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THE WORLD BANK ECONOMIC REVIEW, VOL. 4, NO. 1: 8 1 -1 02
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Corporate Tax Holidays and Investment
Jack M. Mintz
Governments of developing countries commonly adopt tax holidays to encourage
investment. This article evaluates the incentives provided by company income tax
holidays and explains the importance of the timing of depreciation allowances in
determining the effective tax rates and the cost of capital to firms considering additional
investment during the holiday. If an asset is long-lived and depreciation allowances
for tax purposes are accelerated, the tax holiday, by preventing depreciation deductions
during periods of peak profits, may actually penalize a company for investing during
the holiday. The closer the investment to the end of the holiday period, the more
severe the penalty. If, instead, depreciation allowances may be deferred until after the
holiday, this program of incentives is quite generous to the firm. How these sharply
contrasting results may emerge is illustrated through estimation of effective tax rates
and user costs of capital under tax holiday systems in Bangladesh, C6te d'Ivoire,
Malaysia, Morocco, and Thailand.
A common form of tax incentive found in about half of developing countries is
a "tax holiday" which permits a new company to operate for a given number
of years before paying corporate income taxes. Companies may be required to
meet certain conditions to qualify for a holiday. Most often, the tax holiday is
an instrument used by a government to encourage investment in long-lived
capital and to direct a country's long-term development.
The issue addressed here is how tax holidays affect the user cost of capital
and thus a company's investment decisions. The user cost of capital is the sum
of economic depreciation and financing costs, adjusted for taxes. The effective
tax rate on capital is calculated as the difference between the value of the
marginal product of capital (net of economic depreciation but before taxes) and
the rate of return on capital that savers earn when investing in the firm's capital;
the difference is divided by the pre- or post-tax marginal rate of return.
If a firm is exempt from income taxation during the holiday, what is the
total effective tax rate on income? A first response might be that it is zero. This
The author is a professor of business economics at the University of Toronto and a professor of
economics at Queen's University, Kingston, Ontario. He wishes to thank two anonymous referees for
helpful remarks, and Reza Firuzabadi for research assistance. He also wishes to thank Richard Gordon
of Arthur Andersen who provided valuable advice on company tax systems in some of the countries
covered in this paper.
©D 1990 The International Bank for Reconstruction and Development / THE WORLD BANK.
81
82 THE WORLD BANK ECONOMIC REVIEW, VOL. 4, NO. 1
woulad be correct for short-term capital that fully depreciates before the end of
the holiday. But the effective tax rate on assets which continue to generate
income after the holiday depends crucially on the rules for tax depreciation.
Assume, for example, that the entire capital stock must be depreciated for tax
purposes in the first two years after purchase but has an economic life of five
years. In years three to five, therefore, no tax depreciation allowances may be
claimed against the earnings of the assets.
This does not imply that the tax holiday is of no value to the firm. Short-
term investments and labor (compensated by profits) bear no tax during the
holiday. It is only long-lived capital that may be penalized. This suggests that
an appraisal of the full impact of the tax holiday on investment decisions
requires explicit consideration of economic and tax-related rates of deprecia-
tion, depreciation deferral allowances, interest expense deductions, and related
tax exemptions and liabilities.
The analysis here uses standard techniques developed in the tax literature on
the user cost of capital (Jorgenson 1963; Boadway and Bruce 1979) and effec-
tive tax rates (King and Fullerton 1984; Boadway, Bruce, and Mintz 1984).
The issues are similar to those addressed in earlier work on the cost of capital
when company tax rates vary (King 1974) and when companies experience tax
losses (Edwards and Keen 1985; Auerbach 1986; and Mayer 1986). The scant
literature on tax holidays has primarily addressed why tax holidays may be
used, rather than deriving the effective tax rate on capital during a holiday
(Bond and Samuelson 1986; Doyle and van Wijnbergen 1984). While Agell
(1982) and Bond (1981) do measure effective tax rates, they assume that the
capital stock is constant over the tax holiday period, which is incorrect since
the value of tax depreciation allowances is not constant during the holiday
period.
The task here is to calculate a firm's marginal tax rate under the assumptions
that the firm knows the length of the holiday and the tax regime that will exist
after it. I also assume that it is the marginal rather than average returns to
capital and marginal rather than average tax rates that affect investment deci-
sions. As has been established by the literature, average tax rates are not good
indicators of how the tax system may deter investments since the measure
includes taxes imposed on intramarginal returns or rents earned by a firm. For
example, a pure profit tax has no impact on investment decisions, yet the
average tax rate is positive in value. It is for this reason that economists have
concentrated on marginal tax rates instead.
The analysis is organized as follows: in section I examples are provided to
explain how company tax holidays affect long-lived capital investment. A sur-
vey of tax law for five countries that use tax holiday incentives is given in
section II. Derivation of the user cost of capital and effective tax rates is first
explained in section III, and estimates of the rates for the five countries are
presented in section IV. Section V concludes with a discussion of the relative
Mintz 83
costs and benefits that arise from tax holidays. A technical appendix provides
a mathematical derivation of the costs of capital under tax holidays.
I. How COMPANY TAX HOLIDAYS AFFECT INVESTMENT: AN EXPLANATION
AND ILLUSTRATIONS
In this section, I first illustrate how company income taxes can affect incen-
tives to investment in long-lived capital, and I then outline the relative incen-
tives of a tax holiday.
Company Income Taxes
The company income tax paid is the product of the statutory tax rate multi-
plied by company profits, as defined by the tax authorities. In principle, taxable
profits correspond to shareholder income: revenues net of labor, material, and
capital costs (depreciation, inventory, and interest expenses). In practice, how-
ever, taxable profits rarely correspond to true shareholder profit for three
reasons. First, capital goods are written off for tax purposes at a quicker rate
than the true economic rate of depreciation. Second, imputed income, such as
capital gains resulting from increases in the assessed value of land, structures,
and other forms of capital, may be partly or fully exempt from tax. Third, in
most tax systems adjustments for inflation are not made. Depreciation and
inventory cost write-offs are based on original rather than replacement costs,
and costs of borrowing, unadjusted for inflation, are fully deductible against
taxable income. Without adjustments for inflation, depreciation and inventory
costs are underestimated and interest expense is overestimated relative to infla-
tion-adjusted measures.
Actual tax rates may also differ from the statutory rate. In Bangladesh and
Malaysia, for example, statutory tax rates range from 40 to 45 percent, but
depreciation allowances are generous, and interest, unadjusted for inflation,
may be deducted from taxable profits. Thus, marginal investments in machin-
ery and buildings are taxed at very low and often negative rates. In contrast,
countries such as Morocco and Thailand do not allow accelerated depreciation,
so that companies not qualifying for a tax holiday may be highly taxed.
The Company Income Tax Holiday
In most countries, tax holidays are granted to newly formed projects. If the
activity is undertaken by an existing corporation, the project qualifying for the
tax holiday must be maintained as a separate entity. The holiday lasts for a
given number of years, after which the company begins paying taxes. Holiday
status may permit foreign nationals to own land or domestic companies (oth-
erwise prohibited) and provide full or partial relief from corporate income
84 THE WORLD BANK ECONOMIC REVIEW, VOL. 4, NO. 1
taxes, business taxes, and import duties, and from withholding taxes and
personal income taxes on dividends. Only the corporate income tax holiday is
discussed here.
Although a company qualifying for a tax holiday must file an income tax
form, the qualifying activity is taxed at a zero or lower-than-standard rate
(nonholiday activities remain taxed). If the firm has a taxable loss, it may be
allowed to carry it forward to apply to post-holiday income (although the loss
is not carried forward at a rate of interest).
Investments made during the holiday may generate post-holiday tax liabili-
ties, however. Consider, as an example, depreciation deductions. To reflect the
physical deterioration of capital goods, during a tax holiday firms are allowed
to deduct some portion of the value of those goods from taxable income each
year after purchase until their full cost has been deducted. In the absence of a
tax holiday, the value of depreciation allowances to the firm depends on the
relative rates of economic and tax depreciation.
The value of the depreciation allowances is greatest when a company can
write off capital immediately rather than taking the depreciation deduction
over several years. When a company can write off depreciation for tax purposes
quicker than depreciation for accounting purposes, the company's taxable in-
come generated by the asset is smaller than economic income in early years and
larger than economic income in later years. The company pays less tax up front
and more taxes in later years. If there were no discounting of revenue streams,
it would not matter that tax and economic depreciation are mismatched in this
manner. With a positive discount rate, however, the company pays less in
present-value terms if tax depreciation is faster than economic depreciation
than it will if tax and economic depreciation are matched. The converse holds
when tax depreciation is less than economic depreciation-a company pays
more taxes in present value than in a situation in which tax and economic
depreciation rates are perfectly matched.
The tax holiday complicates this picture somewhat. Because the holiday
exempts a firm from income tax during the initial few years after purchase of
an asset, depreciation allowances will be redundant during the holiday. If the
asset is short-lived and does not generate income thereafter, this is not a loss-
the asset was untaxed due to the holiday in any case. If the asset is long-lived,
however, a firm would prefer to defer use of the depreciation deductions until
after the holiday to take advantage of both the tax holiday and the depreciation
allowances. Accelerated depreciation, which concentrates tax benefits in the
first few years after purchase, will not benefit the firm during the holiday; the
firm will find that its taxable income will be greater than economic income
after the holiday is completed.
To illustrate, say that an asset that initially costs $100 produces output for
four years, and depreciates at a rate of 25 percent each year according to
straight-line depreciation methods. Under straight-line depreciation, an asset
declines at a constant rate based on its original value. This can be contrasted
Mintz 85
with declining-balance depreciation whereby an asset declines exponentially,
based on the remaining value of the asset. For tax purposes, however, the asset
is to be written off at a 50 percent (straight-line) rate each year. If the holiday
ends two years after the asset is purchased, the income that it generates after
the holiday will be taxed without depreciation deductions. If the asset produces
a 60 percent rate of return (on the value of the asset after depreciation each
year) and that income is taxed at a 50 percent rate, the total tax accumulated
is $22.50 or, on a present-value basis (discounting by 10 percent), $18.02 (see
table 1). In the absence of the holiday, the firm pays total taxes of $25, or
$20.75 on a present-value basis. Thus, despite the holiday, investment in long-
lived capital bears some company tax although it is less than the tax without
the holiday.
Inflation, which is ignored in this example, reduces the value of the tax
holiday to the firm. Inflation affects a company's tax burden by raising nominal
(taxable) income, production costs, and replacement costs of capital goods.
Inflation-indexed tax depreciation rates allow the company to increase the
reported price of the asset by the rate of inflation when calculating depreciation
allowances. Without inflation indexation, if capital is largely written off for
tax purposes during the holiday but generates income thereafter, nominal in-
come (which is assumed to rise with inflation) and thus tax liabilities rise,
depreciation allowances do not, but production costs and actual replacement
costs for capital do. In this case, the company may be very heavily taxed.
An alternative technique used for handling depreciation deductions during
the tax holiday is deferral of deductions, which has the opposite effect. If a
company can defer depreciation deductions until it accrues tax liabilities, this
makes the tax holiday very generous, and assets could even be subsidized.
Using the example above but assuming that depreciation deductions are de-
ferred until the end of the holiday, the firm accumulates a negative tax liability
of $27.50 (see table 2) after the holiday. If the company were able to write off
tax losses against other forms of income, the holiday could lower the tax costs
of other assets and thus also encourage related nonqualifying investment. Legal
Table 1. Effect of Accelerated Tax Depreciation with and without
a Tax Holiday
(dollars)
Tax Taxable Taxes paid
Year Gross profit depreciation income Holiday No holiday
1 60 50 10 0 5
2 45 50 -5 0 -2.5
3 30 0 30 15 1S
4 15 0 15 7.5 7.5
Total 22.5 25
Note: Assumes asset costing $100, 25 percent annual economic depreciation (straight-line), 50 per-
cent annual tax allowance depreciation, 50 percent tax rate, and two-year tax holiday.
86 THE WORLD BANK ECONOMIC REVIEW, VOL. 4, NO. I
Table 2. Effect of Deferred Depreciation Deductions with a Tax Holiday
(dollars)
Tax Taxable Taxes paid
Year Gross profit depreciation income (holiday)
1 60 0 60 0
2 45 0 45 0
3 30 50 -20 -10
4 15 50 -35 -17.5
Total -27.5
Note: Assumes asset costing $100, 25 percent annual economic depreciation (straight-line), 50 per-
cent annual tax allowance depreciation deferred until after the holiday, two-year tax holiday, and 50
percent tax rate.
clauses which restrict the tax holiday to new and separate entities, however,
would preclude this outcome if the entity remains separate after the holiday.
A similar result emerges when capital is financed by debt. Both principal
repayments and interest deductions reduce taxable income during the initial
period after purchase which coincides with the tax holiday. For a holiday firm,
these interest deductions cannot be used to reduce the taxable income of the
company over time. If the company is able to defer the interest expense deduc-
tions until after the holiday and after principal is repaid, once again the tax
regime becomes quite generous. If interest costs are not adjusted for inflation,
the deferral is even more valuable to the firm.
While the examples above give an indication of the importance of interest
deductions and depreciation allowances in calculating the relative costs of
capital under a holiday, the analysis becomes more complicated when assessing
not just the initial holiday-qualifying investment, but also additional invest-
ments which the company may undertake throughout the holiday period. Be-
cause later investments will be exempt from income tax for a shorter period,
mandatory accelerated depreciation without inflation adjustment will increase
their overall tax liabilities substantially relative to investment undertaken in the
first year of the holiday. This point emerges more sharply in the applied
analysis in section IV below.
11. TAX HOLIDAYS IN FIVE COUNTRIES
This section describes the company income tax law that is relevant to tax
holidays used in five countries: Bangladesh, Cote d'lvoire, Malaysia, Morocco,
and Thailand. These countries were selected on the basis of providing a useful
contrast of various tax laws interacting with inflation and interest rates. Table 3
provides a summary of the relevant tax provisions in each country; provisions
other than company and dividend tax relief are ignored. Information was taken
from the International Bureau of Fiscal Documentation and was provided by
the Arthur Andersen accounting firm. It is possible that some features of the
tax law may have been misinterpreted in my reading.
Mintz 87
Table 3. Tax Holiday Provisions for Industrial Enterprises
Feature Bangladesh C6te d'Iuoire Malaysia Morocco Thailand
Duration (years) 4-12 7-11' 6-10 10-14 3-8' plus 6
(optional)
Rate of income 100 100 for 4, 6, or 100 100 in zone IVb 50 or 100
tax 8 years, 50 in zone Ill 50 for five
exemption depending on additional
(percent) region. 75 years
third to last
year, 50
second to last
year, 25 last
year
Depreciation First-year Straight-line: First-year Straight-line: Straight-line:
(annual allowance: buildings, 5 allowance: conformity conformity
percentage buildings, 10 machinery, buildings, 20 with book with book
rate) machinery, 10-33 machinery, value value
20 20
Declining Straight-line:
balance: buildings, 2
buildings, 15 machinery,
machinery, 12
30 (average)
Depredation Unused may be All may be All may be Unused may be May not be
deductions carried deferred delayed until carried deferred
deferral forward only indefinitely end of forward only
when no holiday in loss
profit is periods
declared
Treatment of May not be May be carried May be carried May be carried Allowance
losses carried forward three forward forward four aggregation
forward years indefinitely years of holiday
beyond and
holiday associated
nonholiday
income and
loss
Other 5-30 percent of National Dividends are Dividends are
income must Investment exempt from exempt from
be invested in Fund: 10 personal tax personal tax
government percent tax is
bonds. fully
Dividends of recoverable at
public firms a rate that
are exempt varies
from personal according to
tax the type of
investment
a. The duration varies by region to encourage investment in priority areas.
b. Zones to encourage decentralized investment: zone III includes Agadir, Fez, Tangier, and Marra-
kech; IV includes Oujda and El Jadida.
Source: International Bureau of Fiscal Documentation (1987, 1988) and Arthur Andersen correspon-
dence.
Tax Holiday Provisions
In the five countries, tax holidays range from three to fourteen years, during
which the firm generally is fully exempt from company income taxes. In C6te
d'Ivoire the length of the holiday depends on the location of the firm and only
part of income is exempted during the last three years of the holiday. In
Morocco exemptions vary among and are restricted to set rural areas and are
88 THE WORLD BANK ECONOMIC REVIEW, VOL. 4, NO. I
designed to encourage investment out of the Rabat area. In each of the coun-
tries, firms must apply for holiday status and not all firms qualify. Bangladesh,
C6te d'Ivoire, and Malaysia do not allow tax holiday firms to claim other tax
incentives.
Provisions for deferral of depreciation vary considerably across countries.
Morocco and Thailand require assets to be depreciated for tax purposes during
the holiday, while Cote d'Ivoire and Malaysia permit the firm to fully depreci-
ate assets after the holiday. The tax laws of Bangladesh require that deprecia-
tion deductions be claimed in the year accrued. If the firm earns taxable profits
during the holiday, I interpret the rules to imply that depreciation deductions
are fully used during those years and thus are not carried forward. Thus I
assume that unused deductions may be carried forward only if a firm does not
earn sufficient taxable profits during the holiday.
Some investment requirements may reduce the incentives of the tax holiday.
In Bangladesh, S to 30 percent of income earned during the holiday (depending
on the region) must be invested in government bonds. If the government bond
rate is below the market rate, this imposes an implicit tax on the firm. In C6te
d'Ivoire the National Investment Fund (NIF) is financed by a 10 percent com-
pany tax. The tax is recoverable (at a rate that varies by region) if the firm
purchases government bonds or undertakes "sufficient" levels of investment.
The firm is exempt from the NIF tax during the holiday so that the extent to
which this affects the investment incentives offered by the tax holiday is unclear
and is not considered in the following analysis.
Tax holidays may also encourage equity investment, as dividends paid to
shareholders may be exempt from personal taxes during the holiday. Malaysia
and Thailand fully exempt dividends while Bangladesh only exempts dividends
of holiday firms listed on the stock exchange. (How dividend taxation affects
the marginal investment decision of the holiday firm is discussed in Mintz
1989.)
The effect of tax holidays is complicated for cases in which capital is im-
ported. Most capital-importing countries impose a withholding tax on earnings
remitted from abroad (dividends, interest, and capital gains). Some capital-
exporting countries, such as Japan, the United States, and the United Kingdom,
impose taxes on remitted earnings from foreign sources but provide credits for
withholding taxes paid abroad and for company taxes that a company claims
were paid on income subsequently distributed as dividends.
For investment incentives such as tax holidays, an additional complication
arises. When a capital-importing developing country provides a tax holiday to
encourage investment, that incentive may be lost if the resulting profits are
taxed by the government of the foreign investor. In the worst case, in which
the investment project was only marginally profitable, it may not be undertaken
at all. In the case of offsetting taxes by the parent government, at the least the
developing country will lose potential tax revenue to the foreign government.
In some countries, such as Japan, a capital exporter will grant "tax sparing"
Mintz 89
whereby remitted earnings are not taxed in order to pass the tax incentive on
to the firm. In the calculations reported below, it is assumed that tax sparing
is provided. Otherwise the techniques developed would need to be substantially
revised.
Post-Tax-Holiday Provisions
After the holiday, the firm must pay company income taxes according to the
normal tax code (see table 4). The statutory tax rate imposed in the five
countries in the late 1980s varied from 30 percent in Thailand to about 50
percent in Morocco. To encourage further investment after the holiday, Malay-
sia provides a 100 percent investment tax allowance, Bangladesh a 25 percent
allowance, and Morocco an investment reserve protecting profits from taxation
up to 30 percent of the value of the new investment. Tax depreciation rates on
existing capital remain in effect after the holiday; accelerated depreciation for
new investment by existing firms is allowed in three of the five countries. To
simplify the empirical analysis below, however, I assume that post-holiday
investments do not qualify for accelerated depreciation. This will only mean
that the analysis below may overestimate the incentives to investing in short-
lived assets provided by the tax holiday. As discussed above, firms investing in
longer-lived assets may prefer that depreciation allowances be deferred rather
than accelerated. Once again, the analysis is based on the written tax law, and
in some cases I may have misinterpreted its meaning, or rates may vary from it
in practice.
III. DEFINING THE USER COST OF CAPITAL AND EFFECTIVE TAX RATES
The standard analysis of the impact of taxes on investment decisions is based
on Jorgenson's work (1963) on the user cost of capital, which captures the
financing, depreciation, and tax costs of capital investment. It is assumed that
the firm wishes to maximize the present value of the stream of income accruing
to its owners, and that the tax system, interest rates, and inflation do not
change. The firm invests in capital until the marginal rate of return on capital
is equal to its marginal cost.
Without taxes, the user cost of capital is the sum of financing and deprecia-
tion costs, adjusted for inflation. For investment financed by debt, the real per
dollar cost of finance is defined as the nominal interest rate, i, less the rate of
inflation, 7r. The cost of equity finance is equal to the shareholders' nominal
opportunity cost of investing capital in the firm, denoted in per dollar terms as
p, less the rate of inflation. Let 6 be the (declining-balance) rate of economic
depreciation, in which depreciation is defined as the replacement cost of the
physical deterioration of the asset, net of real capital gains. If ,3 is the propor-
tion of capital financed by debt, the pre-tax per dollar cost of holding capital
can be written as:
(1) C = oi + (1 - O)p + 6 - X
Table 4. Tax Provisions after the Tax Holiday
Tax provision Bangladesh C6te d'Ivoire Malaysia Morocco Thailand
Rate of company tax 40 for public firms; National Investment 43 less 5 percent tax 49.5 30 for public firms;
(percent) 45 for private firms Fund tax abatement for 35 for private firms
companies with
income below
$200,000
Tax allowance Same as holiday, or Same as holiday, or Same as holiday, or Same as holiday Same as holiday
depreciation rates firms may firms may firms may
accelerate at 100 accelerate at twice accelerate at 40
percent (one year) the normal rate percent
or 80 and 20
percent over two
years
Other tax incentives 25 percent investment None 100 percent Investment reserve: 20 None
to investments allowance investment tax percent of profits
(depreciation base allowance abated (up to 30
not reduced by this) percent investment)
Source: International Bureau of Fiscal Documentation (1987, 1988) and Arthur Andersen correspondence.
Mintz 91
The relationship between the cost of equity and debt finance depends on capital
market equilibrium and is not derived here (see Mintz and Purvis 1987).
When taxes are introduced into the analysis, the user cost of capital is
amended to reflect their cost, net of interest deductions and depreciation allow-
ances. First, the cost of finance, rf, is adjusted to account for the deductibility
of nominal borrowing costs. If u is the corporate tax rate, the real cost of
borrowed finance is i(I - u) - r, while the cost of equity finance is unaffected
by the corporate tax. Thus the real cost of finance, net of corporate taxes, is:
(2) rf = ,Si(1 - u) + (1 -Mp - r
The user cost of capital next is adjusted for tax depreciation allowances. The
average per dollar present value of the depreciation allowances, A, is calculated
based on the original purchase price of the asset and discounted at the nominal
cost of finance, net of corporate taxes, rf + 7r. Let u again denote the corporate
tax rate, and let a be the (declining-balance) rate of depreciation for tax
purposes, which changes each year. The present value of the tax depreciation
allowance per dollar, A, is thus:
(3) A ua(1 -a) ua(1 - o)2 ua (1 + rf + 7r)
(3) A ui 1 + rf + wr (1 + rf + ir)2 a + rf + r
Combining the interest deduction and depreciation allowance adjustments, the
per dollar cost of holding capital is equal to depreciation and financing costs
multiplied by the effective purchase price of capital: (6 + rf)(1 - A). The user
cost of capital adjusted for taxes is thus:
(4) C =~~~~~ (6 + rf) (1 - A)
U (1 - u)
The larger the present value of the depreciation allowance, A, the lower the
user cost of capital; and the higher the corporate tax rate, u, the larger the user
cost so long as the company is not too leveraged such that rf declines substan-
tially because of the deductibility of nominal borrowing costs.
The effective tax rate on capital is defined as the difference between the
marginal pre- and post-tax rates of return on capital, as a percentage of the
pre-tax rate of return, and is derived as follows. First, define the marginal
before-tax rate of return on capital as the marginal value product of capital,
which is equal to the user cost in equilibrium, net of economic depreciation: C.
- 6. The after-tax rate of return to capital is the rate paid to the market, r =
Oi + (1- f3)p - ir. The difference, C. -6- r, is the effective tax on capital.
Taking this difference as a proportion of the pre-tax marginal return to capital,
the effective tax rate is u* = (Cu - 6 - r)/(C. - 6).
The above discussion applies to firms that are taxpaying. To account for a
tax holiday, the analysis becomes more complicated, and in particular, it must
reflect the time at which investments take place prior to the end of the holiday.
This formulation is outlined in the appendix.
92 THE WORLD BANK ECONOMIC REVIEW, VOL. 4, NO. I
IV. EMPIRICAL ESTIMATES OF COST OF CAPITAL AND EFFECTIVE TAX RATES
On the basis of the formulations developed above and in the appendix, the
user cost of capital and effective tax rates for capital investment are estimated
for the five countries: Bangladesh, Cote d'Ivoire, Malaysia, Morocco, and
Thailand. These calculations are intended to be illustrative only, because the
data needed for a more precise measurement of the user cost of capital were
not available. The countries' tax codes indicate statutory rates for company
income and dividend taxes and tax depreciation allowances and establish the
length of tax holidays. No information was available, however, regarding the
weighted marginal dividend tax rate, the distribution of machinery or building
assets that is needed to calculate the average tax depreciation rate, or the
number of times that a firm can claim a tax holiday. It is quite possible that
the effective holidays may last longer than is indicated by the tax law statutes.
Estimates based on data from developed countries are used for physical
depreciation rates for capital: the rate for buildings is 5 percent, and for
machinery 15 percent on a declining-balance basis. For C6te d'Ivoire, however,
I assume that machinery (including vehicles and office furniture) depreciates at
a 30 percent rate on a declining-balance basis, because of the difference there
in the types of assets eligible for tax depreciation. Straight-line physical depre-
ciation rates are converted into declining-balance rates. Straight-line tax depre-
ciation rates also are converted to the equivalent value declining-balance form.
In the calculations, I assume that tax depreciation is deferred until after the tax
holiday for firms operating in C6te d'Ivoire and Malaysia.
Effective tax rates and user costs of capital for tax holiday investments-
assuming that capital is fully financed by equity (personal taxes are ignored)-
are presented in table 5. In table 6, I assume that debt accounts for half of
capital finance during the holiday and for 70 percent of capital afterward.'
Although effective tax rates on capital during a tax holiday are generally
below those after the holiday (except for the final year), what is surprising is
that they can be quite high (Bangladesh and zone 3 in Morocco). This is
because tax depreciation deductions for investments made during the holiday
cannot be deferred, and because of the higher inflation rate in those countries.
Where firms are allowed to defer tax depreciation until after the holiday,
capital is taxed at lower or negative effective rates.
Table 5 also indicates that effective tax rates at the end of the holiday are
particularly high: income earned on new assets is fully taxed after the holiday
is terminated. Even in those countries that allow depreciation to be deferred,
the allowances do not accrue interest when they are carried forward. These
extraordinarily high effective tax rates would be likely to induce firms to sell
off their capital stock before the holiday is terminated and then repurchase
1. Bartholdy, Fisher, and Mintz (1987) estimate that a point increase in the corporate tax rate in
Canada is associated with a three-quarter point increase in the debt-asset ratio.
Table 5. Effective Tax Rates and User Costs of Capital for Holiday and Post-Holiday Investments, Assuming 100 Percent
Equity Financing
(percent)
Bangladesh C6te dlvoire Malaysia Morocco (t' = 10) Thailand
(t = 7) (t = 7) (t = 7) Zone III Zone IV (t* = 5)
Period Buildings Machinery Buildings Machinery Buildings Machinery Buildings Machinery Buildings Machinery Buildings Machinery
Effective tax rate'
During holiday
t = 0 15.7 6.3 -1.1 -909.8b -1.9 -44.1 28.0 28.8 1.4 0.8 0.4 0.4
t = 3 30.9 22.4 -1.5 -610.4b -2.7 -76.3 28.3 29.2 2.5 2.1 0.7 1.0
t = 5 44.6 43.3 -1.8 -325 0b -3.4 -119.9 28.7 29.8 3.6 3.7 n.a. n.a.
t = 8 n.a. n.a. n.a. n.a. n.a. n.a. 29.7 31.7 6.3 8.9 n.a. n.a.
Last year of holiday 88.1 93.0 56.0 61.6 51.5 51.1 59.1 68.2 63.9 75.7 41,9 51.7
After holiday 44.6 46.7 45.2 34.9 36.9 8.4 53.0 54.3 53.0 54.3 34.6 32.9
User cost of capital
During holiday
t= 0 8.6 18.2 10.1 30.5 13.0 20.6 16.5 26.7 13.4 23.4 21,2 31.2
t = 3 9.3 18.9 10.1 29.0 12.9 19.6 16.6 33.0 13.5 23.5 21,2 31.3
t = 5 10.4 20.3 10.1 27.7 12.9 18.7 16.7 26.8 13.6 23.6 n.a. n.a.
t= 8 n.a. n.a. n.a. n.a. n.a. n.a. 16.8 27.2 13.9 24.1 n.a. n.a.
Last year of holiday 30.2 57.7 16.8 43.5 21.8 31.6 25.3 41.1 28.0 49.1 32.7 48.4
After holiday 10.4 20.6 14.5 38.0 17.9 23.9 22.7 33.2 22.7 33.2 29.6 39.2
Nominal interest rate 14.0 9.9 12.2 15.5 18.6
Inflation rate 11.0 4.7 4.1 7.2 2.5
n.a. Not applicable.
t= year following commencement of holiday.
t= first year after the holiday.
Note: Assumes 5 percent rate of depreciation on buildings and 15 percent on machinery on a declining balance basis, except for C6te d'lvoire, in which the
rates are 5 and 30 percent.
a. Estimated as the difference between the marginal pre- and post-tax rates of return on capital divided by the pre-tax rate of return.
b. User cost of capital net of depreciation actually negative in this case. This implies a negative value for the difference between pre- and post-tax rate of return
on capital but a positive effective rate. A minus sign is included to indicate a negative tax.
Source: Author calculations, based on International Bureau of Fiscal Documentation (1987, 1988) and Arthur Andersen correspondence.
Table 6. Effective Tax Rates and User Costs of Capital for Holiday and Post-Holiday Investments, Assuming 50 and 70
Percent Debt Financing
(percent)
Bangladesh C6te d'Ivoire Morocco (t = 10)
(t = 7) (t = 7) Malaysia (t = 7) Zone III Zone IV Thailand (t = S)
Period Buildings Machinery Buildings Machinery Buildings Machinery Buildings Machinery Buildings Machinery Buildings Machinery
Effective tax rate'
During holiday
t = 0 30.9 13.0 1.7 -532.8b -2.1 -48.9 5.9 8.6 2.7 1.4 0.5 0.4
t = 3 51.0 38.3 -2.2 -269.4b -3.0 -81.5 7.4 9.6 4.6 3.3 0.8 1.1
t = 5 64.6 61.6 -2.6 -212.8b -3.7 -124.0 8.8 11.6 6.5 5.8 n.a. n.a.
t = 8 n.a. n.a. n.a. n.a. n.a. n.a. 11.8 16.3 10.7 13.0 n.a. n.a.
Last year of holiday 90.5 94.4 53.6 8.4 48.6 46.6 58.5 72.0 63.4 76.2 50.5 62.4
After holiday -225.1 -301.0 -13.8 -34.7 -17.2 -114.6 -29.3 -7.5 -29.3 -7.5 4.6 2.8
User cost of capital
During holiday
t = 0 7.3 16.8 9.1 29.0 11.8 19.6 12.2 22.4 11.9 21.8 19.3 29.3
t = 3 8.3 17.6 9.1 27.5 11.7 18.8 12.3 22.5 12.1 22.0 19.4 29.4
t = 5 9.5 19.2 9.1 26.3 11.7 18.1 12.4 22.6 12.2 22.4 n.a. n.a.
t = 8 n.a. n.a. n.a. n.a. n.a. n.a. 12.7 23.1 12.6 22.8 n.a. n.a.
Last year of holiday 29.1 56.2 15.1 41.3 19.7 29.1 23.2 41.8 25.6 46.7 35.7 55.4
After holiday 3.2 13.9 9.1 33.5 11.4 18.5 10.8 22.0 10.8 22.0 20.9 30.6
n.a. Not applicable.
t = year following commencement of holiday.
t' = first year after holiday.
Note: Assumes 50 percent debt financing during the holiday and 70 percent thereafter. Assumes 5 percent rate of depreciation on buildings and 15 percent on
machinery on a declining-balance basis, except for Cote d'Ivoire in which the rates are 5 and 30 percent.
a. Estimated as the difference between the marginal pre- and post-tax rates of return on capital divided by the pre-tax rate of return.
b. User cost of capital net of depreciation actually negative in this case. This implies a negative value for the difference between pre- and post-tax rate of return
on capital but a positive effective rate. A minus sign is included to indicate a negative tax.
Source: Author calculations, based on International Bureau of Fiscal Documentation (1987, 1988) and Arthur Andersen correspondence.
Mintz 95
capital afterward. (Unfortunately, there are no data available to the author on
this issue.)
These results can be quite sensitive to the degree to which firms finance
capital by equity. In table 6, I assume debt financing of 50 percent during the
holiday and 70 percent thereafter. In Thailand, dividends are tax exempt
during the holiday. Since this exemption may not be given to foreign investors,
I am effectively assuming for these calculations that the cost of equity finance
for the firm is affected by personal taxes on domestic investors. If equity
financing was available from the international market, personal taxes on do-
mestic savers would not affect the cost of finance faced by the company in
world markets.
Because nominal interest costs are tax deductible, it is not surprising to find
that user costs of capital and effective tax rates are much lower in table 6 in
the post-holiday period for all countries. Interest deductions can be quite gen-
erous since they allow the firm to write off part of the real value of the debt.
Debt finance also increases the tax rates during the holiday relative to those
afterward. Since interest deductions are beneficial only after the holiday period,
the effective tax rate may be higher during and at the end of the holiday than
in the post-holiday period. As seen in table 6, effective tax rates on capital
during the holiday are higher than those after the holiday in Bangladesh and
Morocco overall, and in Malaysia and Cote d'Ivoire on buildings. End-of-
holiday investments also bear a high tax liability for the reasons cited earlier.
V. CONCLUSIONS
The tax holiday provisions for investment in long-lived assets are not as
generous to the firm as one might initially believe. Even if the firm is fully
exempt during the holiday, its investment decisions may be significantly af-
fected by tax liabilities that will occur after the holiday. If a firm must write
off tax depreciation allowances during the holiday but its capital goods gener-
ate high income thereafter, without depreciation deductions, the firm may face
relatively high effective tax rates. The closer to the end of the holiday, the
higher the effective tax rates on new investment. Only when the firm is allowed
to defer depreciation until after the holiday do effective tax rates become low
or negative. In some cases, when deferral is allowed, the effective subsidy is so
large that I suspect government officials would be taken aback by the generosity
of the tax holiday.
A company tax holiday can be generous to labor if such labor is compensated
by profit distributions that may be exempt at the individual level. Moreover,
although it is generally disallowed, investors may try to shift taxable income
earned by associated companies into the tax holiday firm.
In the rather simple analysis above, I have abstracted from a few technical
issues that would require explicit attention in policy analysis for a particular
country. The first is the impact of tax holidays on foreign investment which
96 THE WORLD BANK ECONOMIC REVIEW, VOL. 4, NO. I
may be taxed by both the capital-importing and capital-exporting countries.
Further work is necessary to show how tax holiday provisions interact with
foreign tax systems. The outline above also ignores imperfections in capital
markets and the determination of financial policy of companies. The theory is
based on equal net-of-tax rates of return on all assets, perfect markets, and
companies minimizing their after-tax finance costs by borrowing for invest-
ment, independent of capital decisions. If, however, investors and companies
are constrained in borrowing funds, as is common in some developing coun-
tries, the standard capital market equilibrium used in this literature does not
apply. Finally, I do not address "recapture" rules that apply to the sale of assets
by corporations. I assume here that the sale of an asset by a firm reduces the
base used to calculate depreciation write-offs. In most tax systems, however, if
a firm sells an asset, a "balancing charge" is imposed that may require the
inclusion of the sale value of the asset (net of unclaimed tax depreciation) in
the income of the corporation, an approach which is far less generous than
merely writing down the undepreciated capital base. Since a firm may be
expected to sell its capital, particularly at the end of the holiday, a more
complete analysis must account for these balancing charges. This suggests that
the effective tax rates calculated here are, if anything, underestimates relative
to rates likely to emerge if recapture rules were modeled correctly.
APPENDIX. MODELS OF TAX HOLIDAY INCENTIVES
The model examines company tax holidays first for mandatory deduction of
depreciation allowances when they accrue, and then for their deferral.
Mandatory Depreciation
A competitive firm uses capital in each period to maximize the value of
shareholders' equity. If the firm has no debt, the payment made to shareholders
is equal to the cash flow of the firm: revenues net of expenditures on gross
investment and corporate taxes. Labor inputs are ignored since wages are fully
deductible from the company tax base.
In each year, the firm earns nominal revenues as a function of its capital
stock, Kt, equal to f(Kt)( 1 + 7r)t where Xr is the rate of inflation. Real revenues
are output, which is derived as a strictly concave production function. The
revenues are distributed as dividends to the shareholder or used for investment.
Capital goods prices rise with the general inflation rate, and the price is equal
to unity. Real gross investment in each period, It, is new investment plus a
component to offset physical depreciation, 6 (which is assumed to be of the
declining-balance form):
(A-1) I, = WK + K,, -K
Let t = 0 be the time when the firm starts up and t = t* be the time at which
the tax holiday ends and the firm becomes fully taxable. Prior to t'- (t = 0 . ..
Mintz 97
t* - 1), the firm's taxable profits, revenues net of mandatory depreciation
deductions, are taxed at the rate uo and, for t > t*, at the rate u, with ul >
uo. The net-of-tax real revenues of the firm are thus equal to (1 - uo)f(K,), and
the real expenditure on gross investment, net of the present value of tax allow-
ances, is equal to I,(1 - A,). The tax value of depreciation allowances per
dollar of gross investment (A,) varies in each year of the holiday as shown
subsequently.
When the firm invests in capital at time t < t*, it writes off its gross
investment at the initial allowance rate of y. An annual depreciation allowance
is also given based on the undepreciated capital cost base (ucc), which is
increased at time t, in real terms, by the amount (1 - cy)I, with c denoting
the proportion of the initial allowance that is written off the ucc base. If there
is full adjustment, c = 1, and if there is no adjustment, c = 0. At each point
in time the annual allowance rate is cx, which is assumed to be of the declining-
balance form and based on the original purchase price of capital. At time
s 2 t (s = t, t + 1, . . , t + T, . . .), the annual allowance deducted from
profits is equal to ca(1 - t(1 - cy)(1 + ir)t, in nominal terms. Prior to t*,
the initial and annual allowances are written off at the rate u0, and after tV, the
remaining annual allowances on the investments made prior to the termination
of the tax holiday are written off at the rate u,. Since these tax depreciation
write-offs are valued in nominal terms, they are discounted at the nominal cost
of finance i. Deflating by the price index at time t, the real values of tax
depreciation allowances, At, are computed as follows:
(A-2) A,=u0y+(1-c) [ i u ao (1 -)S + E ( ( )s]
Equation A-2 yields a simpler expression for A,:
(A-3) At= u0z ± Z{uo + (ul -uO) l + i]j }for t < t*
where Z = (1 - c-y)(1 + i)a/(a + i). As shown, the tax value of depreciation
write-offs is equal to the value of the initial allowance (u.-y) plus the present
value of the annual allowances written off during and after the holiday. Given
u, > u0, the firm receives the additional tax benefit of the deduction of
depreciation allowances after the holiday. However, the value of the deduction
is lower the earlier that the investment takes place during the holiday, since
[(1 - a)/(1 + i)]t*-t is lower in value as t is further from t*.
For investments undertaken after the holiday, real revenues are equal to
f(K,)(1 - ul) and the real cost of investment expenditure is I,(1 - A,) with
(A-4) A, = u ,y + (1 - c-y) [Eu, (1 +a) = u,(y + Z) for t 2 t*.
The present value of tax depreciation allowances is then time-invariant since y
98 THE WORLD BANK ECONOMIC REVIEW, VOL. 4, NO. I
and Z are independent of t. This is the usual case found in the tax literature.
(Note that if -y = 0, then A, = u1a(1 + i)I(a + i) = A which is the present
value of annual tax depreciation on a declining-balance basis).
The value maximization problem is formulated given the firm's real discount
rate, 1 + r, which is equal to (1 + i)/(1 + 7r). Shareholders' equity, V, is the
discounted value of real cash flows earned during and after the holiday period:
co 1
(A-S) V + [f (K,)(1 - u,) - (6K, + K - K,)(1 -A,)]
t= 1+ r)t Y1-A)
with A, defined by equations A-3 and A-4 and u, denoting time-varying corpo-
rate tax rates. For convenience, let A, = A for t > t* since the present value of
tax depreciation allowances on gross investment is shown to be time invariant
after the tax holiday.
The firm maximizes shareholder equity, V, choosing K, in each period. The
first order condition for each period is:
(A-6) AK = (l + [f (1 - uo) - (b1-1)(1 -At)] - AI - A,_1 = 0
aKt (1 + r)t (1 + r)t-1
Investment during the holiday period. When t < t*, the user cost obtained
from equation A-6 is
(A-7) ft = (1 - u0)- [(6 + r)(1 - A,) + (1 + r)(At-At-A)]
The user cost of capital during the tax holiday is adjusted to reflect the fact
that marginal revenues (gross of depreciation costs 6) are taxed at the rate u0,
and for the cost of purchasing capital in period t - 1 rather than t. Since
depreciation write-offs increase in value over time, the firm is better off waiting
one period.
Substituting equation A-3 into A-7 and combining terms yields:
(A-8) ft (1 - uo)-l [(6 + r)(1 - A,)
+ (u, - uo)(1 - cy)a(l + r)] (G+ i)
This expression may be interpreted as the tax depreciation penalty of investing
in assets during the holiday rather than after the holiday.
In most cases, 100 percent of the firm's profits are exempt from taxation
during the holiday. This implies that uo = 0 and that the present value of tax
depreciation allowances is based on write-offs made after the tax holiday:
A, = u1Z[(1 - a)/(1 + i)]'-t. The user cost of capital in equation A-8
becomes:
(A-9) f' = (8 + r) - 16(1 + r) - (a + r)] u,A (1 + ir)
By investing in capital in period t - 1 (yielding income in period t), the firm
Mintz 99
replaces 6 units of capital in period t at the price 1 + ir. The replacement cost
of depreciation is 8(1 + ir), and this generates tax depreciation allowances per
dollar of capital equal to u,Z[(1 - a)/(1 + i)]tt-' after the period. However,
by investing in capital in period t - 1 rather than in t, the firm loses, in
present-value terms, tax depreciation that would be based on higher capital
goods prices. This is the term a + ir multiplied by the present value of tax
depreciation allowances later earned by the firm. Equation A-9 therefore indi-
cates that if an asset's economic depreciation rate S(1 + ir) is equal to the tax
depreciation rate plus inflation, the firm will be exempt from capital taxation
during a tax holiday. If economic depreciation is more than tax depreciation
plus inflation, capital during the holiday is subsidized; if it is less, capital is
taxed. If the tax depreciation allowances were indexed for inflation, however,
the inflation term would drop out and all that would matter would be the
relationship between economic depreciation and tax depreciation.
Investment at the end of the holiday period. When t = t*, the tax holiday
ends and the firm becomes fully taxable. Its income is based on its capital stock
determined by investment in the previous period (as determined by equation
A-6). The cost of capital for this case is:
(A-l0) ft* = (61 r (1-A) + (1 + r) (u, - uo) [-y + a(1 - cy)]
where A = u,(-y + Z).
Intuitively, the user cost of capital stock for period t* is equal to the cost of
depreciation and finance, now adjusted for the post-holiday statutory tax rate,
u,, and for the loss in the tax value of initial and annual allowances arising
from investing in period t* - 1. This latter cost is captured by the second term
of equation A-8.
Investment made after the tax holiday. When t > t*, the firm is fully taxed
both at the time of investment and when income is generated. In this case, the
general formula for the user cost of capital is derived:
(A-11) 6 + r (1 A) for t > t*
Deferral of Depreciation
When depreciation is deferred until after the holiday, the firm deducts the
allowances from taxable income at the post-holiday corporate tax rate. This
could cause the firm to be nontaxpaying for a lengthy time if unused holiday
depreciation allowances are large relative to post-holiday net revenues. For
convenience, it is assumed that the firm is taxpaying after the holiday so
deductions are used immediately, beginning at time t*.
If depreciation allowances may be deferred, the present value of tax depreci-
ation allowances is calculated beginning in period t as follows. At time s 2 t,
100 THE WORLD BANK ECONOMIC REVIEW, VOL. 4, NO. I
where s = t*, t* + 1, . . . t* + r . . . (that is, when the holiday is over), the
firm deducts the initial allowance at the value ul5y or in present-value terms at
U,-y (1 + i)* Investment expenditure also adds 1 - c'y dollars of investment
expenditure to the ucc base, which is used to calculate the annual allowance
given at the rate ca on a declining-balance basis.2 The firm deducts an annual
allowance only after the holiday is finished. The deduction for the annual
allowance is equal to the nominal value u,a(1 - u)s-t* in each post-holiday
period. In present-value terms, this is equal to u,a(1 - a)St-*(l + j)(St§) The
tax benefit of depreciation allowances is thus:
(A-12) A, = {u;y + (1 - cY) [ u1ot (1 +) I 1+
= ul(-y + Z)(1 + i)-(t*-t) for t < t
The three expressions for the user cost of capital, adjusted for depreciation
allowance deferral, are, for the holiday period (t < t*):
(A-13) I = + r) [1 - u1(Qy + Z)(1 + i)tt*-] + u(y + Z)(1 + i)-(t -t)
\1- _u0/ (1 - u0)(1 + 7r)
for the end of the holiday (t = t*):
(A-14) ftr = (3 _ ) [1 - U&(y + Z)] + iu5(y + Z)
__U~~~~) ~(1 - u1)(l + it)
and for the post-holiday period (t > t*):
(A-15) _( + r)(1 -A)
1 - u
Equations A-13 and A-14 are similar to A-8 and A-10 respectively except for
the treatment of the value of tax depreciation allowances. The value of tax
depreciation allowances for investments made during the holiday period is the
discounted value of write-offs that begin after the holiday is completed. This is
quite unlike the case in which the firm must write off capital during the holiday,
and thus has only (1 - a)t-t units of capital invested at time t to write off.
The second terms in equations A-13 and A-14 are also similar in interpretation.
They denote the tax penalty of investing in capital prior to the end of the
holiday and taking depreciation allowances afterward. If the firm could accrue
interest on the tax deductions that it carries forward, then this second term
would disappear. Equations A-11 and A-15 are identical, as one would expect.
If the firm can defer depreciation allowances until after the holiday, capital
investment may be subsidized, especially if u. = 0. For example, in the first
term of equation A-13 the firm deducts depreciation allowances at the rate u,
2. In some cases, the total amount of depreciation undeclared during the holiday may be expensed
at the end of the holiday rather than written off in the post-holiday period at the rate a. This practice
does not seem to be followed in the countries that are dealt with in this paper.
Mintz 101
which is higher than the tax on revenues, u,. The only cost to the firm of
investing in capital at time t > t'" is the loss in the present value of tax
depreciation allowances as captured by the second term in equations A-13 and
A-14. Note that when uo = 0, the effective tax on capital is negative if 6 + r
< 1/(1 + ir), in an equation corresponding to A-9. This implies that deferral
in the presence of a tax holiday causes the effective tax rate to become negative
unless inflation rates are sufficiently high. If inflation rates are high enough,
the second term in A-13 dominates the first, implying capital under deferral
during the holiday is taxed at a positive rather than negative rate.
In some countries, such as Cote d'Ivoire, the firm may choose whether to
deduct or not its depreciation allowances during the holiday period. Under
deferral, the present value of tax depreciation (denoted Ad) is equal to that
shown in equation A-12; without deferral (And) it is as shown in equation A-3.
Deferral is preferred if ('y + Z)[(u, - uo(l + i)t-t] > (u, - uo)(1 - a)t*-tZ. If
u0 = 0, deferral is preferred since y 2 0 and (1 - o) < 1. If uo > 0, deferral
is preferred only if t* - t is small enough such that claiming deductions early
is less valuable than claiming deductions at a later time. These results are
particularly useful for Cote d'Ivoire and Malaysia since companies would gen-
erally wish to defer depreciation.
For the treatment of debt and dividend taxes, see Mintz (1989).
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