Most of the time, when passions are high it is because conflicting greeds are involved. Some rare times, when passions are high it is because conflicting principles are involved. Among the promontories of contention in the proposed TRAIN 2 or its TRABAHO version is the shift from gross income taxation and other “forever incentives” to net income taxation (e.g., CIT) and time-bound incentives for PEZA locators. Since the government is switching policy lanes, this question is a propos: “Is the old system broke?” By “broke” it means wasteful.

As I have previously observed, dismal scientists (economists) are drilled to confront a policy initiative with the question, “What is the market failure?” A market failure is economist-speak for a status quo that is broken because productive of net social waste. A government that intervenes without there being a market failure produces a government failure – a state of greater waste than before intervention. In real economies such as the Philippines, governments routinely violate the market failure canon in either of two ways: (i) by intervening despite there being no broken status quo; or (ii) by failing to lift an extant intervention that has become over time unproductive and wasteful because conditions have changed: either the market has grown and/or the technology has improved. Subsequent well-meaning administrations can try to clean up the mess left behind by past administrations and recoup the foregone welfare. This is what the Duterte DoF aims to do with TRAIN 2.

Past administrations adopted and grew the status quo fiscal incentives system now enjoyed by corporations in PEZA largely to induce entry. The rationale was that foreign investors deterred by institutional or market deficits were shying away from the Philippines. For example, the extant market may be too small for current fixed capital investment requirement, or the peso was too strong and thus wages too high to attract export platform investors – a ‘missing market’ failure. An analogous idea in trade policy is the “infant industry argument.” No firm – not even a monopolist – will break even let alone realize a profit under laissez faire in a missing market failure. But a direct or indirect subsidy or a tax holiday from the government can push firms to profitability and induce entry. If so, such a subsidy or tax holiday could eliminate the missing market and its social waste. The extent of required subsidy depends on the severity of the hurdles that have to be overcome. For example, a jurisdiction beset by small internal markets, high power cost, high logistics and transport cost, etc., will need more incentives to compete with another jurisdiction with better endowments.

An incentive frequently foisted to induce entry into a missing market is a franchise. The entrant loses money in the first few years and recoups in the subsequent years when the market has grown sufficiently. The franchise acts as an indirect subsidy in the form of future profits protected by the franchise in the subsequent years when the market has grown and matured sufficiently to allow two or more firms to be viable under market conditions alone. When initial losses of the pioneer have been sufficiently recompensed, the franchise becomes overstaying and wasteful. A sunset clause in the franchise contract – say, 25 years – specifying the number of years of its effectiveness usually limits the social cost. Unfortunately, many of the so-called pioneer or infant industry contracts did not have sunset clauses, thereby becoming endless dispensers of “forever incentives.”

The Duterte government is right to want to be rid of these legacy cash burns. We have done this to good effect in the past. The NASUTRA sugar monopoly, the coconut levy and the Oil Price Stabilization Fund (OPSF) were government failures that impoverished farmers and nation and when lifted brought great relief to suffering Filipinos.

That the discussion of incentives to correct a missing market failure has gravitated around incentives to attract entry is natural. But sometimes, entry is only one part of the equation. The incentives to stay is another. Where locators can decide whether to stay put or walk away from one jurisdiction to join another more clement one, the game changes. This happens when there is intense inter-jurisdiction rivalry for locators. As long as the jurisdictional rivalry persists, certain incentives for entry also serve as incentives to stay: as such, they remain useful as long as locators are highly mobile and rival jurisdictions keep knocking on their doors. Furthermore, many PEZA firms are subsidiaries of multinational companies whose factories straddle several competing locations at once. These can quickly reassign production volumes to the most favorable locations even without physically moving a factory. Vietnam has just raised the ante on the incentives tussle for bigger share of investor dollars. Under these circumstances, incentives become, as it were, “weaponized.”

Weaponized incentives resemble military spending for national defense against threats of outside invasion; as Adam Smith told us, national defense is a public good as long as the outside threat remains. In Manufacturing, the outside threat from our regional rivals never sleeps. You treat Tradables the same way you do Non-Tradables at your peril. “Weaponized incentives” is the idea underpinning the popular refrain, “We are not the only game in town.”

TRAIN 2, though overall in the right direction and should be supported, can make use of some tweaking; especially as it touches mobile Manufacturing and tradable services. Passions are high, yes, but it may not be because of greed but because of a conflict of principles.

Source: https://www.bworldonline.com/weaponized-incentives-and-train-2/