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Negative Effects of Tax Incentives Towards Foreign Direct Investment: a Hypothetical Report

Executive Summary The tax incentive policy widespread around the globe in the 1990s due to the belief that attracting multinational firms would create more job opportunities and eventually better off for the whole economy. There have been some evidences that foreign direct investment (FDI) benefited developed countries’ economy. Recently, the Australian government has proposed a new policy that would give fairly large incentives to foreign direct investors. However whether the FDI would benefit Australia’s automobile industry and textile industry, is questionable, and needs to be critically evaluated.

This report has been written by the Manufacturers Association, and it is believed that there would be more disadvantages than advantages to Australian economy, especially automobile industry and textile industry. Giving incentives to FDI only helps to destroy small business sectors, and will have a negative impact on the government’s revenue. For the future growth of the industry and businesses, revising the government’s proposal will be important. The Manufacturers Association suggests three main ideas towards the new policy, and the recommendation for the government is as follows.

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The government should establish and improve laws that are relating to market’s assessment, regulations and the standard system as soon as possible. The government should carry out some policies to ensure market competitiveness. The government should play a catalytic role in corporate mergers. Introduction This report has been written by the manufacturers association due to a new government policy proposal that was introduced lately. The new proposal states that the government will give significant tax incentives to foreign investors who are prepared to invest in expanding the nation’s manufacturing base in automotive and textile industries.

However, there may be some problems that might arise with this new proposal. Thus the objectives of this report are to critically evaluate advantages and disadvantages of tax incentives towards foreign investors, and to suggest or recommend a better proposal for the sake of future growth in domestic businesses and the whole economy. This report examines policy effects on two different areas: policy effects on the industry, and policy effects on companies. There have been numerous governments that tried to attract foreign direct investors (FDI) by offering tax incentives, since the 1990s. Li, 2006) The reason why the host countries wanted foreign direct investors was because of the belief that foreign firms and their developed technology would encourage transformation of domestic technology, and it seemed like that some countries have proven this belief. However, attracting multinational companies was becoming harder as the number of competitors, host countries that also wanted foreign investors, increased. (Morisset & Pirnia, 1999) To attract new foreign investors, host countries offer tax incentives, such as lower income taxes, income tax holidays, import duty exemptions, and subsidies for infrastructure. Aitken & Harrison, 1999) Offering tax incentives was definitely a great way to attract multinational companies, and this phenomenon soon became a global trend in the 1990s. For example, the Korean government changed the law foreign investment law to offer more incentives to FDI in 1998. (Yun, 2001) Slovakia offered a 20 precents tax cut in corporate tax. (Turkenburg, 1993) The widespread of this phenomenon was because developing countries’ wanted to globalize their economy, and also they needed employment opportunities.

By adopting this tax incentive programs, many countries faced a dramatic change in both economy and politics. Adopting the program ensured globalization in economy, and short-term employment needs. However, there have been some issues that need to be thought and evaluated very critically. According to Quan Li, (2006) giving tax incentives to foreign investors could have a negative effect on its economy. He argues that FDI could affect allocating financial resources, and also may have negative impact on government’s revenue.

Moreover, when the government implement the new program, administration cost will also be added, and for local small businesses, foreign direct investors are the biggest threat. Therefore, it is hard to judge whether the tax incentive program would benefit to the economy. To continue in response to the government’s recent proposal, although the manufacturers association somewhat agrees with the points, which states that depending on the incentive, there can be huge investments of foreign capital, and encourages long term planning, these advantages only applies to the new industry fields.

Especially in terms of natural resources, tax incentives would allow foreign investors to purchase it without additional taxes, which would not be fair for domestic businesses that purchase raw materials with the full cost. Furthermore, since the foreign investors only seek for lower labour cost, when there is a better opportunity in terms of labour cost, then they are likely to relocate their investment. Therefore, depending on the foreign investment is highly risky, and may have more negative effects than positive effects on the economy. Policy Effects

Tax cuts for foreign investors are not very influential in factors for selecting investment locations. It is not to say that tax incentives have no effect on foreign investment and can sometimes be the critical thing that brings foreign investment, after the consideration of things such as basic infrastructure, political stability and the cost and availability of labor. Also there is the added cost of administration by government when implementing tax cuts to specific sectors and the benefits of the foreign investment itself are very questionable.

When considering administration costs the government actually incurs twice the revenue loss as it not only has increased administration costs but less revenue gained from tax. The administration cost and resource could also be better spent on local manufacturers rather than foreign investors especially for subsiding green initiatives and can provide huge benefits for Australian manufacturers as it will give them a global advantage due to the ever increasing demand for green technology to reduce carbon emissions and other waste products that significantly affect the environment.

Tax cuts for foreign investors only give foreign investors an extra unwanted advantage over local manufacturers, especially small and medium businesses as calculating how much foreign investors should be compensated is not simple and straightforward. The lack of certainty can lead to a government granting overly generous incentives especially if they want to attract high-tech projects. The advantage gained by foreign investors essentially will help to destroy the competitiveness of the current Australian manufacturing sector and shut down local businesses due to the immense advantages and lack of protection of the sector.

It is stipulated that foreign investment leads to the creation of new businesses as well as expanding the market and stimulating new research and development this is not the case as most foreign investors tend to buy already privatized and profitable existing public and private enterprises. This has happened to many companies such as Arnott’s Biscuits Holdings which has been around since 1865 and became an iconic Australian company was bought out by Campbell Soup Company of North America, this caused a lot of controversy in Australia due to Arnott’s symbolic affiliation to Australia.

Instead of complementing local public or private capital, foreign investment essentially ‘crowds out’ local businesses and destroys public initiative as well as undermining emerging technological research centers. However when you consider market expansion the especially sectors like telecommunications that can be starved for funds, foreign investment can grow the market by expanding the customer base. Although foreign investment can help in sectors like telecommunications it can also reduce markets for sectors like transport, water and electricity by charging unreasonable fees to customers, severely affecting the low-income class. Transfer of technology’ considering the fact that most research and development of companies is carried out at the main office is unlikely to occur unless the company rents or sells the technology produced from research findings; which is produced elsewhere rather than locally, and even if they do sell or rent the technology to the subsidiary they charge excess royalty fees and other costs, this also lowers profits and taxes to local governments.

This ‘crowding out’ can lead to no competition in the manufacturing sector as well as leading to huge economic losses due to job export and research and development down-sizing this would make Australia’s manufacturing sector quite ‘insignificant’ compared to what it is today.

Foreign investments rather than increasing export competitiveness and stimulate economy through value adding to raw materials and buying local product and service, just buy the rights to raw goods and export them with no value added or minimal value added; this is especially detrimental to manufacturing sector due to less rights available for raw resources making it more expensive to produce finished products for the local manufacturers.

Since most of the resources are converted into semi-finished or finished goods in the home country or elsewhere rather than creating jobs and diversifying economics and skills in Australia these are created elsewhere. The new owners generally make huge profits selling the raw material to booming countries such as China but, all conversion of the raw goods into finished products is done in the country exported to rather than done in the country the materials originate from this leads to the loss of potentially hundreds of thousands of jobs in the manufacturing sector.

Usually due to the company exporting most of the raw material, the prices rise for the consumers within the country, this also leads to a failure of providing supplies to low-income consumers. Extraction of raw materials is capital intensive but uses very few workers whereas processing and manufacturing is much more labor intensive and job creating so having foreign investment incentives for manufacturing and textiles can instead lead to a great number of job losses as well as causing resources shortages affecting the entire manufacturing sector negatively.

Tax revenue collect from foreign investor boosting local treasury which can help in supporting local manufacturers and financing for reports of the manufacturing sector to better it and reduce its weaknesses. However since most companies that are bought out by foreign investment become a subsidiary of a parent company, this leads to a huge problem with tax revenue as the subsidiary incurs huge costs to the parent company as well as ‘external sources’ meaning an overall reduction in revenue due to reduction in the subsidiaries profit.

Most foreign invested companies import machinery, design and methods from their parent company or country and export the finished product with, which results in a dependency on the cost of imports relative to the value of exports. In many cases the imported component cost charge to the local economy/ subsidiary is quite large and the relative value added is quite minimal.

Since the subsidiaries have large import costs and pay large amounts of principal dividends, interest, ‘external services’ and other negative effects on government revenue due to things such as profit remittances. This means that the government cannot help out local businesses as essentially there isn’t ‘extra’ tax revenue as well as loss of business for manufacturers; especially affecting small and medium business due to economic paradigm shifts. When foreign investment is used maintaining debt payments becomes essential and it can also be risky.

The maintaining of foreign debts badly can lead to jeopardizing long-term financial standings as well as the integrality of the domestic financial system eventually leading to financial collapse if too much debt is incurred and when this has little chance in the way of development it is essentially useless capital. A lot of money is borrowed to secure hard money allowing the facilitating of change in dollars. The money is made available to prominent businesses and people who generally then go and invest this money back into the parent company or somewhere overseas.

A lot of the borrowings are also used for ‘economic’ openings and imports as well as non-productive goods. The loans borrowed generally are high interest and then are deposited by the government with lower interest compared to what is charged for the borrowing, this leads to a net loss of huge quantities of money and in turn actually adding to foreign debt. This loss of integrity has a negative impact on the image of Australian manufactures leading to lower profits and essentially can spiral out of control.

A lot of small economies like the Australian economy are said to be dependent on foreign investment, but when you considering everything foreign investment is essentially foreign borrowings of national savings which are then used to buy local already established business and finance investments. A lot of foreign investors secure overseas loans with backing by the local government, or just get loans from local banks and financers; this essentially means that it ends up being local investment rather than foreign investment that is being used.

This essentially enforces a pattern of foreign borrowing to pretty much ‘consume’ local markets and productive facilities leading to a forming of this as a common practice. This is very contradictorily to the idea that foreign investment brings in ‘fresh capital’ and adds to the country’s capital pool, the reality is that instead of allowing for more capital to be available in the country, foreign investors divert local saving from local public and private investors, crowd out local borrowers usually forcing them to seek informal money lenders who charge much higher interest rates and essentially leading to a much less diverse market.

Small economies don’t need foreign investment due to ‘small’ amount of available capital. Foreign investment pretty much competes for local capital and using its privileged position in the credit market, especially due to government backing, takes the capital using its greater overseas assets and political influence in securing the loans from the local lending agencies and banks. Foreign investors are thought of as beacons to bring in more foreign investment however this cannot be further from the truth.

Unlike local manufacturers foreign manufacturers are not loyal at all as they are generally after cheap labor, less manufacturing cost and as such are much more likely to relocate to a different country with cheaper labor if such an occasion arises where they have an opportunity to such as the opportunities available in the current Asian markets where cheap labor and less manufacturing costs can easily be achieved.

Local manufacturers will upgrade technology and skills and move to higher quality products; however foreign investors are going to most likely just relocate as there is a huge cost in advancing the market. The lack of loyalty by foreign investors means that if you make them a key in the growth of the market that the Australian manufacturing sector will become highly unstable and insecure markets, also foreign investment as evidenced by a study of development in India has no correlation with the growth of a market.

This means that foreign investors essentially mean an unstable and insecure market with absolutely no guaranteed growth for the market, there is no point in a huge risk low reward venture or government centered policy of foreign investment as it only amounts to a waste in government resources, this type of policy making can lead to the ‘destruction’ of the Australian manufacturing market especially when and if foreign investors decide to relocate, leaving local manufactures ‘out in the cold’.

As per Manufacturing’s role in the economy (ABS Australian System of National Accounts, 2002) illustrates manufacturing’s still plays a major role in the Australian economy with levels of output and employment that can be said to greatly secede mining and agriculture combined. Although there is no comparison to the services sector in output, employment and capital stock, manufacturing is responsible for nearly 1/2 of Australia’s Research and development as well as its exports.

Trade in manufactures is growing faster than primary commodities, meaning there are huge opportunities for Australian manufacturing in trade. Therefore it is essential that Australia’s manufacturers be protected from foreign investors at such a critical time. Giving tax incentives which as previously stated give foreign investors major competitive advantages and destroy local manufacturers would be hugely detrimental to capitalizing on a unique opportunity for rapidly increasing Australia’s trade presence.

As such it would be better to not give tax incentives to foreign investor but rather local investors thus protecting Australian manufacturers. As per Changes in the composition of the Australian economy (ABS Australian System of National Accounts, 2002) manufacturing between 1962 and 2002 has gone from accounting for 1/4 of Australia’s economy, to only accounting for 1/8 of the economy.

The statistical data indicates that the manufacturing market doesn’t really need growth as Australia’s economy is moving to a more service centered market meaning that there is no point in investing in the manufacturing sector especially from foreign capital. Although the manufacturing sector will grow and it is essential that it does, it doesn’t really need to be grown quickly as essentially the benefits gained from growing it rapidly through investment whether local or foreign is to high a cost for the low return benefits and thus there is no reason in doing so.

Although the manufacturing sector only accounts for 1/8 of Australia’s economy it doesn’t mean that the sector is in decline in terms of growth, it just means that it isn’t growing as rapidly as other Australian sectors as there is much less demand for it. As can be seen in Growth Trends in manufacturing (ABS Australian System of National Accounts, 2002) Australia’s manufacturing sector has pretty much quadrupled from 1954 to 2002 and has a healthy pattern of steady growth with a general upward trend.

It may have been shaky in the 1973 – 1995 years but it was still an overall growth by the end of 1995 after which till 2002 there was essentially no dip down indicating a stable and healthy growth of the sector. As in relative growth rates among Australian Industries (ABS Australian System of National Accounts, 2002) which shows the relative growth between sectors of the Australian economy between 1974 and 2002. One can observe that the Australian manufacturing sector only accounts for 1. 65 % of the Australia’s economic growth. 1. 5 % is the lowest growth of any sector in the Australian economy however the service and mining sector have had massive growths, meaning that a huge amount of the mining sector exports due to low demand from Australian manufacturers, as there isn’t a viable way to grow the manufacturing sector as it is not limited by capital but by practicality restrains. When you consider the fact that manufacturing has quadrupled in growth between 1954 and 2002 there would be a huge amount of local capital that can be drawn from, as other sectors have had huge amounts of growth, especially considering that the economy has had a huge overall 3. 7 % growth. The use of foreign capital, to fund growth of the Australian manufacturing sector is not only unneeded but as previously stated highly risky. Pushing the incentive for tax cuts for foreign investment is a bad strategy and one the manufacturing sector should be actively opposed to, instead of tax cuts for foreign investment current Australian manufacturers should instead be given tax cuts or subsidies which will be much more beneficial for the sector then relying on foreign investment.

Foreign investors crowd out the local hard working Australians and are not at all loyal to Australia. When you consider the fact that the demand for manufacturing is going down yet the sector actually growing, quadrupling in the years between 1962 and 2002 and still steadily growing it doesn’t need to be rapidly grown through foreign investment. When adding the fact that Australia’s economy is rapidly growing, now pretty much 1 to 1 with the US dollar there is more than ample local investors who can help grow the manufacturing sector slowly but steadily while still keeping it Australian owned.

It is best to rather than support foreign investment to support and subsidies the manufacturing sector and give tax incentives to local investors rather than foreign investors, this will lead to a much more stable sector with steady growth while keeping the company rooted where it belongs, this is much more important in the long term especially as foreign investors will instantly ‘jump ship’ when they find one ‘smaller and cheaper” , this will not only lead to an instable sector but job instability as well. Recommendations

Due to the government is proposing to give significant tax incentives to foreign investors who are prepared to invest in expanding the nation’s manufacturing base in automotive and textile industries, it means the government set low entry barriers to foreign investors. The market share of automotive and textile industries of home country will suffer a big shock and a series of challenge from foreign investors. There are some suggestions to government to response the unfavorable condition. Firstly, the government should establish and improve laws that are relating to market’s assessment, regulations and the standard system as soon as possible.

Drawing on experience of most developed countries can also be helpful, and then government can use legislation to review on the establishment of new large retail companies by the aspect of “economic needs”. The standard of review can contain lots of things like the local population density, the number of existing industries and services, geographic scope, the influence of foreign investors on the operating income of existing industries and the influence on the transport environment, the employment opportunities created by new investors and so on.

Of cause, this kind of review must be treated equally on the domestic and foreign investors. So that, the effective management to domestic business sector’s implementation can be done, when government phasing out the restrictions for the aspect of foreign market access. Secondly, the government should carry out some policies to ensure market competitiveness. The economies of scales can be used in market competition, which authorized by government. The scale advantages are obvious.

Since purchasing a large scale, not only from the manufacturers receive a lower discount price, but also in the method of payment and time aspects can be facilitated. In the low-price competition, a large number of sales and small profits by quick turnover may access to certain profit. Taking the advantages of large quantity purchasing to organizing order and developing their own-brand business can also improve product profitability. Therefore, the automotive and textile industries of host country urgent need to build their own business “aircraft carrier” to against the shock from foreign investors.

Moreover, the government could establish standardized business groups with parent-subsidiary system. At the same time, they should pay attention to develop sales network through commodity, trade names, distribution and management technique. On the other hand, in order to make technological innovation into productivity and ultimately achieve significant cost advantages, the government should attach importance to the follow two points. One is through improvement of the production process and manufacturing skills to increase productivity and reduce production costs.

The other is improvement to existing products or research and development of new products; building brands with independent intellectual property rights and barriers to prevent foreign investors seize more market share. Overall, the government should support the manufacturers of host country reduce costs as much as possible to maintain long-term cost advantage in order to improve their core competitiveness. Finally, government should play a catalytic role in corporate mergers. The domestic manufacturers can cooperate with foreign investment to achieve win-win.

While the foreign investors enter to home country and impact the domestic manufacturers, they also provide some opportunity to the automotive and textile industries of home country. The domestic manufacturers can be shared resources with foreign investors, which is conducive to the optimal allocation of resources. Furthermore, foreign investors may affect the whole supply chain of the automotive and textile industries. It is an opportunity to the industries to re-integration and mergers, which makes the industries more stable and stronger.

Besides, more job opportunity provides to host country that eased the pressure on their employment. Conclusion In conclusion, from what have been discussed above, the tax incentive could attract foreign direct investors (FDI). The foreign technology and firms would encourage the development of domestic automotive and textile industries. At the same time, however, the number of competitors would be increased while the foreign direct investors enter to host country. It negative affect on government revenue and many small business.

The tax cuts may bring foreign investors some impacts on investment locations, resource utilization, environmental protection, government guidance and discernment and the corresponding reference of incentives. Therefore, foreign companies get some provisions. They are like double-edged knives, causing financial losses because of damaging local core technology as well as promoting local development of some joint economic. Besides, the most immediate benefit of foreign investment is to promote the import and export trade of raw materials, upgrading and improving both the number and quality.

It is obvious that tax cuts make local enterprises and foreign investors learn from each other on the economic structure and promote each other. When one encounters a debt crisis, the other will not hammer or exclude, which can put the loss and gain in an ideal range. Furthermore, attracting more foreign funds by cutting tax will consolidate the domestic market; certainly the chips people live by also speak more. Thus, tax cuts seem to be as much a risk an asset for both foreign investors and local enterprises. Only by handling the problem mentioned above reasonably can obtain win-win.

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