Fiscal Frameworks and Financial Systems in East Asia: How Much Do They Matter? 9781442674905

Table of contents :
Preface
Contents
Fiscal frameworks, financial systems and the Asian crisis
The fiscal framework for business in Asia
How much does finance matter in East Asia?
About the authors
Institute for International Business

Citation preview

Hongkong Bank of Canada Papers on Asia Editor A.E. Safarian University of Toronto Managing Editor Wendy Dobson University of Toronto Editorial Advisory Board David E. Bond, Dr. David E. Bond and Associates, Vancouver Edward K.Y. Chen, Lingnan College, Hong Kong Chia Siow Yue, Institute of Southeast Asian Studies, Singapore Farid Harianto, PEFINDO Credit Rating Indonesia Ltd., Jakarta Ralph W. Huenemann, University of Victoria Lawrence B. Krause, University of California, San Diego Karen Minden, Asia-Pacific Associates, Winnipeg Eleanor Westney, Massachusetts Institute of Technology, Cambridge, Mass. Ippei Yamazawa, Hitotsubashi University, Tokyo

Institute for International Business University of Toronto

Hongkong Bank of Canada

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Hongkong Bank of Canada Papers on Asia, Volume 4

Fiscal frameworks and financial systems in East Asia: How much do they matter?

Wendy Dobson, Editor

UNIVERSITY OF TORONTO PRESS Toronto Buffalo London

Other titles in this series Benchmarking the Canadian Business Presence in East Asia (Volume 1) East Asian capitalism: Diversity and dynamism (Volume 2) The people link: Human resource linkages across the Pacific (Volume 3)

ISBN 0-8020-4435-2 (cloth) ISBN 0-8020-8229-7 (paper) © Institute for International Business Rotman School of Management University of Toronto 105 St. George Street, Toronto, Ontario M5S 3E6 Printed and bound in Canada

Canadian Cataloguing in Publication Data Main entry under title: Fiscal frameworks and financial systems in East Asia : how much do they matter? (Hongkong Bank of Canada papers on Asia ; v. 4) Includes bibliographical references and index. ISBN 0-8020-4435-2 (bound) ISBN 0-8020-8229-7 (pbk.) I. Finance - East Asia. 2. Taxation - East Asia. 3. Financial crises East Asia. 4. East Asia - Economic conditions. I. Dobson, Wendy. II. Series. HG187.E37F57 1998

332'.095

C98-932241-6

Preface This volume is the fourth in a series that examines Canada's business and economic relationships with the countries of East Asia. As we've seen in previous volumes, the Canadian business presence in East Asia has been modest, primarily because East Asian markets are different from, and farther away than the more familiar markets of Europe and North America, and because there is less information available about them. The immediate overall impact of the 1997-98 financial and economic crisis has been negative, and mainly concentrated among commodity producers in the forest and mining industries in the western region of Canada. The impact on manufacturing may yet be felt as it spills over through intra-firm linkages within multinational companies with subsidiaries in Canada — some of which are among Canada's largest exporters. But the diversified global businesses of these producers could also mean that the decline in Asian sales is offset by growth in other places, like the European Union. The other side of the Asian crisis is that it presents potential business opportunities to firms who are late entering the market or who want to expand activities they already have in place. There are many opportunities to acquire assets at prices that are drastically lower than before the crisis, or to form alliances and joint ventures with distressed but potentially sound Asian business partners. Investors need to understand very clearly what they are doing before they take advantage of these opportunities, however, because the promise of high returns is always accompanied by potential risks. This is where the Hongkong Bank of Canada Papers on Asia can make a significantthe Hongkong Bank of Canada Papers on Asia can make a significant contribution.

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Volumes 2 and 3 in the series explained the key aspects of Asian business systems, like the Japanese keiretsu, the Korean chaebol and Chinese networks, and the human resource and cultural characteristics that underly both the business systems and the related economic linkages between Canada and the Asian economies. This volume evaluates and compares two little-understood aspects of the Asian business environment: tax frameworks and financial systems. Two of the papers assemble and analyze original information and explain their significance for business decision making. Professor Richard Bird and Duanjie Chen of the University of Toronto have developed a sophisticated measure of the features of national tax systems that compares the burden of taxation in these economies. Professors Varouj Aivazian and Walid Hejazi of the University of Toronto compare key aspects of the financial systems. Both teams find that Hong Kong has the strongest financial system and is the lowesttaxing jurisdiction. More surprising, they both find that Japan ranks lowest on both counts, with other countries ranked in between. Both papers look to the future to assess how and why these rankings might change. This volume is especially timely, coming as it does in the midst of the Asian financial and economic crisis, which Wendy Dobson discusses in some detail in the first chapter. While the studies of the tax and financial systems demonstrate the links between financial institutions, financial policy and economic growth, the crisis illustrates that weak and out-of-date institutional structures can severely set back the growth and development process. In other words, fiscal frameworks and financial systems matter. The Hongkong Bank of Canada Papers on Asia publishes timely and readable scholarly work in the fields of business and the social sciences, aimed primarily at the Canadian business community, to help increase their knowledge of and familiarity with the East Asian economies. The Papers are intended to become an authoritative source of research, in Canada and beyond, on the rapidly-changing Asian economies. The Hongkong Bank of Canada has provided generous support for this project. Professor A. E. Safarian is the series Editor; he leads a distinguished international Editorial Advisory Board that provides peer review and editorial advice. To stimulate high-quality research, the ii

editors seek out top researchers and encourage them to write on subjects central to the Papers' mission. Manuscripts are commissioned and symposium and conference contributions solicited. In addition, events are organized by the Institute for International Business to ensure timely dissemination to interested audiences. The University of Toronto Press cooperates in this project through its Scholarly Publishing Division. Support is also provided by Heather Munroe-Blum, Vice-President, Research and International Relations, and Paul Halpern, Interim Dean of the Rotman School of Management at the University of Toronto. This volume was prepared with the assistance of staff at the Institute for International Business. Sherene Hu prepared the manuscript. Vivien Choy ably looked after all logistical arrangements. The manuscript was expertly prepared and brought to publication with the editorial assistance of Catherine Gordon. Wendy Dobson September 1998

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Contents Preface

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Fiscal frameworks, financial systems and the Asian crisis . . 1 Wendy Dobson The Asian crisis 3 Implications for Canadian business in the crisis context 14 The fiscal framework for business in Asia Richard M. Bird and Duanjie Chen Fiscal developments in Asia Tax effects on investment and production decisions Implications of the analysis Appendix — Information used in METR analysis Annex A — An outline of relevant Canadian tax provisions . . .

21 23 35 57 68 81

How much does finance matter in East Asia? 91 Varouj A. Aivazian, WalidHejaziwithJ.D. Han Economic growth theory 93 Financial systems and economic growth 93 An analysis of East Asian financial systems Ill Conclusions and lessons for international investors 117 Annex A - Growth theories and the East Asian economies . . . 123 Annex B — Country profiles 128 About the authors

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Fiscal frameworks, financial systems and the Asian crisis Wendy Dobson The Asian economic crisis provides a dramatic backdrop to this, the fourth volume of the Hongkong Bank of Canada Papers on Asia. The papers in this volume focus on two elements that are key to business decisions in East Asia: fiscal frameworks and financial systems. They provide valuable information about taxation and financial systems that can affect the business decisions foreign investors make. The basic premise of the volume is that financial and fiscal systems can contribute to economic growth, but they can also significantly constrain growth and foreign investment if they are underdeveloped. As Professor Richard Bird and Duanjie Chen of the University of Toronto point out in the second paper, which discusses fiscal systems, relatively little attention has been paid to the fiscal dimension of government policy, both before and since the economic crisis began in 1997. Governments have used fiscal incentives, particularly to attract foreign direct investment (FDI), because they believe these incentives contribute to rapid growth. Expert opinion has changed from being sceptical of these practices on the grounds that they are redundant and ineffective, to qualified approval of incentives for research and development and other investment-facilitating activity. These measures should obviously be used selectively, however, since they may deprive governments of revenue, complicate the fiscal system and channel direct investment into uses that do not promote maximum efficiency. In their paper, Bird and Chen develop a sophisticated measure that helps investors assess the burden of major forms of taxation on 1

production in the East Asian economies. The marginal effective tax rate, METR, is a complex measurement that takes into account taxes on capital, payrolls, sales and property taxes on capital investment and labour costs. As with most constructs of this kind, some heroic assumptions are necessary. In this case, the authors assume that interest rates are equal across economies. This is a somewhat questionable simplification in the light of the role interest rate differentials and exchange rate risk played in the Thai financial crisis, as is discussed below. Nevertheless, the METR provides a comparison across economies that may surprise those using simpler measures. Bird and Chen find that Hong Kong has the lowest tax burden, followed by Malaysia, Korea and then China, Singapore and Taiwan. Surprisingly, they find that Japan is the highest taxing jurisdiction. They caution that these rankings may change in the future in the economies whose populations are ageing the fastest. Based on this prediction, Japan, which has the most rapidly ageing population, will probably stay where it is, while China, which will age very rapidly in the years ahead because of the radical impact of the one-child policy, can be expected to face severe revenue pressures. One should temper this prediction with the knowledge that international capital mobility will provide an offsetting incentive to maintain relatively attractive tax regimes. In the third paper, Professors Varouj Aivazian and Walid Hejazi of the University of Toronto present a comparative analysis of East Asian financial systems and an estimate of their relative importance to longterm growth. Financial market development is potentially a central factor in an economy's long-term growth and development. It can change the speed at which capital accumulates and influence the efficiency of production in an economy. Financial institutions not only mobilize resources and facilitate the transactions necessary to carry on economic exchange—they also play a critical role in managing risks and closing information gaps1. These institutions lessen and diversify 1

2

Financial systems address the central problem of the asymmetry of information between the providers and users of funds. On the asset side, financial institutions take on risk in valuing projects and funding borrowers whose ability to repay is uncertain. On the liability side, creditors and Wendy Dobson

the risks faced by investors by pooling their savings and distributing them among many users. They also collect and evaluate the information necessary to make prudent and productive investment decisions. And they participate in corporate governance by evaluating the performance of corporate borrowers and, when necessary, compelling them to act in the best interests of a firm, and therefore of its providers of funds (Levine 1996). Traditional analysis has tended to portray finance as an auxiliary factor in growth and development. More recently, however, as financial crises have disrupted growth and other aspects of real economic activity with increasing frequency, interest in financial reform has grown, and with it the realization of its potentially central role in economic growth. It is apparent, however, that the financial institutions in the East Asian economies experiencing crisis have either not carried out the functions outlined above, or have failed to carry them out properly. Aivazian and Hejazi find that their indicators of financial market development do contribute to long-term growth. In comparative terms, the economies with the most mature financial systems (Taiwan, Hong Kong and Singapore) have not been as damaged by the recent crisis as other economies, but they have had to endure negative spillovers channelled through international trade and capital flows.

The Asian crisis Aivazian and Hejazi's finding is part of a growing body of analysis that suggests there is no simple explanation of the causes of the Asian crisis—and therefore no silver bullet to fix it. The crisis resulted from a combination of international and domestic factors. As seasoned observers of financial crises in history, like Charles Kindleberger and more recently Morris Goldstein, have noted, crises like these are depositors lack information about the actual position of the financial institutions in which they must have confidence. When these institutions are highly leveraged, lack liquidity or provide little information about their assets, they are vulnerable to losses in confidence, and depositors have an incentive to flee when confidence erodes (Lindgren et al 1996).

Fiscal frameworks, financial systems and the Asian crisis

3

difficult to predict by their very nature, and each successive crisis has its own causes. Recent events in East Asia have contributed to the second major crisis in developing countries in the 1990s. The first was the Mexican peso crisis in 1994-95. The events in East Asia are different from the crisis in Mexico (and the Latin American debt crisis of the 1980s) because they occurred in a relatively benign international environment of low interest rates and because the major debtors are in the private, rather than the public, sector. Some observers have generalized from these characteristics to suggest that the Asian crisis is the first of what will be a series of 21st century crises resulting from increasingly unfettered global capital. From a historical and analytical perspective, however, an inference like this misses a key point: free capital movements can facilitate more efficient international allocation of savings, and channel these resources to where they will be most productive. Those who allocate and receive capital, however, must ensure there is adequate information, supervision and risk assessment. With the explosion of cross-border flows, financial sector deregulation in the industrial countries frequently has been associated with excessive credit growth and a boom-bust cycle in equity and property markets. These excesses have caused serious damage to banking systems and, in many cases, have been corrected only by government bailouts and major changes in incentive systems. Emerging markets need to strengthen the foundations of their domestic financial systems so that they can allocate both domestic and foreign capital efficiently and withstand shocks like a reversal of capital inflows. Despite the complexity of the factors that have triggered the Asian crisis, and the severity of the subsequent economic effects, there are three fundamental weaknesses underlying the crisis. First, many East Asian governments still see their role as interventionist despite the growing complexity of their economies. Many protect domestic financial institutions and provide implicit guarantees that undermine accurate risk appraisal. In some cases, their slowness to face up to the severity of the resulting structural weaknesses and distortions and the need for decisive corrective action has contributed to loss of confidence and the severity of the crisis. 4

Wendy Dobson

Second, the East Asian economies are characterized by institutions that developed to manage the risks of imperfect capital and labour markets by internalizing them within groups bound together by relationships. These characteristics were studied in some detail in the second volume of the Papers. As the economies have developed and opened to international trade and capital flows, however, the financial sector has needed to change to ensure transparent information, adequate supervision and risk assessment. As the third paper in this volume concludes, changes in this sector have not keep pace. Third, information flows in international financial markets are inadequate. Developments in communications technology have greatly altered the magnitude and volatility of capital flows by reducing the direct costs of trading. Financial engineering has produced derivatives; and other highly leveraged financial instruments; and a proliferation of aggressive financial intermediaries moves large pools of capital among the world's financial markets. Short-term capital flowed into the East Asian economies, often on the basis of years of good press about rapid growth, rather than after due diligence about counterparts and borrowers, or on the basis of careful evaluation of changing macroeconomic conditions. The magnitude of the crisis resulted in large part from investors re-evaluating their perceptions of risk as the news spread about the vulnerability, not only of the Asian economies, but also of international institutions and the global financial system itself (Hale 1998b; Goldstein 1998). Weak financial systems played a central role in the crisis economies, as did relatively fixed exchange rates and open capital accounts (Goldstein 1998; Dobson and Jacquet 1998). These factors represent a combination of macroeconomic and microeconomic, or structural, features. Table 1.1, which summarizes key characteristics of the economies, shows that the traditional precursors of financial crises, including rising current account deficits, lax fiscal policy, and high inflation and pegged exchange rates, were not the culprits. Without repeating the chronology of events in each economy, which have been recorded in detail elsewhere (IMF 1998; BIS 1998; Goldstein 1998; Montes 1998), it is fair to say that the precise combination of factors varied in each case. Thailand, Indonesia and the other Southeast Asian Fiscal frameworks, financial systems and the Asian crisis

5

Table 1.1

Selected economic indicators: Asian economies, 1993-19973 (percentage of GDP unless otherwise indicated)

GDP (1995 current US$ billions)

Real GDP growth15

Inflation1"

Domestic saving

Fixed capital investment

China

700

11.0

11.4

41.6

35.9

Hong Kong SAR

142

5.1

7.6

31.9

30.2

India

325

6.4

8.4

23.7

24.0

200

7.2

8.8

29.1

27.4

5,110

1.5

0.7

31.4

28.9

8.5

3.6

34.6

41.3

Indonesia Japan

General government balance -1.7

1.9 -9.6

0.7 -2.9

1.9

M2 growth (end of year)b'f

Domestic credit growth (end of year)d>f

Foreign liabilities of banks'"

Current account balance

33.2

28.5

6.1

0.5

12.3

18.2

69.2

0.5

16.1

12.3

na

-1.2

23.7

22.1

10.0

-2.5

2.6

0.9

14.89

14.29

10.3

e

2.3

Malaysia

80

Philippines

69

4.3

7.7

19.3

23.6

-1.2

24.7

55.5

14.8

-4.7

Singapore

78

8.8

2.1

49.0

34.8

11.3

10.3

14.9

35.5

14.1

8.79

South Korea

436

7.3

5.0

34.2

36.3

0.0

16.7

16.3

9.5

Taiwan

200

6.2

3.2

27.7

22.3

0.3

11.3

14.3

3.9

156

6.6

5.2

33.8

39.5

1.6

15.2

22.2

Thailand World

28,340

na = not available a. Averages for the 1993-1997 period. Figures for 1997 are projected. b. Annual percentage change. c. Consumer price index. d. In percent of total liabilities of the banking system. e. Includes only goods and nonfactor services. f. Average for 1993-96, unless otherwise indicated. g. Average for 1993-95. Sources: International Monetary Fund 1997, World Bank 1997.

19.9

-6.7

-2.2

3.4 -6.1

economies had fixed exchange rates and open capital accounts, while Korea's exchange rate floated and its capital account was relatively closed. The three economies that are experiencing the most protracted crises—Korea, Thailand and Indonesia—share the common characteristic of a weak financial system. Japan should be included in this as well. Financial systems in emerging markets are at various stages of development. Frankel (1995) has developed a useful stylization for understanding these stages. In the first phase of development, an increasing proportion of national saving is channelled to investment as internally generated funding and informal financing from family, friends, and business associates are gradually replaced by market transactions and institutions. Government involvement is typically extensive at this stage, however, in an attempt to promote growth through artificially low interest rates, directed credit, subsidies and other incentives to socially desirable activities. In 1994, state-owned banks still accounted on average for 33-5 percent of banking assets in key emerging markets (Dobson and Jacquet 1998). In the second stage, as incomes rise and development proceeds, markets are created and financial deepening (a rise in the ratio of financial to real activity) occurs. Financial intermediaries develop and improve the provision and circulation of information as well as the ability to monitor. Short-term money markets begin to emerge. These institutions also raise the productivity of capital in the economy and create better incentives for saving. To allow market forces to function, governments at this stage have often removed administrative regulations, privatized state-owned assets, and allowed market forces to determine interest rates. In the third stage, disintermediation begins as demand for longerterm assets appears and direct finance institutions and capital markets develop. Government bonds become the initial mainstays of the bond market while frequent and regular public-sector bond issues help deepen and broaden these markets. Markets for corporate bonds and equities, and eventually for derivative instruments, follow. Inherent in this process is the increasing sophistication of financial institutions in their ability to mobilize the economy's resources and secure linkages between lenders and borrowers. Savers are unlikely to

Fiscal frameworks, financial systems and the Asian crisis

7

lend directly to borrowers they do not know, or to finance investment projects they do not understand, without a hefty risk premium. By gathering information on the would-be users of funds and their proposed investments, financial institutions reduce this premium and stimulate economic growth (Caprio et al 1996). In Indonesia, Malaysia and Thailand, banks account for between 64 and 91 percent of financial assets (Dobson and Jacquet 1998). In these economies and others, the third stage of financial market development has not been fully realized. Capital markets are not well developed. Central to the crisis was the fact that banks and private corporations borrowed short-term capital and used these funds for long-term investment purposes. They often borrowed from foreign sources and on an unhedged basis because fixed exchange rate regimes made investors complacent about exchange rate and interest rate risk. Stateowned banks in Indonesia still account for nearly 50 percent of total assets (Dobson and Jacquet, 1998). In Korea and the other economies, the fact that Asian business systems are based on relationships played a role in bank lending. Relationships, rather than objective criteria of credit worthiness, influenced credit decisions and short-term debt was treated, de facto, as quasi-equity. When interest rates rose and central banks tried to defend fixed parities in the foreign exchange market, many of these loans became nonperforming, contributing to the banking crises that followed. Economies with open capital accounts, diversified financial sectors and well-developed supervision of their financial sectors (Taiwan, Hong Kong and Singapore) largely escaped the recent crisis, as Aivazian and Hejazi find. Malaysia, to some extent, is in this category because of the strong supervision it gives its financial sector. Financial systems with open capital accounts in other Asian economies, however, suffer from a number of striking deficiencies, as shown in Table 1.2, even though governments are deregulating and restructuring these systems in response to internal and external pressures. Accounting practices need to be standardized; clearing and payments systems need to be modernized; the supervision of banking, securities, and foreign exchange markets needs to be reinforced, both through the hiring of more agents and through an enhancement of 8

Wendy Dobson

Table 1.2 Weaknesses in financial systems in Asian emerging markets 1 China Hong Kong Indonesia Korea

2 •

3 •

4 •

5 •

6 •

•

•

•

•

•

•

•

•

•

•

•

•

•

•

•

•

•

•

Malaysia Philippines

•

7 •

8 •

9 •

10 •

•

•

•

•

•

•

•

•

•

•

•

•

•

•*

Singapore Taiwan

•

Thailand

•

•

• •

1. Inadequate prudential supervision 2. Inadequate financial reporting and audit 3. Weak credit assessment 4. Limited bank reserve regulations 5. Political - financial links

•

•

•

•

•

•

•

6. Immature financial sector 7. High percentage non-performing loans 8. Slow to close/write off 9. Limited foreign entry 10. Underdeveloped portfolio of financial instruments

* in the domestic market only Source: Dobson, 1998

their skills; and effective legal frameworks are required to give supervisory agencies powers of enforcement. Independent credit rating agencies are required while bureaucrats need to encourage, not resist, restructuring and market opening. Governments continue to provide safety nets in the form of financial bailouts for banks with serious loan problems. These practices introduce serious moral hazard problems in that investors develop the implicit expectation they will be bailed out when they take risks. A more sophisticated approach would be to provide some form of deposit insurance for depositors and savers and clear procedures for the authorities to close insolvent institutions and recapitalize restructured but viable institutions. New Zealand provides yet another model, which relies on strong competition and regular detailed disclosure to depositors and shareholders, instead of a deposit insurance scheme.

Fiscal frameworks, financial systems and the Asian crisis

9

Systems with these weaknesses worked well in closed developing economies because savings were often only available from government sources or from people with whom the borrower had personal relationships, like friends, family or business associates. Financial markets were fragmented and inefficient. Information about borrowers was often inadequate to evaluate and manage risk. Market imperfections were addressed by government intervention through state-owned financial institutions or through finance entities within business groups among whom risk could be internalized and managed. As these economies developed and became rich, and governments allowed capital to flow freely in and out of the economy, they attracted foreign savings so that they could grow faster. Institutional reform lagged behind; bank loans replaced personal lines of credit, but relationships dominated creditworthiness as criteria for these loans. The pressures on domestic financial institutions were increased by financing that flowed in from international financial institutions attracted by relatively high interest rates compared to those in Japan and the United States. Before the crisis began, most of the ASEAN economies had opened their capital accounts. Only China's was still mostly closed, except to FDI. Korea's capital account was also highly restricted, particularly to FDI, although its opening has been part of the 1997 rescue package led by the International Monetary Fund (IMF). Taiwan's capital account still has some restrictions that are scheduled to be lifted in 2000. Events in the crisis suggest that strong financial institutions are an essential prerequisite to full-blown capital inflows and that financial market reform should be addressed before or at the same time as full-blown capital account liberalization. This means that China would be well-advised to delay further capital account liberalization until it has made more progress toward dealing with its weak banks and high level of non-performing loans, and then to proceed at a very cautious rate. Domestic factors, themselves, do not wholly account for the severity of the crisis or the way it spread throughout the region. Several international factors also played a role in the crisis. First, the realignment of the yen-dollar exchange rate during 1995-97 was predicted to cause problems (Ito et al 1996). While the US economy surged ahead 10

Wendy Dobson

in the 1990s, the Japanese economy under-performed. The Japanese authorities have relied mainly on easing monetary policy to stimulate domestic demand and, since 1995, on yen depreciation to stimulate output growth. Most of the export-oriented Asian economies depend on trade with both Japan and the United States and on inflows of foreign direct investment, which has made them highly vulnerable to this yen-dollar divergence. A major downturn in the international semiconductor markets, on which most of the advanced developing Asian economies depend, contributed to the difficulties of exporters and has further complicated the picture. Second, most Asian economies have encouraged international capital flows in the form of both FDI and short-term capital, to augment domestic savings and access modern technology (through FDI). They have experienced both significant inflows of all kinds of capital, and, in the crisis, significant reversals in capital flows. The inflow patterns vary, however, with China, for example, relying almost exclusively on FDI. The World Bank estimates the stock of short-term debt in East Asia and the Pacific to be US$ 124 billion by mid-1997 (World Bank 1998). Bond issues and loan commitments to Asia and Latin America fell by more than a half in the fourth quarter of 1997 (Stiglitz 1998). Others estimate that East Asia, excluding Japan, has accumulated US$ 370 billion in dollar liabilities, 90 percent of which is held by private companies and 66 percent with maturity of less than one year (BIS data reported by Hale 1998a). Both borrowers and lenders got it wrong. Borrowers underestimated the exchange rate and interest rate risks and failed to hedge their accumulating short-term foreign liabilities. Lenders apparently assumed foreign currency-denominated debt would be as secure as local currency debt. These statistics suggest that inadequate information about international financial markets and lack of due diligence by international investors are major issues for the future. Many investors apparently did not evaluate the risks of their emerging market transactions—they did not know what they were doing, or who they were dealing with. The third international factor that contributed to the crisis is moral hazard, where investors take more risks than they would if they expected to bear the full consequences of their decisions. Moral hazard Fiscal frameworks, financial systems and the Asian crisis

11

exists because of the implicit guarantee by domestic governments trying to protect their domestic financial sectors, noted earlier, and because of the international community's intervention during the Latin American debt crisis and the Mexican peso crisis. To some extent, the problems of international intervention can be offset by imposing conditions on governments to reform, and by forcing lenders and borrowers to organize orderly debt workouts. In Asia, the fact that IMF programs failed initially to stabilize economic performance and exchange rates means that international banks have taken large losses on loan and securities portfolios. Banks are also being encouraged to reschedule private sector debt voluntarily while governments are implementing IMF adjustment and reform programs. This analysis suggests a number of policy changes are necessary to end the crisis and restore confidence and growth momentum. Programs to strengthen and modernize financial systems must be at the core of these efforts. The small open export-led Southeast Asian economies are also anxious to find an alternative exchange rate regime that will be more flexible but that will provide an anchor for expectations. Both governments and business are anxious to prevent shortterm capital flows from overwhelming their small open economies. In addition, many believe finance ministries and central banks should engage in much closer surveillance of each others' economic performance and policies and participate in a regional fund to help moderate future exchange rate fluctuations. All players are aware of significant risks that could create new volatility and hardship. One risk is the stagnation of Japan's potential economic and political leadership. The strong US dollar relative to the region's currencies, and particularly the yen, means that Asian imports will flood the US market, raising the trade and current account deficits and risking a protectionist backlash in the US congress. Additionally, although the Chinese authorities have provided remarkable leadership in the crisis, their internal problems pose a wider threat. China contributed to the IMF-led rescue packages and repeatedly assured the world of its determination not to devalue its currency to compete with the devaluations by their Southeast Asian competitors. China, however, faces internal restructuring priorities of awesome dimensions, not 12

Wendy Dobson

least in its weak and immature banking system that is weighted down with bad loans made to uncompetitive, and often technically-bankrupt, state-owned enterprises. While China has large foreign reserves and a current account surplus, its trade balance and growth performance are deteriorating. Thus a devaluation cannot be ruled out in the medium term. Finally, the reform of the financial sector involves strengthening and modernizing supervision by the authorities, the financial institutions and the financial infrastructure, including payments, settlement, accounting, and legal arrangements. One way to do this, which is not addressed in this volume, is by relaxing restrictions on foreign entry. The presence of foreign financial institutions (FFIs) helps to strengthen, deepen and diversify domestic financial systems, reducing their vulnerability to upheaval. Foreign institutions bring new products, systems and skills, increasing choices and returns available to users, lowering borrowing costs and encouraging greater legal and regulatory transparency to ensure compliance with local laws and regulations. Governments in both developed and developing nations, however, share common concerns that FFIs will either depart at the first signs of uncertainty or trouble, have different priorities or tend to ignore domestic objectives like servicing socially important market segments. Available evidence confirms the volatility of short-term crossborder transactions (Dobson and Jacquet 1998). Banks are major channels for short-term deposits and loans. In some cases, domestic policies encourage short-term flows. The Bangkok International Banking Facility (BIBF) is an example of a tax and policy distortion that encouraged external borrowing. The Thai government created the BIBF in 1993 to internationalize its financial system and promote Bangkok as an international financial centre. Local banks, faced with high domestic interest rates, were able to borrow yen and dollars at much lower interest rates and lend the funds onward into the domestic market. In an environment of weak oversight, large international interest rate differentials and little exchange rate risk because of the fixed exchange rate regime, unprecedented amounts for foreign currency-denominated short-term capital flowed into Thailand. While FFIs may contribute to volatility, it is important to

Fiscal frameworks, financial systems and the Asian crisis

13

distinguish between transactions and institutional presence. FDI represents a long-term commitment that helps to diversify the host country's financial system because these investments are not quickly unwound, even at times of crisis. Comparative studies of the strategies and objectives of foreign and domestic financial institutions are extremely scarce. One study on banks in Australia found that while foreign banks are more innovative than domestic banks, they differ from each other in the strategies they pursue. The number of international banks that have significant retail banking business abroad, for example, is very small (HSBC Holdings PLC and Citibank being the leading exceptions) because most banks lack the necessary assets, like knowledge of and relationships with their customers.

Implications for Canadian business in the crisis context Is there a correlation between the tax jurisdiction and strength of the financial system? Table 1.3 categorizes the economies, based on the findings in this and other studies. It shows a rough positive correlation. Hong Kong emerges as the most advanced economy, fiscally and financially, followed by Malaysia as one of the lowest taxing jurisdictions. Malaysia is in the "medium tier" because of its modernized financial sector, the close business-government ties, the lack of corporate governance, and its protectionist stance towards foreign financial institutions. Korea is the next lowest taxing jurisdiction, but is also in the middle financial system tier for reasons similar to Malaysia. Singapore and Taiwan rank high on financial market development, but are among the middle taxing jurisdictions, while China shares the tax ranking with them, but is by far the laggard in financial market development. Indonesia ranks lowest on both taxation and financial market development, while the Philippines shares the tax ranking but is among the more developed financial markets. Finally, the assessments of Japan are especially troubling since it ranks low in both taxation and financial market development despite its wealth and the advanced nature of the export-oriented sectors of its economy. The implications for Canadian investors are fairly clear in this table. Investors will have the lowest tax costs and the smallest financial risks in

14

Wendy Dobson

Table 1.3 The relationship between tax burdens and financial market development in the Asian economies Weak financial system Low tax jurisdiction Medium tax jurisdiction

China Thailand

High tax jurisdiction

Indonesia

Medium financial system

Strong financial system

Malaysia Korea

Hong Kong

Philippines Japan

Singapore Taiwan

Hong Kong, the international financial centre in Singapore, and Taiwan. Will the crisis change these rankings? Professor Bird argues that investors are unlikely to be required to change their assessments of fiscal systems in the near future because the systems are unlikely to be changed extensively. One exception may be the lowering of corporate income tax rates for competitive reasons. Changes in specific tax-related arrangements, like those that contributed to the BIBF in Thailand, can also be expected. In contrast, extensive changes in financial systems can be expected throughout the region as supervisory structures are tightened, more sophisticated monitoring and risk assessment systems are installed, failed financial institutions are closed and surviving ones are recapitalized and strengthened. Unilateral liberalization of restrictions on market access, that goes beyond concessions made in the December 1997 financial services agreement in the World Trade Organization, is likely because foreign institutions can play a role in this process by providing capital, new skills, technology and products (Dobson and Jacquet 1998). Will the crisis spread to North America? The Institute for International Finance (IIP 1998) estimates that, as the Asian economies expand their exports and reduce their imports in order to turn current account deficits into surpluses, the negative trade impact on the industrialized economies will fall most heavily on Japan. Since the crisis began in 1997, the first impact has already been felt by

Fiscal frameworks, financial systems and the Asian crisis

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commodity producers and manufacturing industries like semiconductors and electronics. Commodity-like products in the steel and auto industries are expected to be next. The geographic impact on world trade balances is likely to be equally divided among North America, the European Union, Japan and other emerging markets, with each bloc's share likely to be around US$ 40 billion. The impact on economic growth is likely to be spread over the 1997-99 period, with the US growth rate dropping by 0.7 percentage points for one year. The negative impact on the Canadian economy has already been felt by the commodity-producing firms in the forestry and mining industries and in the western region of the country where these activities are concentrated. Manufacturing in the steel and auto industries will feel the effects with a lag although Canadian producers should be active in complementary goods with higher value added that do not come into direct competition with price-sensitive Asian products. Tourism has been negatively affected, although travel to and from China and Taiwan is expected to show strong growth despite the crisis. Canadian banks have varying but relatively small exposures to the non-Japanese economies, ranging from 0.80 to 4.75 percent of total loan portfolios (Asia Pacific Foundation 1998). Finally, North American financial and other institutions, which are not implicated in this crisis like their European and Japanese counterparts can expect the creation of opportunities for them to enter Asian markets or expand their presence there by acquiring assets or entering into joint ventures with distressed but potentially viable partners. It is essential to recall, however, that inadequate risk assessment by international investors, particularly those with short-term capital, was an important trigger factor in the crisis. As Aivazian and Hejazi stress in their conclusions, this is not so true for equity investors. With Asian assets available at so-called fire sale prices relative to their valuations during the height of the asset bubbles in the region, however, all investors should evaluate these assets with extreme care. The first volume in this series pointed out that Canadians are not big players in Asia. While this turns out to be an advantage in the cur-

16

Wendy Dobson

rent crisis, it is not an argument to continue to remain on the sidelines in the future. Although many Asian economies are experiencing wrenching contractions in their economies, a number have strong fundamentals and are likely to solve their problems. Japan is the biggest source of risk to regional recovery (and global prospects) because of the effects of its protracted banking crisis and halting political leadership on both domestic and international confidence. A major uncertainty for the closely linked Asian economies will be removed, however, if the restructuring and modernization of this sector gets underway after a long overdue and uncertain start in mid-1998. The resilience of the Asian economies may then surprise us. As they take measures to move to more transparent, arms length transacting, at least in international transactions, the barriers to foreign entry will be reduced as their business systems become more familiar to us.

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References Asia Pacific Foundation. 1998. "Asia's Currency Crisis: What Next?" Asia Pacific Papers. Vancouver: Asia Pacific Foundation. March. Bank for International Settlements (BIS). 1998. Bank for International Settlements: 68th Annual Report. Basle: BIS. Caprio, Gerard, Jr. Izak Atiyas, and James A. Hanson. 1996. Financial Reform: Theory and Experience. Cambridge, UK: Cambridge University Press. Dobson, Wendy. 1998. Financial Reform in East Asia Post-crisis. Paper presented to Brandeis/ISEAS/KIEP conference. May 26 (processed). Dobson, Wendy and Pierre Jacquet. 1998. Financial Services Liberalization in the WTO. Washington DC: Institute for International Economics. Economist, The. 1998. "Of take-offs and tempests." March 21. Frankel, Jeffrey A. 1995. "Recent Changes in the Financial Systems of Asian and Pacific Countries." In Sawamoto, Kuniho, Zenta Nakajima and Hiroo Takaguchi, eds. Financial Stability in a Changing Environment. Tokyo: Macmillan Press. Goldstein, Morris. 1998. The Asian Financial Crisis: Causes, Cures, and Systemic Implications. Washington, DC: Institute for International Economics. Hale, David. 1998a. "The IMF after the Asia crisis." The Global Economic Observer. Chicago: Zurich Research (processed). February 13. 1998b. "Developing country financial crises during the 1990s." Chicago: The Zurich Group (processed). June. Institute of International Finance, Inc (IIF). 1998. "Impact of the East Asian Financial Crisis on Trade of Industrial and Emerging Market Economies." HP Research Papers. No. 98-2. Washington DC: IIF. June. International Monetary Fund. 1997. World Economic Outlook: Interim Assessment. December. International Monetary Fund. 1998. World Economic Outlook. April.

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Ito, Takatoshi, Peter Isard, Steven Symansky and Tamim Bayoumi. 1996. Exchange Rate Movements and their impact on trade and investment in the APEC region. Washington, DC: IMF. Levine, Ross. 1996. "Foreign Banks, Financial Development, and Economic Growth." In Claude Barfield, ed. International Financial Markets. Washington, DC: American Enterpise Institute. 1997. "Financial Development and Economic Growth: Views and Agenda." Journal of Economic Literature. XXXV:2. 688726. Lindgren, Carl-Johan, Gillian Garcia and Matthew I. Saal. 1996. Bank Soundness and Macroeconomic Policy. Washington, DC: IMF. Montes, Manuel F. 1998. The Currency Crisis in Southeast Asia: Update. Singapore: Institute for Southeast Asian Studies. Stiglitz, Joseph. 1998. "Boats, planes and capital flows." financial Times. March 25. World Bank. 1997. Global Economic Prospects and the Developing Countries. Washington, DC: World Bank. World Bank. 1998. Global Development Finance. Washington, DC: World Bank.

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The fiscal framework for business in Asia Richard M. Bird and Duanjie Chen Businessmen often see taxes simply as costs to be minimized. In contrast, governments view them both as a means of securing revenues and as a way to influence the level and shape of private business activities taking place within their jurisdictions. While each of these views is valid from its own perspective, it can be extremely difficult to discern how they combine in practice to affect growth and the relative competitiveness of foreign and domestic firms. Nowhere is this more true than for the economies of East and Southeast Asia, where even local businesses often find it difficult to know just how the tax system affects their activities, and where foreign firms must also understand how the local tax system interacts with that of their home country. Experience suggests that businesses that want to operate successfully in an Asian context generally need to take the long-term view. The same is true of the fiscal context for business in the region. To put this another way, the "cost-minimizing" approach to taxes sometimes attributed to business is too often not only short-term but also shortsighted. This paper provides some elements of the long-term view on the evolving fiscal framework for business in Asia, and presents an analysis of the implications of fiscal differentials within the region for Canadian firms contemplating investment and production there. In the first section of the paper, we review recent fiscal developments in Asia in fairly broad terms. The causes and nature of the marked growth of Japan and other Asian economies in recent decades have been the subject of much controversy. Since a central focus of this

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controversy has been the precise role and importance of government policy in bringing about this growth, the relatively small amount of attention paid to the fiscal dimension of government policy is rather surprising. More recently, the much-publicized financial problems of some Asian countries have also been discussed for the most part in a fiscal vacuum. It is important therefore to consider some aspects of past and current fiscal trends in Asia before discussing the impact of present Asian fiscal systems for Canadian investors. Against that background, we set out in the second section of the paper the key structural features of the tax systems in Asian countries. Then we compare the effects of these features on business and on potential Canadian investors using the "marginal effective tax rate," or METR. This method of analysis sums up the total effect of the tax system in each country on the cash flow generated by an additional unit of investment, or production. The lower the METR, the higher aftertax profits and hence the more attractive the location from the firm's point of view. The countries covered in this analysis are Japan, China, Hong Kong, Korea, Indonesia, Malaysia, the Philippines, Singapore, Taiwan, and Thailand. Our findings show that Japan and Hong Kong are at opposite ends of the Asian fiscal spectrum, as even a casual glance at their tax systems might suggest. Findings for some of the other countries, however, may be quite different from the expectations of those who look only at corporate tax rates when considering the fiscal aspects of investment or production decisions. Finally, in the last section of the paper, we return to the broader perspective of the first section. We briefly review some probable future developments in the level and structure of taxation in the region, taking into account both the recent financial crisis and long-term factors like demographic change and the general implications of worldwide factors like globalization, financial innovation, and the digital revolution. The fiscal impacts of these developments—which are as yet largely unknown—are likely to be critically important to the development of the Asia-Pacific economic region and the rest of the world over the next few decades.

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Our METR analysis shows that Hong Kong is the lowest taxing jurisdiction, followed by Malaysia, Korea, and then China, Singapore and Taiwan as a group, and finally the others, which are much closer to Japan. These rankings are quite different from those derived from a simple analysis of corporate income tax rates (CIT), because they measure the potential impact of the total tax system. We also point out that in a longer-term context, rapid ageing in many of these economies is likely to create new revenue pressures, but, in a world of cross-border capital flows, these are likely to be offset to some extent by competitive pressures.

Fiscal developments in Asia Public finance and corporate finance are linked in many ways, ranging from the effects of taxation on the decisions of domestic and foreign investors, through the availability (or not) of tax-financed infrastructure, to the competition for access to savings. Perhaps the most immediate connection, however, is the effect of taxation on the financing constraint facing firms. Corporate tax policy affects not only the aftertax rate of return but also, and perhaps more immediately, the financing decision around retained earnings and external finance. When foreign investment is involved, the analysis can become quite complicated1 because two tax systems, and the way in which they interact, are in play. This paper does not try to depict all aspects of this complex relationship—it cannot give anything like a complete picture of all the potentially relevant fiscal developments in the ten jurisdictions 2 over 1

For a simple general analysis of this kind of interaction, see Brean, Bird and Krauss (1991) and for a more recent useful overview, see Tanzi (1995). Eden (1998) provides a particularly thorough treatment of many of the relevant issues.

2

Although Hong Kong is now part of China, and the status of Taiwan is a matter of controversy, these regions, with their distinct fiscal regimes, are the focus of this paper. Strictly speaking, the paper should therefore refer to jurisdictions rather than "countries." We may slip at times, however, into using the latter expression without, of course, taking any political position on these matters.

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the last ten or twenty years, or even over the last year. Instead, this section simply sketches the background of each jurisdiction's current fiscal system, both to allow for a sensible interpretation of the results of the quantitative analysis in the next section, and to provide a launching point for the more speculative analysis of the last section.

Trends in Asian fiscal frameworks Asia is a diverse region. Even within the limited group of countries discussed in this paper, there are wide and important differences. Japan, for example, is a rich country by any standard. But so are Singapore, Hong Kong, Taiwan and Korea.3 In contrast, the Philippines, Indonesia, Malaysia, and Thailand had per capita incomes of between US$1,000 and US$4,000 in 1995, while China, although fast-growing, was still well below US$1,000. Similarly, the average annual growth rates within these countries over the 1965-90 period ranged from a low of 1.4 percent in the Philippines to a high of 7.4 percent in both Korea and Singapore. There are also obvious and important geographical differences between East and Southeast Asia, as well as differences in size between the "island states" (Singapore, Hong Kong, and Taiwan) and such giants as Indonesia and especially China. There are differences in political and economic systems, notably the "transitional" nature of recent Chinese policy as it moves from a centralized to a market system. Nonetheless, all of these countries, with the notable exception of the Philippines, have, over most of the last two decades, moved far along the road to catching up with the regional leader, Japan. Some recent analyses (World Bank, 1993; Asian Development Bank, 1996) have argued that for most of these countries, the trigger to growth—the point at which their growth rates began to converge with that of Japan—came when they began to initiate certain "liberal" economic reforms. Others, however, not least Japanese scholars 3

24

In 1995, for example, Hong Kong and Singapore were estimated by the World Bank (1997) to have higher levels of per capita GNP than Canada, while Korea's per capita GNP, at an estimated $9,700 (US), was half Canada's level. Data are not available for Taiwan.

Richard M. Bird and Duanjie Ch

(Ishi, 1997), have argued that it has been the very "visible hand" of state interventionist policy that has led the way to success in the region. Still others (Rodrik, 1994) have emphasized the variety of strategies encompassed in the "Asian model," ranging from interventionist (Japan and Korea) to non-interventionist (Hong Kong and Thailand), from redistributive (Malaysia) to distributionally neutral (Korea, Thailand, Indonesia, etc.), and from emphasis on large conglomerates (Korea) to an emphasis on small, entrepreneurial firms (Taiwan).4 One important conclusion emerges from an examination of fiscal developments over this rapid growth period. Almost all of the countries experiencing high and sustained growth rates have maintained relatively prudent fiscal policies—either surpluses, or low deficits. They have, also maintained relatively low levels of public expenditure, although with considerable allocations to basic education, health, and infrastructure in most countries (Mundle, 1997)—presumably "growth-facilitating" expenditures in human and physical capital. Equally important, there has been very little inflation in most of these countries, with the fiscal brakes being quickly applied whenever inflationary pressure builds up. The major exception to the rule of fiscal prudence has been the main laggard in the region, the Philippines, although budgetary balance has largely been achieved even there in recent years. China, too, has run deficits, but mainly to finance rapid investment expansion. Given this history of fiscal prudence, it should come as no surprise that most countries of the region have reacted fairly quickly and strongly to the recent turmoil in financial markets. What about tax developments? Here, there seems to be somewhat more variation in behaviour. Japan, the regional leader, has for the most part relied on its complex but nonetheless mature and generally well run tax system to mobilize resources for public purposes. As early as 1970, for example, public sector saving in Japan accounted for 4

For detailed, and often conflicting, discussions and illustrations of the variety of conditions and strategies found within the region, see Rowen (1998), Booth (1997), Rowthorn (1996), and Singh (1995).

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7 percent of gross domestic product (GDP), rising to a high of 12 percent in 1990. In contrast, the second richest country in the region, Singapore, has followed a rather different path of relying on "extra-budgetary" devices such as the Central Provident Fund (Asher, 1994), as well as a wide variety of charges and state enterprise monopoly revenues (notably from land), to mobilize funds for development. Public sector saving in Singapore matched Japan at 7 percent of GDP in 1970, and subsequently rose to a peak of 19 percent in 1985, a level that was largely maintained over the next decade. On the other hand, administrative and political constraints in countries like Indonesia and the Philippines have severely constrained the ability of their governments to raise resources efficiently and, consequently, constrained their ability to finance growth-productive expenditure in a non-inflationary way. As the history of Korea in the 1960s shows (Bahl, Kim, and Park, 1986), these barriers can be overcome with time and effort. Nonetheless, a good deal of both still seems to be needed in countries like Indonesia, Thailand, and the Philippines, before they can be expected to perform as well as Korea in these respects. A recent analysis (Choi, 1997) identified the key elements of Korean tax policy in its period of most rapid growth as (1) comparatively low taxes, (2) relatively low taxes on capital income, (3) low reliance on property taxes, and (4) liberal use of investment incentives. A similar message emerges from a recent study of Japanese tax policy and post-war growth (Ishi, 1997). We comment on the first and fourth of these points later in this section. The analysis in the next section emphasizes the importance of the second and third points. First, however, to sum up this quick survey of a complex regional picture, it is perhaps not too misleading to say that, excluding the special case of China, two extreme fiscal models may be found in the region. At one extreme is Hong Kong, which comes as close to the noninterventionist "market" ideal as one can find. Hong Kong has a small government, very few "welfare state" elements (hence strong incentives to personal saving), almost no interventionist policies on either the fiscal or the financial side, and an expenditure policy directed 26

Richard M. Bird and Duanjte Chen

almost entirely to presumably growth-facilitating physical and human investment. This is all set in a context of strong property rights and a fairly well enforced and impartial legal system. At the other extreme is Korea, which has similar expenditure policies, but a strongly interventionist fiscal and financial system and a government noted less for impartiality to economic actors than for playing favourites. Japan and Singapore are in varying degrees in the same mould. Japan, however, is increasingly moving to "welfare state" expenditures (for reasons we discuss later) and Singapore has a legal and political system closer to that of Hong Kong than of Korea in terms of its effects on economic decision-makers. Taiwan's system is also along Korean lines, but it is clearly the least interventionist of this set of countries. The other countries of Southeast Asia considered here can be placed at various points along this spectrum. Malaysia is perhaps the most interventionist. Indonesia is the most like Korea in terms of the tendency of governments to play favourites. The Philippines places the least emphasis on growth-facilitating expenditure while Thailand is in between on all these dimensions. As we see in the next section, a more detailed examination of how tax policies in the various countries affect business investment and production decisions results in a similarly mixed picture. The changing role of fiscal incentives As noted above, a major point of controversy with the "Asian miracle" has been the extent to which interventionist rather than marketfriendly policies have resulted in growth in a number of countries in the region. In the fiscal sphere, this issue is seen most sharply in the role played by specific tax incentives as opposed to general tax structure policies. In the balance of this section, we discuss the role of specific tax incentives, but to make the topic a bit more manageable, we consider only incentives that are designed to improve the quantity, and perhaps the quality, of investment. We do not discuss either the incentives for investment—or disincentive—created by different tax structures per se, or the many special tax incentives intended to foster other policy objectives, like research and development, regional develop-

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ment, employment, exports, or savings.5 The next section analyzes the impact of the general tax structure on investors in ten Asian countries. Over the years, many authors have looked at tax incentives for growth in developing countries.6 The usual pattern is to describe the variety of incentives found in a number of countries and then to evaluate their likely effectiveness and efficiency in a more or less rigorous fashion. The conclusion to which most come—what may be described as the ruling fiscal orthodoxy—is clearly that tax incentives in general are a "bad thing." Either they are redundant and ineffective, forgoing revenue and complicating the fiscal system without adding to capital formation, or they are distorting and inefficient, directing investment into less than optimal channels. Studies of countries like Indonesia (Gillis, 1985), support these arguments. Even in the successful East Asian countries that have made considerable use of tax incentives in the past, some recent analysts have condemned the tax incentive approach and urged the adoption of a more neutral system.7 At one level, arguments like these seem convincing. Clearly, tax incentives for investment have sometimes had undesirable effects and have seldom been convincingly demonstrated to be effective and efficient. At another level, however, something seems a bit odd about this conclusion. Consider, for example, the five Asian countries usually considered to be the principal development successes of the post-war

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5

There are many studies on each of these subjects. On regional development incentives, for example, see Bird (1966), Modi (1982) and SanchezUgarte (1987); on employment incentives, see Lent (1971) and Bird (1982); on savings incentives, see Byrne (1976) and Ebrill (1987); on export incentives, see Balassa (1975) and De Wulf (1978); and on research and development incentives, see McFetridge and Warda (1983). The balance of this section is based largely on R.M. Bird, "Tax Incentives for Investment in Developing Countries," Paper presented to Seminar on Tax Reform and Macroeconomic Policy in Developing Countries, New Delhi, August 1993.

6

For examples, see Heller and Kauffman (1963), Lent (1967), Shah and Toye (1978), and several of the papers in Gandhi (1987) and Shah (1995).

7

See, for instance, Ishi (1993) on Japan and Choi (1997) on Korea.

Richard M. Bird and Duanjie Chen

period: Japan, Korea, Taiwan, Singapore, and Hong Kong. With the exception of Hong Kong (Krauss, 1983), all of these countries have made extensive and prolonged use of specific tax and other incentives both before and during their periods of most rapid growth.8 Most continue to use similar special tax incentives for investment and, as we shall see later, seem likely to continue to do so in the future. If everyone is doing it, can it really be so wrong? The apparently sharp disparity between expert opinion and policy practice leads to several questions. Are the East Asian countries mistaken in thinking that tax incentives and other policies fostering investment had something to do with their growth success? To quote a recent appraisal in, of all countries, Indonesia: "Generally, the promotion of investment through the use of incentives has been effective" (Sumantoro, 1993, p. 266). Of course, many other factors were also important in explaining the Asian success stories, such as macroeconomic stability, high and growing investment in "human capital," and the "market-driven" (export) nature of growth (Summers and Pritchett, 1993). Nonetheless, high investment levels clearly played a critical part, as emphasized by Young (1993). Are other countries mistaken in hoping for the same linkage? Does the "Hong Kong model" of low and uniform taxes—one that some have urged for countries such as Thailand—offer a surer path to success than what may perhaps be called the JKS (Japan-KoreaSingapore) model of fiscal (and other) interventionism? Would the East Asian "tigers" have done as well, or perhaps better, without the incentives? Does the apparent failure of superficially similar incentive packages in Indonesia, for example, not to mention most of Latin America, reflect differences in political or social "culture,"9 in the 8

See, for example, Ishi (1993) on Japan, Bahl, Kim and Park (1986) and Trela and Whalley (1995) on Korea, Chang and Riew (1994) on Taiwan, and Asher (1988) on Singapore.

9

Ishi (1993, p.156), for example, suggests that "socio-cultural" factors seem more likely to explain high savings rates in Japan than do tax incentives.

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macroeconomic context,10 or simply differences in the design and implementation of the incentives? To put the point at its simplest, would nothing have worked in Argentina in the 1970s, and anything have worked in Korea? These questions are not easy ones to answer, and we do not try do to so here. Instead, we briefly review some recent experience to support two general conclusions about investment incentives. First, although the evidence supporting the case for such incentives is by no means conclusive, neither is the case against them, not least because our understanding of what determines investment, and the effects of incentives on investment, still leaves much to be desired.11 Second, regardless of how the arguments among experts are finally resolved, investment incentives will likely continue to exist in a variety of forms in many developing countries. Investors as a rule need to consider not only the general tax structure, but also, in most countries, a myriad of industry- and firm-specific fiscal features that we cannot take into account here. The history of investment incentives in the post-war period can be viewed from two quite different perspectives. One perspective sees this history as a more or less steady trend away from the extensive reliance on incentives that characterized the initial development efforts in many countries in the 1950s and early 1960s, towards the nirvana of "incentiveless" tax systems now commonly recommended by international experts (World Bank, 1991). These systems were actually put into place to some extent in a few countries, notably Indonesia (Gillis,

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10

See, for example, Weeks (1997), as well as Thirsk (1989), on the importance of this factor in evaluating incentives. Investment incentives are obviously less likely to be effective in countries with high variability in inflation and growth rates, just as export incentives are unlikely to be very effective in countries with substantial exchange rate instability.

11

Nonetheless, for the sake of simplicity, we proceed in the second section as though investors always act like fully rational profit-maximizers.

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1985), in recent years.12 In this view, the palpable failure of central planning in Eastern Europe and elsewhere, the accumulated, although not unquestionable, empirical evidence of the inefficiency and ineffectiveness of incentives (Ebrill, 1987), and the growth of economic knowledge all point in the same direction. They point away from the sort of interventionist policy represented by incentives and towards the ideal of a uniform "level playing field" in which market forces, rather than government officials, make investment decisions. The move away from incentives is seen as part of the general move towards market- rather than state-dominated allocative decisions. From this perspective, the truth about incentives has been revealed to knowledgeable experts, and once this truth has been fully absorbed at the policy-making level, the end of incentives will be in sight. The second perspective on recent changes in attitudes and actions on incentives is quite different. In this view, many different ideas and approaches to incentives can be found in the literature at any one time, and which will influence policy often depends as much on chance and circumstance as on inherent merit. Over time, both ideas and practices may change—away from interventionism and towards the market, for example—as may the country models viewed as exemplary—witness the demise of the Soviet central planning dream a decade ago. As the current disillusion with the "East Asian miracle" (World Bank, 1993) demonstrates, the ideas that dominate at any point in time may well be reversed a few years down the road to the extent that they reflect less increments in knowledge than changes in fashion. The recent episode of the "Asian flu" has, for example, clearly reduced the market appeal of the JKS approach to growth in Southeast Asia. 12

Similar, if less drastic, moves may be seen in a number of Latin American countries in recent years, including Bolivia, Mexico, and Colombia (Bird, 1992).

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Which view is correct? Does the de-emphasis on investment incentives in countries like Indonesia represent a trend or a cycle? We think the evidence suggests that, for better or worse, investment incentives are not dead but at most dormant. For example, Shah (1995) lists tax holidays in at least 14 developing countries, accelerated depreciation schemes in at least 28, and other investment incentives (credits, reinvestment allowances, etc.) in at least 21.13 Earlier surveys (Lent, 1967; Shah and Toye, 1978; Gandhi, 1987) have also found widespread use of a variety of tax incentives in all parts of the world. Chia and Whalley (1995) suggest that there are a greater variety of tax incentives currently found in developing countries than in developed countries, and that these incentives are now more common in developing countries than they were a decade ago. On the whole, Asian countries seem to have made relatively more use of incentives than developing countries in other regions. As Asher (1997) notes, even the Indonesian case was by no means the "clean sweep" of incentives sometimes portrayed. In contrast to relatively unchanging practice, a recent review of tax policy advice found that the attitude to tax incentives in the 1950s and 1960s was markedly different from the attitude that currently prevails (Goode, 1993). In the earlier period, reports and advisers frequently favoured tax incentives to channel investment in one direction or another. Later, as scepticism grew about the efficacy of incentives and the wisdom of interventionist policies in general, attitudes changed, and tax incentives for investment fell into disfavour. At first, incentives were condemned as ineffective in encouraging investment, and costly in terms of revenue forgone (Heller and Kauffman, 1963). Later, as the neo-classical investment paradigm came to dominate the literature following the pioneering work of Hall and Jorgenson (1967),14

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13

Although there are some overlaps among the countries as they are counted here, other studies (e.g. Mintz, 1995) list various incentives in a number of countries not included in the figures cited from the introduction to Shah (1995). Thus the figures mentioned certainly do not exaggerate the variety and spread of tax incentives around the developing world.

14

For an extensive review of this literature, see Jorgenson and Yun (1991). For more critical appraisals, see Bosworth (1984) and Chirinko (1987).

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less emphasis was placed on the ineffectiveness of investment incentives. After all, if investment is assumed to respond to changes in the cost of capital, and incentives change the cost of capital, then incentives must affect investment, or so most economists tend to assume. Even if incentives are effective in channelling investment into favoured sectors, however, they might still be inefficient because they discourage investment decisions that would have been made in their absence. The ability to channel investments in directions favoured by the authorities is not necessarily considered a virtue by those who put their trust in markets rather than governments. In particular, the new political economy, with its emphasis on the possibility of destructive rent-seeking behaviour in response to state-granted favours, argues against tax incentives as it does against trade protection (Krueger, 1993). Many economists therefore remain sceptical about the usefulness of investment incentives, although the grounds for this scepticism have changed over time. Recently, however, some developments in economic theory have seemed to some to cast a slightly more favourable light on incentives. So-called "new trade theory," for instance, with its emphasis on imperfect markets and external economies, has to some degree re-opened the case for selective government intervention in trade and factor markets. The relevance in the real world of these ideas remains doubtful, however, because of the unclear importance in practice of external economies and the concern that governments may not be capable of implementing even beneficial interventions without opening the doors to dubious special interests.15 The exacting practical demands of strategic trade theory make it an uncertain foundation on which to base an argument for incentives. The enthusiasm for arguments made by special interest groups that stand to gain from tax favours seems unlikely, however, to be restrained by such considerations. 15

See, for example, the interesting papers by Krugman (1993), Krueger (1993) and Slemrod (1995). As Krugman (1993, p.364) puts it: "Free trade [read uniform factor taxation] is a pretty good if not perfect policy, while an effort to deviate from it in a sophisticated way will probably end up doing more harm than good."

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Much the same may be said of the new literature on "endogenous growth." Some scholars have demonstrated in this framework how incentives favouring research and development or machinery and investment may, under certain circumstances, accelerate growth.16 The fact that a few empirical studies (notably DeLong and Summers, 1991; 1992) lend some support to these arguments makes the apparent case for interventionist policy stronger, even in the face of the many political and organizational constraints on implementing these policies in developing countries (Levy, 1993). The partial shift in the ruling paradigm, with incentives moving back into favour to some extent, may be illustrated by contrasting two recent studies done under World Bank auspices. World Bank (1991) reflects the prevailing conventional wisdom about tax incentives: they erode the tax base, reduce investment efficiency because they mostly respond to pressure from special interests, are ineffective and often inequitable, and facilitate rent-seeking activities and tax evasion.17 In contrast, Shah (1995) concludes his introduction to an impressive set of empirical studies of tax incentives recently carried out under World Bank auspices by noting that some tax preferences (such as investment tax credits for R&D) have strong theoretical and empirical support. Expert attitudes to tax incentives may therefore be changing again, whether influenced by changes in theory (endogenous growth), in empirical results (for example, the production function studies reported in Shah, 1995), in real world experience (the "East Asian miracle"), in intellectual fashion, or by changes in all these factors.

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16

See, for example, Barro and Sala-i-Martin (1992). Although there is no necessary implication in these models that increased growth results in increased welfare, policy-makers looking for a rationale for doing something they want to do have never worried about such refinements in the past, and they seem unlikely to do so in the future.

17

Despite these harsh words, the "reference set" of taxes proposed in World Bank (1991) recognized that there might still be tax preferences in some cases. It argued, however, that any incentives should both be limited in duration and, in line with the METR analysis discussed below, be distributed more evenly across sectors and assets in order to avoid distorting investment decisions.

Richard M. Bird and Duanjie Chen

Whatever the experts may say, however, incentives seem likely to be demanded, and supplied, in the future, much as they have been in the past. As we suggest in the third section, recent developments in Asia, and for that matter in the world at large, may well result in increased attempts to foster and channel investment through fiscal incentives in the future. The design, implementation, and evaluation of tax incentives remain important questions both for businessmen considering particular investments in particular countries, and for economists who may be far from convinced that such incentives are worthwhile from a broader social perspective.

Tax effects on investment and production decisions The question we consider in this section is simple. How do the tax systems of the ten Asian countries compare from the perspective of a Canadian firm considering investing in the region? We approach this question by calculating the marginal effective tax rate, or METR, that the firm would face, first on its initial capital investment and then on its overall cost of production.18 Since our focus is on real rather than financial investment, only taxes that affect real capital and production decisions are relevant to this analysis. For this reason, although tax treaties may be important determinants of repatriation decisions, they need not be taken into account in these calculations because they affect only financial flows. A few limitations to the analysis reported here should also be noted.19 First, we consider only manufacturing and service industries. Investment in resource-based industries is excluded, in part because such investments are often subject to very special tax regimes. Investment in financial services is also excluded, again in part because, 18

For an earlier, more limited, study of METRs for investment in some of the same countries, see Mintz and Tsiopoulos (1992).

19

It should be emphasized that it is possible in principle to take into account all of the factors mentioned here in a METR analysis. We have not done so here both to keep this presentation as simple as possible and because we think the cases we analyze cover the main forms of foreign investment in the region.

The fiscal framework for business in Asia

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as in the case of the resource sector, it is frequently subject to quite different tax rules. In addition, it is well-known that the financial market in Asia is not very open to foreign investors in any case, although recent events seem likely to result in some loosening in this respect, at least in some countries. Also, only profitable (tax-paying) firms are considered in our analysis. For this reason, rules on tax-loss carryovers, although important in some respects, are not included in our METR calculations. Finally, although our analysis does encompass broader fiscal incentives to investment, we do not explicitly take into account specific tax incentives like those for investing in specific locations or those available in some countries to smaller firms.

Marginal effective tax rate analysis METR analysis rests on the simple assumption that economic decisions are made by profit-maximising agents. The decision to invest in a particular activity in a particular location, for example, is assumed to be determined by the expected impact on incremental net revenue or, in economic jargon, the effect at the margin. Investors in principle should compare marginal revenues and costs in making decisions. Taxes generally affect both capital and production costs, including labour and materials, and therefore investment and production decisions at the margin. A METR analysis estimates the effective rate of tax applied on the marginal unit of capital, or on the overall marginal cost of production. METR calculations measure the extent of tax bias on marginal economic decisions and hence, if other things are equal, on the efficiency with which resources are allocated. To some business analysts, the METR thus defined may seem at first sight to be a purely theoretical concept and not at all relevant to the "real" task of effective and efficient cash flow management. In reality, however, a METR calculation measures the effect of taxes on the present value of the accumulated cash flow that would be generated by an additional dollar of investment (or, as the case may be, an additional unit of production input). Presumably, if a company invests a dollar in an additional unit of capital goods, it does so to generate a future stream of profits over the life of the invested capital. Taxes reduce the share of profits that flow to the investor, and various tax allowances in

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Richard M. Bird and Duanjie Chen

Box I Measuring MX impacts: METR vs. AETR An alternative measure of the impact of taxes is the average effective tax rate (ABTR). Like METR, AiTE is bawd oa a cash flow calculation gad-h sometimes xjsed to compare the impaet «£tom*jtai*«e&^ AETB. is calculated as the total amount of tam j*p^ taxable input or output. It is relatively single for any Single firm to calculate from standard accounts, and it may provide a useful measure of overall tax impact from some perspectives. Nonetheless, there are important differences between the two approaches, and METR is definitely superior for oar purposes. As we have emphasized above, it is marginal rather than average factors that drive economic decisions. The ABTR concept measures ex post performance, die result of past decisions,and is not necessarity relevent or useful for future decisions In contrast, METR measures the to^ra^pA~«^@^^ti^^;|>^M« on the last unit of taxable input, or output, being «»niti