Types of Tax Concessions for Promoting Investment in Free Economic and Trade Areas



Introduction

The establishment of a free economic and trade area (FETA) seems to be one of the most
significant institutional innovations which have widely spread throughout the world
economic scene in past years. The FETA as a territorial enclave in which foreign firms (in
many cases also in co-operation with indigenous companies) benefits from generous
incentives and privileges and thereby producing industrial goods mainly for export, found
popularity in developing countries, notably in the newly industrialised countries in Asia.
The diffusion of this development concept as a growth-oriented policy instrument in
developing countries is likely to continue in the near future. In recent years, however, this
measure has also been adopted in the former centrally planned economies as an instrument
of stimulating economic and structural transformation. The first application of this type of
development measure began with the creation of special economic zones in China.
Nowadays the FETA concept is increasingly gaining importance in other transformation
countries in Europe including the former USSR, Poland, Hungary and Bulgaria as well as
in Asian countries such as Vietnam and North Korea (United Nations Centre on
Transnational Corporations, 1990 and 1991).

One of the crucial characteristics of the FETA is the provision of generous tax
investment promotion schemes solely permitted in this enclave. In general, such
measures include: (a) profit tax exemption, (b) free or accelerated depreciation, (c)
investment tax allowance, (d) subsidy for investment costs, etc. In this study the
incentive effects of various tax concessions on firms’ investment decisions can be
compared on the basis of the net present value model. Such a theoretical approach is
accompanied by a model simulation based on selected parameters.

Without taxation, net present value (NPV) is equal to present value of future gross
return, discounted at an appropriate interest rate less cost of investment. An investment
project is therefore considered to be profitable when NPV is positive. After introducing
corporate income tax, the present value of the asset generated from an investment amounts
to the sum of present value of net return (gross return less taxes) and tax savings led by an
incentive depreciation provision. If the investment is self-financed, the interest rate
directly corresponds to the investor’s opportunity cost. Under the assumption of a perfect
competitive market structure, there is only one interest rate in the financial market.

In addition, anticipated effects of inflation on firms’ investment decisions are examined
in the context of corporate income taxation. The central issue is that the so-called
historical cost accounting method, which is applied in practice when calculating the
(corporate or income) tax base, causes fictitious profits in inflationary phases that are also
subject to tax. This type of increased tax burden is generally referred to as inflation loss
(Devereux, Griffith and Klemm, 2002; Gonedes, 1984; King and Fullerton, 1984;



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