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The tax factor as an investment magnet
December, 05th 2006

Incentives alone are not enough they must be backed by comprehensive policy 
The infrastructure sector, comprising transportation, telecommunications and power, is the backbone of every economy. The presence of a robust infrastructure distinguishes a developed economy from a developing one. Since Independence, the governments assumption of sole responsibility for the development and maintenance of the infrastructure sector without private participation has resulted in poor transport and communication networks and unreliable energy infrastructure. The process of liberalisation that was kick-started in 1991 brought about a series of reform programmes in areas such as monetary, fiscal, industrial and trade policy, as well as infrastructure, with a view to attracting private investment.
Alongside the reform and policy measures, various tax incentives were introduced to encourage investment in infrastructure areas such as telecom services, power generation and distribution, hotels, and railways. Section 80IA/IB was introduced in the Income-Tax Act, 1961, providing a ten-year tax holiday to specified infrastructure sectors. Section 10(23G) was also introduced to provide tax exemptions to the stakeholders of infrastructure companies on income by way of interest, dividend payments, and long-term capital gains.

Barring a few exceptions, such as incentives under section 10(23G), these tax incentives have continued through extensions granted by successive Finance Acts. A tax incentive is a loss of revenue to the government and, hence, comes at the expense of public investment. It is, therefore, important to analyse whether tax incentives provided to various sectors of the economy actually serve the desired purpose: development of the sector on a sustainable basis.

In hindsight, considering the development that has taken place so far since the inception of the reform programmes, it may appear that the tax incentives do work in favour of the development of a sector; however, a closer look would reveal that it is not always true.

Lets compare two important sectors: telecom and power. Section 80IA confers 100% tax holiday to the power sector for ten years, whereas the telecom sector is eligible for 100% tax holiday for the first five years and 30% for the next five years. However, if we look at developments that have taken place in the two sectors over the last decade or so we see that while significant growth has taken place in the telecom sector, the power sector still lags behind.

This disparity in the development of these two sectors, despite greater tax incentives provided to the power sector, brings us to the question whether there is significant correlation between tax exemptions and growth in infrastructure. Analysis reveals no clear correlation exists between the two, as tax incentives alone cannot ensure sustainable growth of a sector. There are some larger policy issues that need to be addressed in order to make the sector viable for investment. For example, the telecom sector witnessed serious policy reform initiatives like the National Telecom Policy (NTP), 1994-1999, which gave a comprehensive roadmap for the Indian telecom sector. The power sector, on the other hand, is still grappling with several issues such as transmission and distribution losses, non availability of fuel and capacity shortages.

Does that mean that tax incentives have no role to play in the growth of a sector? The answer is no. Tax incentives play a significant role in attracting investments in various sectors of the economy as it enhances return to stakeholders and makes them more lucrative. Capital is scarce and it would flow to the country where it earns the most returns. A World Bank study reveals that tax incentives have played a major role in attracting FDI in various tax havens. For instance, Irelands tax incentives are seen to be key to attracting foreign investors to that country over the last two decades.

If India wants to attract much-needed capital in infrastructure, it has to make the sector attractive not only by addressing the larger policy issues such as easy entry/exit options and removing trade barriers, but must also offer attractive returns to stakeholders by providing tax incentives. Besides telecom, the Indian IT sector is another example of how policy reforms and tax incentives have worked in tandem in the development of this sector.

The recent rush for SEZs by investors shows the effectiveness of tax incentives in attracting capital. The concept of SEZs and tax incentives to units in SEZs were introduced in the year 2000 through a revision of the Exim Policy. However, it is only when the comprehensive SEZ Act, 2005, was passed that investors found sufficient comfort for making huge investments.

The World Bank Report on Ease of Doing Business, 2007, places India at 134th position, behind all other BRIC countries. China at 93, Russia at 96 and Brazil at 121 positions are much easier countries to do business in.

India aims to achieve a growth target of around 10% on a sustainable basis for the next 10 to 15 years, the government needs to create an enabling environment to attract and nurture foreign investment. This may remain merely a pipedream if ground-level and policy-level issues plaguing the growth of infrastructure are not sorted out. Tax incentives, by themselves, are not the answer.

The author is executive director, PricewaterhouseCoopers

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