax system including income tax holidays on incentives to invest.

  • What is the likely effect of abolishing the income tax holiday on investment incentives? We analyze the effect on effective tax rates of recent reform proposals under consideration in the Philippines, in particular, the Department of Finance (DoF) sponsored legislation to replace tax holidays with a reduced corporate income tax rate for select exporting companies or a 5 percent tax on gross receipts.

A. A Birds-Eye View of the Taxation Regime

17. The corporate income tax rate in the Philippines is higher than in neighboring countries (Table 1). The Philippines increased the standard CIT rate as part of the EVAT reform to 35 percent in November 2005 and plans to reduce the rate to 30 percent by 2009. The latter reform would make the rate identical to the ones in Indonesia and Thailand. For domestic corporations, the tax base is net world-wide income while for resident foreign corporations, the tax base is net Philippine-source income. Regarding depreciation allowances, unlike its neighbors, the Philippines does not prescribe the method or allowable rate. Instead, it allows the straight-line, double-declining balance, or the sum-of-the-years-digits methods, while the rates are based “on economic or useful lives of the asset or the ones used for financial reporting”. The maximum rate of personal income taxation is comparable to other economies.

18. Incentives in the Philippines appear broadly comparable to those in neighboring countries. Table 1 compares the coverage, duration of the holiday period, as well as other incentives provided in the Philippines to those provided in Lao P.D.R., Thailand, Vietnam, Malaysia, Cambodia, and Indonesia:

  • Duration of the tax holiday period. The duration of the holiday period is very similar and usually ranges between 3 and 8 years. The investment incentives broadly target export and technology oriented firms and aim to promote investment in remote or less developed areas. Loss-carry-forward provisions range from 3 years in the Philippines and Lao P.D.R. to 5 years in the other countries except Indonesia (10 years) and Malaysia which offers unlimited loss carry-forward.

  • Reduced corporate income tax (CIT) rate. Lao P.D.R., Thailand, and Vietnam provide a reduced corporate income tax rate for a number of years after the holiday has ended. This practice ended in Cambodia in September 2005 and is also absent in the Philippines, Malaysia, and Indonesia. However, some firms in the Philippines are subject to a 5 percent tax on gross income, rather than the standard CIT rate, after the holiday expires.

  • Other considerations. Regarding indirect incentives, most countries provide complete exemption of import duties and VAT for qualifying investment by exporters and, in some cases, also to supporting industries. Lao P.D.R., Thailand, and Vietnam use exemptions more selectively and tend to rely more on reduced rates. The Philippines offers a deduction for infrastructure spending and labor expenses under certain conditions.

B. International Experience with Tax Holidays

19. International experiences indicate that tax incentives have mixed results in attracting investment.9

  • Developed countries. There is considerable evidence that differences in international taxation affect the volume, location, and character of FDI in developed economies—see Gordon and Hines, 2002.

  • Transition economies. An OECD study (OECD, 1995) concludes that on balance, tax incentives are unlikely to affect significantly the decision of investors to undertake FDI. In addition, for Central Europe, Mintz and Tsipoulos (1995) find that tax allowances and credits, combined with a moderate tax rate, were probably more cost effective than tax holidays in attracting FDI.

  • Fortune 500 companies. A survey on foreign investment decisions of 75 of these companies found that nontax factors were the main determinants of their location decisions (Wunder, 2001).

  • Brazil. Estache and Gaspar (1995) argue that tax incentives are in fact better at reducing revenue than being a decisive factor in the decision to invest. Hence, they have significantly distorted the tax system rather than stimulating investment.

  • Mexico, Pakistan, and Turkey. Bernstein and Shah (1995) conclude that selective tax incentives, such as investment credits, investment allowances, and accelerated depreciation, are more cost effective for the fiscal authority in promoting investment than selective CIT rate reductions.

20. Tax holidays, in particular, are generally not well targeted and therefore regarded as the most damaging form of tax incentives. One advantage of tax holidays—as opposed to other forms of tax subsidies—is that they provide benefits up front. Indeed, Doyle and van Wijnbergen (1984) show that an initial period of tax concessions followed by gradually rising tax rate can be the outcome of a sequential bargaining process between firms that incur fixed costs of investment and the government. However, the evidence on tax holidays in emerging markets is largely negative, as detailed in Guin-Siu (2004).

  • Country experience. In Malaysia, Boadway, Chua and Flatters (1995) find that tax holidays failed to promote investment in desirable activities or assist infant industries and disadvantaged economic and social groups. Thailand: Halvorsen (1995) similarly concludes that corporate tax holidays were ineffective as an investment incentive arguing that the rates of return in several projects were so high that the investments would have taken place regardless of the incentives (redundancy).

  • Problems in cost effectiveness. Because profits are exempted regardless of their amount. The most profitable investments, which would have taken place in any event, benefit most. Estimates for the Philippines indicate that the revenue loss from redundant incentives could be as large as 1 percent of GDP, providing a windfall gain to receiving firms (Reside, 2006).10

  • Attractive to footloose industries. Such firms 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.

  • Open to abuse. The rules provide many opportunities for tax avoidance (for instance by using transfer pricing or other devices to shift earnings into holiday companies). This is especially true for countries with weak revenue administrations and insofar leakage occurs from special economic zones. Thus, tax incentives present a risk to government revenue as their mere existence allows for potential abuse by investors not intended to receive them. To mitigate these risks, as is the practice in the Philippines, it is important that firms receiving holidays still complete tax returns.

  • Possible WTO consistency issues. Favorable corporate tax treatment for the export sector could be run afoul of international trade rule, except for the lowest income countries.

  • Interaction with tax laws elsewhere. If the home country of the foreign investor operates a worldwide system of taxation, without tax sparing, then the impact of the holiday may be diluted once profits are repatriated. This is because the home country ultimately ensures that repatriated earnings pay tax at its own rate, so any reduction in liability in the Philippines is exactly offset by increased liability there. However, in practice concerned firms are quite successful in avoiding such payments by delaying repatriation and therefore still benefit from tax holidays.

21. Some of the difficulties are aggravated by the well-documented complicated system of granting and overseeing the provision of tax incentives in the Philippines. There are about ten investment promotions agencies (IPAs) and several national government agencies involved in managing investment activities and administering tax incentives. These include the Board of Investments (BOI), the Philippine Economic Zone Authority (PEZA), the Subic Bay Metropolitan Authority (SBMA), the Clark Development Corporation (CDC), and other bodies mandated by various laws to establish, maintain, and manage special economic or free port zones (see Aldaba, 2006).11 BOI-registered enterprises are allowed income tax holiday up to eight years, tax and duty free importation of spare parts, and tax credits on raw materials (Aldaba, 2006). Under Executive Order 226, the incentives for importing capital equipment duty and tax free and tax credit on purchase of domestic capital equipment expired in 1997. After the lapse of the income tax holiday, the standard corporate tax rate will apply to BOI enterprises. PEZA grants the most generous incentives including income tax holiday, basic income tax rate of 5 percent on gross income, and tax and duty free importation of capital equipment, spare parts, and raw material inputs. Except for the income tax holiday, Clark and Subic enterprises enjoy the same incentives available to PEZA registered enterprises.

C. Effective Tax Rates

Methodology

22. In the end what matters is the marginal effective tax rate (METR) and the average effective tax rate (AETR) and these are determined by all taxes and incentives combined. The METR matters for incentives for incremental domestic investment and the AETR—compared with those available in other countries—for discrete rent-earning investments of multinationals. Statutory rates determine incentives for profit shifting (e.g., through manipulation of transfer prices).

23. A hypothetical investment project is used to calculate effective tax rates along the lines developed by Devereux and Griffith (2003). The AETR measure is based on a simple model that can incorporate discrete investment decisions, based on a value-maximizing firm. The AETR determines the level of the post-tax net present value of an investment project and as such its location. Conditional on the choice of location, the size of investment depends on the “effective marginal tax rate”. Typically, countries appear to have the AETR in mind when referring to the need for tax holidays to remain internationally competitive.

24. The analysis of the impact of the current tax regime is assessed by the difference in the net present value of rent generated with and without taxes scaled by the net present value of the expected income stream. The METR is defined for an investment whose economic rent is zero; i.e. a project that just breaks even. The AETR is equal to a weighted average of the METR and the statutory tax rate, and could potentially be adjusted for personal income taxes. As the rate of profit increases, the measure converges to the statutory corporate income tax rate (see Devereux and Griffith, 2003, for further details).

25. We extend the Devereux and Griffith (2003) methodology to incorporate the effects of tax holidays on effective tax rates. The original derivation in the paper by Devereux and Griffith is calculated for a one-period perturbation in the capital stock; i.e., they analyze an investment of one unit of capital that is held for one year and then sold at its remaining value. While this is simple and in many cases appropriate, it is not useful for the study of tax holidays, which typically last longer than one period. We have therefore adapted the framework to study a permanent increase in the capital stock by one unit, which is slowly disinvested over time through depreciation.12 Returns to capital are tax-free during the tax holiday and taxed thereafter, with carry forward of unused depreciation.

26. The calculation of effective tax rates takes into account the main characteristics of a country’s corporate income taxation. As it is not feasible to include every aspect of tax codes, covering often hundreds of pages, the measure used in this paper takes into account the key taxes specific to an investment project, based on the expected profitability, financing source and potential applicability of tax incentives. Besides the statutory tax rate, the depreciation method and rate have an important bearing on effective tax rates. In this regard, we distinguish between investment in buildings and plant and machinery as these are guided by different depreciation regimes. Moreover, the choice of financing is taking into account, in particular the interest deductibility in the case of debt finance. As the countries considered have open capital accounts and most have similar taxation of capital gains and dividends we ignore personal income taxation for simplicity (see Klemm, 2006, for a discussion of the effects of personal income taxation on effective tax rates).

27. Effective tax rates are sensitive to a number of assumptions, in particular the profitability of a project and the manner in which it is financed. As a result, we calculate the effective tax rates for different levels of profitability and for debt and equity financed investment projects. Furthermore, we explore the sensitivity to the assumed economic depreciation rate of investment, in contrast to the depreciation allowed under the tax law.

28. The measures derived below do not incorporate loss-carry forward provisions, which could possibly affect the results for countries with a long provision. Also, the calculations below do not account for reduced corporate income tax rates after the tax holiday has ended, such as in Vietnam. Additional assumptions include: (i) the level of inflation is set equal to 3.5 percent in all countries; (ii) in line with other applications, economic depreciation for buildings is set equal to 3.61 percent, and for plant and machinery equal to 12.25 percent; and (iii) since the depreciation method and allowance for the Philippines is not specified, we assume that firms select the straight-line balance method at 5 percent for buildings, and the declining-balance method at 25 percent for plant and machinery, in line with regional practice.

D. Estimation Results

29. For companies that do not receive tax incentives, effective tax rates in the Philippines are higher than in neighboring countries (Figure 1). The marginal effective tax rate is similar to its neighbors, for investment in both buildings and plant and machinery, but as profitability increases, the average effective rate converges to the statutory CIT rate, which is the highest in the Philippines. This conclusion also applies for debt financed investments, although rates are lower due to interest deductibility. In general, the less generous the depreciation allowance and the higher the CIT rate, the more a firm benefits from interest deductibility, which explains why the Philippines has relatively low effective tax rates for debt financed investments. Marginal effective tax rates are negative under interest deductibility, although a firm will only benefit from this if it has other profits against which these losses can be deducted, for example from profits made in other branches or possibly from foreign sources—although the latter is not allowed in most countries—or in case there is a long loss-carry-forward provision, as for example in Malaysia. Since the difference between tax and economic depreciation is smaller for buildings, effective tax rates are somewhat higher—in the remainder of the paper we focus on plant and machinery.

Figure 1.
Figure 1.

Effective Tax Rates (in percent): No Tax Incentives

Citation: IMF Staff Country Reports 2008, 120; 10.5089/9781451831429.002.A002

Source: Fund staff calculations.

30. Effective tax rates on capital usually tend to be higher in large and advanced economies compared to emerging markets, but not in the case of the Philippines (Figure 2). A small economy that reduces its corporate income tax rate will lose relatively little revenue relative to a larger economy as the additional investment attracted is larger as a share of GDP. Furthermore, advanced economies tend to have a stronger investment climate implying that location decisions of investment are less sensitive to tax rates. Nevertheless, by comparing effective tax rates internationally, it can be observed that the rates in the Philippines, average rates in particular, tend to be high relative to its stage of economic development.

Figure 2.
Figure 2.

International Comparison of Effective Tax Rates for Companies not Receiving Tax Incentives 1/

Citation: IMF Staff Country Reports 2008, 120; 10.5089/9781451831429.002.A002

Source: Fund staff calculations.1/ See Devereux, Griffith, and Klemm (2002) for estimates for effective tax rates for advanced economies. Although these estimates are based on a one-period perturbation of the capital stock, it can be shown that because of the treatment of depreciation in this paper, the rates are identical.

31. Tax incentives are broadly comparable in the Philippines and neighboring countries and reduce effective tax rates significantly. Figure 3 illustrates effective tax rates for firms receiving the maximum duration of the holiday in each country. It should be noted that the effective tax rate is positive under the holiday, because there is a tax payment to be made after the holiday. As the firm is forward-looking, when deciding whether to invest it takes into account, but discounts, the real payments that need to be made after the holiday expires. Given that most of the asset will be depreciated by then for tax purposes, the proportion of profit subject to tax will in fact be quite high. However, because of the many tax free years and because of discounting, the resulting tax rate is still very low early in the holiday period. The effective tax rates faced by firms on equity-financed investments made in the first year of the holiday is between 7-10 percent in the Philippines for plant and machinery and about 11½ percent for buildings. Vietnam’s rates are lower, not because of more generous tax incentives, but because the CIT rate after the holiday is lower. Effective tax rates for debt-financed investments are lower, as not all of the interest deductibility is exhausted during the holiday period.

Figure 3.
Figure 3.

Effective Tax Rates (in percent): Companies Receiving the Maximum Tax Holiday

Citation: IMF Staff Country Reports 2008, 120; 10.5089/9781451831429.002.A002

Source: Fund staff calculations.

32. The tax holiday in the Philippines becomes more generous if firms optimally select the depreciation deduction. In principle, firms receiving a tax holiday will face a lower effective tax rate if tax depreciation is more backloaded. Since firms in the Philippines have an option to select the depreciation method and amount, Figure 3 underestimates the generosity of the holiday in the Philippines. Firms have an incentive to choose a method and level of depreciation that maximizes the residual depreciation allowance after the holiday expires. In doing so, for investment in both buildings and in plants and machinery, a firm can significantly lower effective tax rates—aligning them with those in Vietnam (Figure 4). For plant and machinery, using the declining balance method at 6.2 percent per year, leaves about 60 percent of the asset to be depreciated for tax purposes, rather than 10 percent in our baseline. For buildings, depreciating at a lower rate than the 5 percent assumed in the baseline would not reduce effective tax rates as the higher residual value for depreciating purposes it more than outweighed by the lower depreciation rate itself. Instead, a firm can reduce effective tax rates by choosing depreciation of about 11 percent per year. Thus, accelerated depreciation—depreciation exceeding “true” economic depreciation—may sometimes offer a benefit even when a firm receives a tax holiday.

Figure 4.
Figure 4.

Sensitivity of Effective Tax Rates (in percent) to Depreciation Decision: Maximum Tax Holiday

Citation: IMF Staff Country Reports 2008, 120; 10.5089/9781451831429.002.A002

Source: Fund staff calculations.1/ Assumes 5 percent (straight-line) depreciation for buildings and 25 percent (declining balance) for plant and machinery.2/ Assumes 10.83 percent (straight-line) depreciation for buildings and 6.125 percent (declining-balance) for plant and machinery.

33. Tax holidays are most attractive for highly profitable investments, possibly, but by no means necessarily creating redundancy. As noted in Section III, one disadvantage of tax holidays is that incentives may be offered to firms that would have invested without them as well. We indeed find that incentives are most beneficial at high profit rates, but whether this leads to redundancy depends critically on whether the rents from the investment are firm or location specific and thus whether the holiday is well-targeted. By reducing effective tax rates, holidays increase incentives more for FDI and new investment than for incremental investment. As noted previously, for the former the AETR matters, while for the latter the METR is critical and holidays reduce average more than marginal rates for equity financed investment. Holidays are not attractive for incremental debt financed investments unless negative taxes are offset elsewhere or carried forward.

34. Tax incentives are most attractive for investing in short-lived assets (Figure 5). Focusing on equity financed projects, effective tax rates under the maximum tax holiday increase as economic depreciation declines. This supports one criticism of tax holidays that they tend to support foot-loose companies. In the extreme, effective tax rates are zero on investment projects in short-term capital that fully depreciates before the end of the holiday.

Figure 5.
Figure 5.

Effective Tax Rates (in percent): Impact of Tax Incentives on Short- or Long-Lived Assets 1/

Citation: IMF Staff Country Reports 2008, 120; 10.5089/9781451831429.002.A002

Source: Fund staff calculations.1/Economic depreciation for plant and machinery for short-lived assets is assumed at 12.5 percent (baseline), while long-lived assets have a depreciation rate of 6.25 percent. Economic depreciation for buildings for short-lived assets is assumed at 3.61 percent (baseline), while long-lived assets have a depreciation rate of 1.81 percent.

35. Effective tax rates increase rapidly as the holiday expires, especially for profitable firms (Figure 6). This result is consistent with Mintz (1990) who also concludes that tax holiday provisions for investment in long-lived assets are not as generous to the firm as one might initially believe. This characteristic of holidays implies on the one hand an advantage, in the sense that the benefits are provided upfront, but also has the undesirable side effect that firms have an incentive to lump all investment together at the moment the holiday starts. It also highlights the incentives for firms as the holiday progresses to try to organize new investment by registering a new company or through a joint venture, or instead to leave the country altogether as the holiday expires. As illustrated, marginal effective tax rates towards the end of the holiday period can in fact be higher than when the holiday ends. This finding supports the hypothesis in Mintz (1990) that the difference between the effective tax rate with and without the holiday at some point becomes smaller than the cost to the firm from not being able to deduct depreciation.

Figure 6.
Figure 6.

Effective Tax Rates (in percent): Under Different Holiday Years Granted/Remaining

Citation: IMF Staff Country Reports 2008, 120; 10.5089/9781451831429.002.A002

Source: Fund staff calculations.

E. Incentive Reform in the Philippines

36. Several countries have recently started to move away from special incentives systems:

  • Egypt. A new income tax law was passed in mid-2005 that reduced the top marginal tax rates on income and profits from 32 to 20 percent for individuals and from 40 to 20 percent for corporations and partnerships (rates for petroleum, the Suez Canal authority, and the central bank were left at 40 percent). This reform also increased the exemption threshold, liberalized depreciation, broadened the tax base by eliminating deductions, and provided for the phasing out of tax holidays while grandfathering current beneficiaries. Importantly, these reforms have been accompanied by extensive and continuing reforms of tax administration, including the successful introduction of self-assessment and a reform of the tax treatment of SMEs.

  • Mauritius. The 2006 budget speech announced a package of reforms including the integration of EPZ (export processing zone companies and others) and non-EPZ sectors, the removal of all existing provisions relating to tax credits and tax holidays. At the same time, the corporate tax rate was reduced from 25 to 22.5 percent with a view to reducing it to 15 percent by 2009 (with the intention of also taxing personal income at the same flat rate). Depreciation is to be shifted from straight line to declining balance for all assets, except for non-hotel buildings, and the ceiling for equipment or machinery to be fully expensed in the first year will be raised from Rs 10,000 to Rs 30,000.

  • The Slovak Republic. In 2004, a single rate of 19 percent was adopted and applied to both corporate and personal income. The reduction in the corporation tax, previously at 25 percent, was combined with more rapid depreciation, more generous carry forward rules, the elimination of tax holidays for new enterprises and tighter rules in respect of provisioning and reserves.

37. The DoF sponsored Bill for reforming tax incentives strengthens incentives to invest relative to the current tax holidays by lowering effective tax rates (Figure 7). There are currently several bills under consideration in the Philippines to reform tax incentives, some abolishing tax holidays and others lengthening the holiday period (Box 1). Some of the proposed bills in the House would further extend the length of tax incentives to up to 20 years. Instead, the DoF sponsored bill abolishes tax holidays and instead proposes to give select exporting firms the option of either a 25 percent CIT rate or a 5 percent tax on gross receipts. The implied METR for equity-financed investments is found to be lower than under tax holidays and the AETR is lower still. In fact, effective tax rates are lower even for firms making investment in the initial year of an eight-year holiday period, while in practice the average holiday granted in the Philippines is four years. Furthermore, by maintaining a constant rate over the lifetime of investment projects, further investment is not discouraged as under tax holidays. Firms using equity financing will prefer the 5 percent tax on gross receipts, especially if profitability is high. For low and intermediate levels of profitability, firms using debt financing will instead opt for the 25 percent CIT rate on taxable income to take advantage of interest deductibility. Also, for debt-financed investment projects, AETRs would be lower than those at the start of even the maximum holiday period. Since we concluded previously that investment incentives are broadly comparable to those in neighboring countries, the DoF supported Bill would ensure that the Philippines remains an attractive destination for firm-specific, internationally mobile, investment, at least from a taxation perspective.

Figure 7.
Figure 7.

Effective Tax Rates (in percent): Current Incentives and Reform Proposals

Citation: IMF Staff Country Reports 2008, 120; 10.5089/9781451831429.002.A002

Source: Fund staff calculations.

38. Firms that face considerable uncertainty or those that have large non-deductible costs will also have stronger incentives to invest under the DoF sponsored legislation than under the current tax holiday, although to a smaller extent. As mentioned, one advantage of tax holidays is that they provide benefits upfront. Essentially, holidays are a form of risk sharing between the government and the firm and this may be particularly attractive for firms that face uncertainty about the prospects o their investment, as formalized here by a high discount rate. However, even after doubling the real discount rate to 20 percent, the 5 percent tax on gross receipts still provides stronger incentives than for investments made with four years holiday granted or remaining (text chart). Apart from allowances for depreciation and interest expenses, the definition of gross receipts in the DoF sponsored legislation does also not allow the deduction of marketing, administrative, and selling costs. As illustrated in the chart below, even if these costs amount to 50 percent of pre-tax profits investment incentives are stronger under the DoF sponsored bill than for firms receiving less than seven years tax holiday.13

uA02fig01

Sensitivity Analysis: High Discount Rate, Non-Deductible Costs

p = 0.20; equity financed; plant and machinery; in percent

Citation: IMF Staff Country Reports 2008, 120; 10.5089/9781451831429.002.A002

Source: Fund staff calculations.1/ Non-deductible costs are equal to 50 percent of pre-tax profits.2/ Assumes a real discount rate equalt to 20 percent, instead of 10 percent in the baseline

39. The reform would also improve short- and especially medium-term revenue collection. Unlike under tax holidays, the effective tax rates by firms faced under the DoF supported proposal will lead to actual tax payments. As a result, revenue collected under the reform will increase. Furthermore, the reform would reduce redundancies. As firms currently receiving a holiday will be grandfathered, higher revenue from exporting firms is likely to be modest in the very short term.

40. By aligning incentives, the DoF supported Bill also offers the opportunity for a significant streamlining of the institutional structure governing the granting and oversight of tax incentives. Essentially the abolition of the tax holiday would bring incentives provided by the Board of Investments (BOI) and the Philippine Economic Zone Authority (PEZA) more in line with those provided by the Subic Bay Metropolitan Authority (SBMA) and the Clark Development Corporation (CDC), while adding the option for a reduced CIT rate. Indeed, the DoF supported Bill proposes a major restructuring of the regulatory agencies, effectively merging BOI and PEZA into a single organization—the Philippines Investment Promotion Agency. Furthermore, incentives are likely to be focused on exporters—either new exporters or those expanding existing operations. In addition, the bill mandates submission of a tax expenditure budget each year to the Congressional Oversight Committee.

Incentive Reform Bills Under Consideration in the House of Representatives

Four Bills for reforming tax incentives in the Philippines have been tabled in the House. The Bills differ markedly in terms of reforming the income tax holiday (ITH) and the government agency to take the lead in formulating and monitoring incentives policies. Other incentive policies in the bills are quite similar, such as offering double deduction for training and R&D, accelerated depreciation, and loss-carry forward provisions.

House Bill No. 2278—Introduced by Representative Javier (Department of Finance (DoF) sponsored bill) and House Bill No. 2712—Introduced by Representative Almario.

Incentives. Phase out of ITH within three years, offering instead a 25 percent CIT rate on taxable income or a 5 percent tax on gross income earned in lieu of all national and local taxes, except real property tax on land. Applies to registered exporting firms and firms located in the 30 poorest provinces. Gross income is defined as gross revenue net of sale discounts, sales returns, and allowances minus cost of sales or direct costs, but before deductions for administrative, marketing, selling, operating expenses, or incidental losses.

Institutional reform. DoF formulates and monitors tax and nontax incentives policies; Board of Investments (BoI) in charge of investment promotions; Philippine Economic Zone Authorities (PEZA) and other Investment Promotion Agencies (IPAs) implement investment laws.

Other considerations. Evaluate rationale for a tax expenditure budget, possibly as part of the annual General Appropriations Act; export enterprises registered with IPAs and located inside the ecozones or Free Ports are VAT exempt on imports of capital equipment; registered firms with PEZA and located outside ecozones or freeports are subject to VAT and Customs Duty Refund Mechanism through a Trust Liability Account.

House Bill No. 2530—Introduced by Representative Cua.

Incentives. Exporting firms regardless of location entitled to eight years ITH; after ITH, reduced CIT rate of 15 percent for twelve years; after ITH for firms in Special Economic Zones, Free Trade and Freeport Zones, a five percent tax on gross income in lieu of all national and local taxes, except for real property tax on land, and a twelve-year investment tax allowance of thirty percent. Firms in 30 poorest provinces can choose either an eight year ITH or a reduced CIT rate of 15 percent for 20 years. Micro, small, and medium enterprises are entitled to eight years ITH. Fiscal incentives can be extended beyond twenty years for industries deemed indispensable to national development as determined by the Industrial Development Board (IDB).

Institutional reform. BOI will be the national investments promotion agency attached to the Department of Trade and Industry (DTI). Creation of the IDB (consisting of BOI, PEZA, and other IPAs), attached to the DTI, responsible for development programs, including formulating and monitoring incentives policies.

Other considerations. Exemption of taxes and customs duties for import of capital equipment.

House Bill No. 1757—Introduced by Representative Javier (similar to HB 3295 which failed to win Senate approval in the previous Congress).

Incentives. ITH of four years in highly developed areas, six years in less developed areas or producing/rendering new products/services with strong backward or forward linkages, and six years for exporting firms (eight years if located outside Metro Manila). Additional investments in the project, if listed in the initial investment priorities plan, will also receive eight years ITH, with a maximum of twenty years total ITH. Instead of ITH, 5 percent tax rate on gross income earned in lieu of local and national taxes, except real property tax on land (not available to BOI registered companies).

Institutional reform. BOI shall be responsible for the regulation and promotion of investments and granting of incentives to registered companies and monitoring investment promotion of all IPAs.

Other considerations. Zero rating of VAT of inputs from domestic manufacturers for the production of machinery and capital equipment.

F. Conclusions

41. We compared the general tax provisions and investment incentives in seven east-Asian economies—the Philippines, Malaysia, Indonesia, Lao, Vietnam, Cambodia, and Thailand—in order to provide input into the ongoing debate in the Philippines about reforming tax holidays. Instead of focusing on one aspect of incentives, such as the length of the tax holiday period, we argued for considering the overall structure of taxation and we estimated the effective marginal and average effective tax rates accordingly. Our conclusions can be summarized as follows:

  • For companies that do not receive tax incentives, effective tax rates in the Philippines are higher than in neighboring countries.

  • Tax incentives are broadly comparable in the Philippines and neighboring countries and reduce effective tax rates significantly. The wedge between taxation of companies with and without tax incentives in the Philippines is one of the largest.

  • Tax holidays are most attractive for highly profitable investments, possibly, but by no means necessarily, creating redundancy. Whether incentives on highly profitable investment cause redundancy depends critically on whether the profits are firm or location specific, and in the former case an average effective tax rate in line with neighboring countries will be essential to attract investment.

  • Holidays are more effective in providing incentives for FDI and new investment, rather than incremental investment. As noted previously, for the former the AETR matters, while for the latter the METR is critical and holidays reduce average more than marginal rates for equity financed investment.

  • Tax holidays are most attractive for investing in short-lives assets. Focusing on equity financed projects, effective tax rates under the maximum tax holiday increase as economic depreciation declines. We also found that effective tax rates increase rapidly as the holiday expires, especially for profitable firms. As such, footloose companies benefit more from income tax holidays.

  • The DoF supported Bill compares favorably to other Bills tabled in the House for reforming incentives.

  • Under most circumstances, introducing the DoF legislation and abolishing tax holidays reduces effective tax rates and improves incentives to invest, while also improving short- and medium-term revenue collection. Investment incentives would only decline for firms investing in short-term capital that is fully depreciated at the end of their holiday period.

  • The DoF supported Bill also offers the opportunity for a significant streamlining of the institutional structure governing the granting and oversight of tax incentives.

References

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Annex II.I. Investment Incentives in Cambodia, Lao P.D.R., Thailand, and Vietnam

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Annex II.I. Investment Incentives in Malaysia, the Philippines, and Indonesia

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Sources: KPMG Asia Pacific Taxation, 2003; Fletcher 2002, Tax Incentives in Cambodia, Lao P.D.R. PDR, and Vietnam, IMF (unpublished); Cambodia: Investment Law 1994 and its 2003 Amendment, and Law on Taxation; Lao P.D.R. PDR: Law on the Promotion of Foreign Investment and its draft subdecree, 10/22/2004; Thailand: Board of Investment, Labor Law and Land Law; Vietnam: Law on Foreign Investment, Labor Law and Land Law; Business Issues Bulletin Number 2, IFC/MPDF, 2004; Chalk, 2001, Tax Incentives in the Philippines, IMF Working Paper 01/181, Washington, DC; FIAS, 2007, Transition Issues in Investment Incentives Reform, Draft, April; Various editions of deloitte tax guide.
8

Prepared by Dennis Botman (FAD), Alex Klemm (FAD), and Reza Baqir (APD).

9

The international experience is described in detail in Guin-Siu (2004). See also Zee, Stotsky, and Ley (2002).

10

Reside (2006) first analyzes financial indicators of investment project proposals requesting tax incentives. A high ex-ante rate of return—in excess of 15 percent—is considered a necessary, but not a sufficient condition for redundancy. The author next classifies investments according to their sensitivity to incentives: exporters are sensitive, and non-exporting firms are classified as relatively insensitive to investment incentives. As such, incentives received by non-exporting firms with high ex-ante rates of return are considered redundant, which for Board of Investments (BOI) approvals equaled 1 percent of GDP in 2004.

11

A recent study estimated that at least 83% of all tax and duty exemptions granted to BOI-registered investments are redundant, and 10% in the case of PEZA, Subic and Clark (see Reside, 2006).

12

For details see Klemm (2008).

13

For each ten-percent non-deductible costs as a share of pre-tax profits, the effective tax rate under the 5 percent tax on gross receipts option increases by 0.5 percentage points.

Philippines: Selected Issues
Author: International Monetary Fund
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    Effective Tax Rates (in percent): No Tax Incentives

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    International Comparison of Effective Tax Rates for Companies not Receiving Tax Incentives 1/

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    Effective Tax Rates (in percent): Companies Receiving the Maximum Tax Holiday

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    Sensitivity of Effective Tax Rates (in percent) to Depreciation Decision: Maximum Tax Holiday

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    Effective Tax Rates (in percent): Impact of Tax Incentives on Short- or Long-Lived Assets 1/

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    Effective Tax Rates (in percent): Under Different Holiday Years Granted/Remaining

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    Effective Tax Rates (in percent): Current Incentives and Reform Proposals

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    Sensitivity Analysis: High Discount Rate, Non-Deductible Costs

    p = 0.20; equity financed; plant and machinery; in percent