Foreign Direct Investment

Attracting foreign direct investment (FDI) has become a key part of national development strategies for many countries. FDI reflects the objective of obtaining a lasting interest by a resident entity in one economy into a resident entity in an economy other than that of the investor. This is particularly important for countries where domestic savings cannot meet the increasing demand for capital.

For the investing company, it is able to provide the company with new markets and market channels, cheaper production facilities, access to new technology, products, skills and financing. For the host country which receives the investment, FDI can provide a source of new technologies, capital, processes, products, organisational technologies and management skills, and as a result, can provide a strong drive to economic development.

Many countries have attempted to use tax incentives as a means of attracting FDI. Fiscal incentives are an essential component of many countries’ investment promotion strategies. However, there are two perceptions of the fiscal incentives. Firstly, there are supporters who argue that, under certain conditions, they increase investment, create jobs and other socio-economic benefits. On the other hand, opponents believe that fiscal incentives may not be the most suitable mechanism for attracting FDI and the cost of implementing these tax incentives outweigh the benefits. They believe that tax incentives may worsen problems like governance and corruption.

According to Morriset and Pirnia of the Foreign Investment Advisory Service (FIAS), the most popular form of tax incentive for several developing countries has been tax holidays. Tax holidays provide the investing company with large benefits as soon as it begins to earn income. Since 1998, 103 countries have offered special tax holidays to foreign corporations that have set up production or administrative facilities within their borders.

With the use of tax holidays, companies are allowed a period of time free from the burden of income taxation. During this period, a newly established company shall receive a nil or reduced tax rate and will only be required to pay a normal rate after the end of the period of the tax holiday.

The temporary waiving of the income tax of corporations generally would be expected to boost investment by increasing the amount of after-tax profit earned on new investment and on the existing capital stock. Tax holidays are often considered as one of the main factors that determines the investments of foreign corporations.

In addition to the low or nil tax payable by the company, the tax holiday also attracts investors due to its simplicity and low administration costs. It allows taxpayers to avoid contact with tax administration, which may be important to the company if it is complex or even corrupt.

With the use of tax holidays as a tax incentive, foreign corporations shall be encouraged to establish corporations among developing countries and therefore bring about an inflow of FDI towards the developing country. Nigeria has a regional incentive system that allows tax holidays for companies that establish operations in rural areas where there are no facilities such as electricity, tarred roads, telephones and water supply. By doing so, the establishing foreign corporation may bring with them economic benefits which may assist in the development of the rural area.

The tax holiday policy is widely used throughout the world. Examples of the successful use of tax holiday are evident in China, India and Ireland. In Ireland, this policy has made this country a major recipient of the capital in Europe. The fundamentals of this country are not deficient; however, the country continues to implement tax holidays as an incentive for foreign investors. Ireland’s economic success has earned it the label of a �Celtic Tiger’ and was partially the result of four decades of pursuing an export-led industrial policy that relied on attracting the inflow of FDI. Ireland first started attracted export oriented FDI inflows with the introduction in the mid 1950s, of a fifteen year tax holiday on profits from export sales.

Ireland was able to increase the employment rate significantly and developed new high technological and export-oriented industries. Although it would seem that the government would be making a loss on the tax payable by the foreign company, the benefits obtained from the development of the economy exceeded the losses of the tax payments, and therefore induced the government to continue to use this tax incentive.

China has also implemented the tax holiday policy which has been a success in the inflow of FDI towards the country. China currently offers a two-year tax holiday from the year foreign investors make profits and 50 percent tax concession three years thereafter. In addition, for a further period of