The Dilemma Behind Investment Incentives

Many emerging economies like Ethiopia use tax incentives to offset hindrances in the general tax system and as a counterbalance to disadvantages that investors may face. This includes bureaucracies, a weak administration and lack of infrastructure. However, the benefits of such a system have always been questioned by scholars. In Ethiopia’s case, many organizations, including the IMF, have indicated that generous tax exemptions and incentive packages for local and foreign investors present a major challenge to the country’s tax administration system. Just in the first half of the current financial year, over ETB34.2 billion was relinquished to beneficiaries under the duty free scheme, accounting for 37Pct of the nation’s tax revenues. While the figure is mounting year after year, various institutions such as the Federal Ethics and Anti Corruption Commission are signaling incentives’ exposure to misappropriation and corruption. Meanwhile, the government is attempting to enforce proper usage of incentives, and has established a separate office to handle such privileges and prevent abuses, as Ashenafi Endale, EBR’s Staff Writer report. 

Just last month, officials and experts from the Ethiopian Revenues and Customs Authority (ERCA) and other government institutions conducted checks on items imported by investors entitled to duty free privileges. Surprisingly, the team found many items imported contrary to the guidelines of the incentives they used. 

Many investors engaged in the manufacturing sector and entitled to duty free privileges were caught importing finished products, instead of semi-processed items that are supposed to be assembled locally. “In most cases, especially in electronics, the items imported were almost-finished products that require no or little local processing,” explained Mulugeta Beyene, director of the Manufacturing and Duty Free Support Directorate at ERCA. The Directorate, which is currently under establishment, follows up and monitors the proper use of incentives, which have been exposed to abuse. 

Right after the probe, ERCA temporarily cut 55 businesses from their entitlement to duty free privileges for one round of shipment. This is bad news for a country like Ethiopia which provides scarce financial as well as non-financial incentives to attract as many local and foreign investments as possible into the manufacturing and export sectors.

Ethiopia offers financial incentives such as tax reduction and holidays, as well as customs duty exemptions, grants and subsidies for companies engaged in manufacturing activities, including textile, leather, chemical, pharmaceuticals and mineral production. The construction and agro-processing as well as hotel and tourism industries also benefit from financial incentives. 

Although the total amount of money forgone in the form of monetary incentives is unavailable, it is easy to conclude that Ethiopia is losing a good deal of financial resources, just by looking at the revenue relinquished due to custom duty exemptions. In the first six months of this budget year alone, Ethiopia has forgone ETB34.25 billion for duty free beneficiaries, which is 37.71Pct of the total tax revenue collected by the Authority during the period, according to ERCA’s six-month report. Assuming the tax revenue of the current fiscal year is equal to or higher than last year’s, it is safe to say that Ethiopia loses close to ETB60 billion annually because of custom duty exemptions. 

Out of the forgone revenue over the first six months of 2017/18, 27.27Pct was given to governmental as well as nongovernmental enterprises, and 26.04Pct to private investors, while public developmental enterprises and members of diplomatic missions received 1.7Pct and two percent of the total, respectively. 

On the other hand, non-financial incentives such as access to land, public services and infrastructures, which support business development and enhance competitiveness, are also provided by the government. This includes the recently constructed plug-and-play industrial parks, which the government rents to investors for a minimal price.

Fiscal incentives are provided based on policies devised by the Ministry of Finance and Economic Cooperation (MoFEC). However, the Ethiopian Investment Commission (EIC) has the mandate to approve them. Government institutions such as the Ministry of Industry (MoI) have a say in sectors under their watch while regional governments also provide incentive packages to businesses licensed under their authority.

Globally, there is a mixed view among experts about the kind of relationship that exists between incentives and investment. Experts like Dale Jorgenson, a professor at Harvard University who conducted groundbreaking research on tax policy and investment behavior, argue that there is a direct relationship between incentives and rate of investment. Jorgenson’s argument is based on the hypothesis that firms choose investments with positive net present value. Since financial incentives like tax deductions and custom duty exemptions help the projected earnings of a given investment to exceed the anticipated costs, it will attract businesses. 

Citing the growth of investments registered in the last two decades, officials also agree that there is a direct relationship between incentives, especially financial incentives, and the rate of investment in Ethiopia. “Even though the share is unknown, incentives significantly contribute to the increase in investment flow,” argued Mekonen Melaku, director of Public Relations Directorate at EIC.  

Information obtained from EIC indicates that the number of domestic investment projects licensed at the Commission increased from 17 in 1992 to 310 in 2016. The combined capital of these investments also increased from ETB348 million to ETB3.03 billion during the same time. By the same token, the number of foreign investment projects licensed by the EIC increased from three to 335 between 1992 and 2016.

Tsedeke Yihunie (Eng), founder of Flintstone Engineering and Homes is one of the domestic investors who see a direct relationship between incentives and growth of investments. “Incentives indirectly supported my business in three areas,” explains Tsedeke. “Tax breaks and access to land given to local companies that manufacture cement and steel greatly reduced our cost of construction. Customs duty exemptions for imported heavy duty machinery and trucks, including cranes and concrete mixers have decreased our working capital.”

Tilahun Abay, director of Planning and Communications Directorate at the Metal Industry Development Institute (MIDI), also sees the positive side of the incentives, referring to the number of companies that are growing in the metal sub-sector with the incentives provided to them. Over 230 small and medium factories involved in steel and iron production joined the metal industry in the past decade. “The incentives are not even adequate for companies that add real value,” says Tilahun. 

Although providing financial and non-financial incentives to companies has become an accepted practice for developing countries to attract and retain business, it continues to generate debate, pushback and criticism. John M. Clark, who was professor of economics at Columbia University, developed the accelerator model, which states that investment is driven by change in aggregate demand. This economic theory suggests that as demand or income increases in an economy, so does the investment made by businesses. As a result, incentives have an insignificant effect on a given firm’s decision on where to be located. 

Jamuna P. Agarwal (PhD), a senior economist at the Kiel Institute of World Economics, Germany, also pointed out that other factors such as inflation and exchange rates cannot be ignored when talking about investment decisions. According to Agarwal, businesses first study the basic macroeconomic and institutional situations of a given country. Although prospective markets and relatively low-cost labour attract businesses, other considerations restrain investment, such as uncertain policies and political instability. Therefore, financial and non-financial incentives cannot triumph over these negative factors on their own. 

Birhan Kassa, founder and manager of Birhan Kassa General Contractor, asserts that the policy regarding incentivizing businesses has a fundamental fallacy. “Any growth that comes due to incentives is  not real. Businesses fail as soon as they start getting larger. You cannot grow a tree by supporting it with another piece of wood,” says Birhan. “The government should focus on creating an equal and fair playing field, where all can compete and grow equally.”

Even Tsedeke, who stands in favor of incentives, admits that there are limitations when. “There is a mismatch between what is needed by investors and what is provided by the government,” he argues. “For instance, the government may allow old-fashioned trucks to be imported duty free, but the investor needs the latest model. To square this mismatch, collaboration between the private sector and policy makers is needed.” 

In Ethiopia, the incentives are so far being given in a scattered and uncoordinated manner, and there has been no institution that closely follows up how they are being put to use. “Nobody knows how much is forgone due to incentives,” an official at the Strategic Intelligence Affairs Directorate of ERCA told EBR. “We investigate the few businesses that abuse duty free privileges based on suspicions. There is no body that follows up continuously and regularly.”

According to a report presented during ERCA’s in-house meeting held in Bishoftu (Debrezeit) in 2015, close to ETB91 billion was lost between 2010 and 2015. The report also revealed that incentives were given to businesses that only exist on paper. “The business environment in Ethiopia has become multifaceted and it is difficult to trace a product once it enters the country,” adds Mulugeta. 

To make things worse, there is the perception that the implementation of incentives such as duty-free packages are exposed to corruption and maladministration, according to an assessment released recently by the Federal Ethics and Anti Corruption Commission. Conducted using a sample of 433 businesses in Dire Dawa and Addis Ababa, the assessment discovered that one-third of the companies believe that incentives are prone to corruption. 

Girma Gelalcha, director of the Sectoral Supports Directorate at MoI, however, thinks otherwise. “If the companies which import industrial raw materials duty free are exporting their products, we cannot say the incentives are abused and the country is losing,” 

So far, there is no report that shows an all round figure of the incentive packages Ethiopia is providing in terms of money. Nor has there been any impact assessment. “As a layman, it seems that the incentives are highly abused, especially when you see certain businesspersons becoming wealthy from nothing in a short period of time. But, you are grateful when you see the construction boom all over the country,” says the official at the Intelligence Affairs Directorate of ERCA. 

The Auditor General’s report for 2015/16 also blamed the Investment Board of EIC, which was chaired by former Prime Minister Hailemariam Desalegn, for being a major roadblock to the effective implementation of incentive schemes.  It holds the Board responsible for the approval of duty free requests against rules stated in proclamations, regulations and directives. Some companies were also accused by the Auditor General of abusing their duty free privileges by importing items other than the allowed products and selling them on the local market.  There are also investments that receive incentives before they start operations, and continue after they leave the business, while others also request additional incentives in the name of expansion, even though they do not make any moves to actually expand, according to the report of the Auditor General.

To support its evaluation, the report evaluates the activities of many companies that enjoy different kinds of incentives such as Ashraf Group. Although the Sudanese company exported processed meat to Angola and Comoros only in 2010, Ashraf continued benefiting from all the incentive packages, taking additional licenses for expansion and new operations, without any production, until the state of Amhara revoked its license in 2015. 

The same goes for Karaturi, an Indian company which took 100,000 hectares of land in the state of Gambela. Karaturi imported items worth ETB157.01 million free of duty, between 2010 and 2012, without shipping any product. Around 69 investors engaged in the hotel sub-sector in the state of Tigray were also found abusing duty free privileges by importing construction materials worth ETB311.8 million, between 2010/11 and 2012/13. 

Incentives being taken advantage of can be also observed in the pharmaceutical sub-sector. There are 22 companies licensed to manufacture medicine locally, 14 of which are  actively involved in pharmaceuticals manufacturing, according to the Ministry of Health (MoH). These companies are expected to fill 20Pct of the annual medicine and medical materials demand of the state-owned Pharmaceutical Fund and Supply Agency (PFSA), totalling around ETB2.8 billion. PFSA annually purchases medicines and related materials worth ETB14 billion.  However, local pharmaceutical companies are not fulfilling expectations, despite of enjoying lofty incentives. In the last budget year, local companies supplied drugs and other materials worth ETB1 billion, which only satisfied seven percent of the Agency’s demand. “Local pharmaceutical companies benefit from incentive packages including importing raw materials duty free. Additionally, we give them 70Pct of the total cost of goods upfront. They also benefit from a 25Pct preferential margin, if the bid is open to international companies,” explains Loko Abraham (MD), director general of the Agency. “Despite all this, they deliver limited products after long delays, sometimes even after a year.”

While the incentive privileges are exploited by investors, those companies that badly need them are left behind. One such company is Addis Livestock Production and Productivity Improvement Services (ALPPIS), the only firm in Ethiopia that supplies genetic material of cattle breeds. Its founder, Tamiru Zewde, an expert in genetic engineering, was certain that he would succeed when he opened the company nine years ago. To his dismay, he did not get any incentives. “Our activity is essential to increasing the productivity of Ethiopia’s livestock resources,” argues Tamiru. “But we are not operating according to the demand and our potential. We need incentives like duty free privilege and easy access to foreign currency.” Yet, Temesgen Walellign, director of the Follow-up, Monitoring and Evaluation Directorate at the National Planning Commission, says there is no plan to revise Ethiopia’s incentive policies, for the time being. “There are good policies in place. The main thing needed is improving the implementation mechanisms.” Temesgen argues. “Conducting studies is necessary to know the real impact of incentives.” 

Nine months ago, MoFEC in cooperation with the World Bank, started to conduct a study to figure out why tax revenues did not match the growth of the economy. As a part of this study, the Ministry is also assessing the effectiveness of incentives provided by the government. 

Despite the late start, ERCA is also moving forward to address the problem. “A committee was formed after the joint investigation ERCA conducted with other government institutions last month. Currently, we are undertaking studies on how to coordinate all the mandated institution,” stressed Mulugeta. “Since the main obstacle has been lack of accurate information, we are establishing a central database separately to track the activities of companies permitted to benefit from incentives.”


6th Year . April 16  - May 15 2018 . No.60 


 

 

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