The race among ASEAN’s economies to attract higher levels of foreign direct investment (FDI) may be abusing the tax incentive card.
ASEAN as a group is becoming an attractive destination for global investors in the post-Covid-19 period. It is the 5th largest economy in the world, with an estimated GDP growth of 5.2 per cent in 2022. Foreign direct investment (FDI) has been playing an important role in many economies in the region, particularly those in the early stages of development. To maintain economic growth, avoid the middle-income trap (such as in Indonesia, Thailand, Vietnam) and move their domestic economies up the value chain, countries in the region need to attract and maintain FDI inflows in a sustainable way.
Before the pandemic, foreign direct investment (FDI) inflows into ASEAN rose by 24 per cent from US$146 billion in 2018 to US$181 billion in 2019. ASEAN’s share of total global FDI also increased from 10.1 per cent in 2018 – to 11.8 per cent in 2019. Impacted by the Covid-19 pandemic, which started in March 2020, ASEAN saw smaller FDI inflows in 2020, at US$136 billion. This is 24.9 per cent lower than the previous year.
However, not all ASEAN countries have experienced a decline in FDI inflows during the pandemic. Laos recorded a positive FDI growth of 73.8 per cent despite the sharp decrease in economic growth and severe effects of the pandemic on lives and livelihood. This is mainly due to the construction of the Laos-China railway and the Vientiane-Vang Vieng highway. Other ASEAN countries recorded falls in FDI inflows, ranging from 1 per cent in Cambodia to 54 per cent in Malaysia. Thailand experienced negative FDI inflows of US$6 billion during this period, driven by Tesco’s divestment of its stores in Thailand. The sharp decline in FDI inflows into Malaysia probably reflects dampened investor sentiment arising from heightened political instability and the impact of Covid-19 related travel restrictions in the country. Singapore remains the largest recipient of FDI inflows into ASEAN, accounting for two-thirds of ASEAN’s total FDI inflows in 2020.
But tax incentives alone are not a sustainable tool to attract FDI investment. There is a risk of turning this into a race to the bottom in order to attract the most FDI. Lower tax rates mean a reduction in public revenues.
The pandemic, coupled with the heightened US-China trade tensions, present an opportunity for ASEAN to attract more FDI. Multinational companies will try to diversify their suppliers to avoid becoming over-reliant on China. Being part of ‘Factory Asia’, ASEAN countries may benefit from this shift in foreign investment flows. For instance, Japan will provide funds for 30 Japanese firms out of 100 companies registering for the plan to diversify supply chains to help them shift their manufacturing from China to ASEAN member states such as Laos, Malaysia, the Philippines, Thailand and Vietnam.
So far, ASEAN countries have used tax incentives as a key policy tool for attracting foreign investors. This tool has the advantage of being easy to use and can be applied immediately without any additional capital. The effective average corporate tax rate for ASEAN, after applying incentives, is 12.28 per cent, while the average tax rate without incentives is 21.77 per cent. These levels are also lower than the economies in the Asia-Pacific region, which have an average corporate tax rate of 13.79 per cent before incentives and 22.41 per cent after incentives).
But tax incentives alone are not a sustainable tool to attract FDI investment. There is a risk of turning this into a race to the bottom in order to attract the most FDI. Lower tax rates mean a reduction in public revenues. According to an OECD study, the estimated public revenue loss from the reduction in tax rates is about 6 per cent of GDP in Cambodia and 1 per cent of GDP in Vietnam and the Philippines.
The low tax rates and a wide range of tax incentives are contributing factors to draw FDI inflow to Vietnam. However, according to the Vietnam Productivity Report, the lack of strong incentive policies to generate higher domestic value (e.g., by encouraging foreign investors to transfer technology and help improve the skills of domestic workers) may result in persistently low productivity for foreign firms in the manufacturing sector. Meanwhile, Singapore, Malaysia and Thailand have used tax incentives flexibly, combined with strong regulations. This has forced foreign enterprises to support and improve the capacity of small and medium enterprises and promote technology transfer. These two contrasting pictures show that tax incentives must be accompanied by other regulations in order to enhance the productivity of foreign firms and that of domestic firms through spillover effects.
The ability to enjoy many incentives is not a driving factor for investors. Rather than maintaining a large number of tax incentives which will create an unequal playing field between foreign investors and domestic firms while adding greater budgetary pressures on governments, countries in the region should, in the long-term, focus more on improving the business environment. A stable political and macroeconomic environment and an efficient government bureaucracy with strong and enforceable regulations on intellectual property rights will be far more attractive to investors than incentives. In the era of digital transformation, improving the workforce’s digital skills, investing in infrastructure, especially in technology, are important factors for attracting foreign investment capital from multinational technology companies. In this direction, Singapore has always been considered as an attractive destination for foreign investors. It is due not just to a variety of tax incentives but also to the country’s transparent legal system and the efficient and cost-effective procedure for incorporating a company. Investors who want to enjoy incentives are encouraged to make commitments to introduce the most advanced skills and technologies, as well as contribute to the growth of research and development and innovation capabilities. This, in turn, will improve the quality of the business environment (such as high-skilled labour and advanced technological infrastructure) and attract more foreign investors.
When the above conditions converge, tax incentives will become a positive boost in attracting FDI in a sustainable way. In other words, a country with these strong fundamentals will become an ideal destination for foreign investment without having to abuse the tax incentive card.