While completely endorsing the absolute necessity of the above in the long run, it must be recognized that globally mobile IVINCs operating in multiple markets will base their investment decisions on micro economic conditions that may vary significantly from sector to sector even within the same country.

Thus, globalization actually makes tax incentives more significant, because companies are able to exploit them better by transferring their activities from one country to another easily and cheaply. Particularly in the Services sector, companies can transfer their activities to low tax regimes that are physically far from their customers but virtually only a mouse click away.

Even companies from countries with Double Taxation Avoidance Treaties with the host country benefit. When residence-based tax exempts, by agreement, a corporation from tax in the home country and the host country taxes it at zero rate, the corporation effectively pays no tax at all. The only instance in which we can safely say tax incentives are truly irrelevant is when the home country itself imposes no CIT (as in parts of the Middle East).

So neither can we decouple tax incentives from positively influencing FDI flows in the modern world, nor can we rely on them exclusively. We must instead develop comparative advantages in specific sectors, and tax incentives must be combined with other efficiencies as part of the overall package.

The secret in achieving the correct balance between attracting investment and sustaining economic growth, therefore, is to recognize that a one-size-fits-all approach will not work, and that we need to tailor our tax structure to attract FDI most beneficial to economic needs, and make the most use of our available resources, but still stimulate local industry and increase competitiveness. Most of all, they must not constitute an erosion of our tax base or cause an irreparable loss of revenue to the State. Although nearly 40 years old, we have seen that Kaldor’s words still ring true today.

Since we have concluded that tax incentives do indeed have an effect on the local decisions of IVINCs, especially within regional markets (for example SAARC and ASEAN), there is a risk that Governments will "race to the bottom" with competitive tax incentives. This bidding war has only one outcome. It will favour the IVINC or the treasury of the home country, at the expense of the welfare of the host state and its citizens.

Such has been this experience that recent efforts have been made to harmonize tax regimes in both the industrial and the developing world. In the EU, for example, member states are discussing more stable, uniform and transparent tax rules. Similarly, several West African countries have been working to harmonize their tax incentives for FDI in one unified investment code within the Monetary Union of West African States. Although 1 have to say that this fact seemed to have bypassed the head of Trade of one African nation who visited here recently. At a dinner for the business community in Sri Lanka he proclaimed, "Whatever Sri Lanka offers we will better". Engaging in such irrational competition must be resisted in the long-term interests of our country.

Beyond the risk of a bidding war, tax incentives clearly reduce State revenue collection and create opportunities for illicit behaviour by companies and tax administrators. These issues are more pressing in developing countries like Sri Lanka, Which face more severe budgetary constraints and corruption than do industrial countries.

So there is no doubt that tax incentives are costly, directly in terms of reduced fiscal revenue, and indirectly in terms of undesirable activity. They also have other, less obvious costs. They can attract investors looking exclusively for short-term profits, especially in countries where the basic fundamentals are not in place. They place a substantial burden on the State to effectively administer them. They lead to corruption, screen out desirable investments, undermine sound policymaking and obstruct the development of competitive markets. Finally, there is no compelling evidence to show that their benefits reach the consumer. 1 have seen, on my travels through the world’s oil cities, too many hovels right up against plush camps to fully subscribe to the trickledown theory.

It is clear therefore, that if we are to use Tax incentives to attract FIDI, we must fully understand the cost per employment generated, and the benefit to State in the long term.

Let us now consider the case of Sri Lanka. When Sri Lanka liberalized her economy in 1977, one strategy to stimulate growth was to accelerate job creation and net foreign exchange earnings by attracting foreign investment into the export oriented manufacturing sector.

The BOl currently has 1695 commercially active projects, exporting nearly 2.5 Billion USD per year (which comprise just over half of Sri Lanka’s exports), and providing employment for 434,000 direct, and 651,000 indirect workers. Cumulative exports from 1978 to 2003 amount to 2.25 trillion rupees, in order to do which 1.67 Trillion rupees worth of Capital Goods and Raw Material were imported.

The cumulative FDI realized to effect the above business is 186 Billion rupees equivalent, which when combined with 91 Billion rupees of local investment, totals 277 Billion rupees.

Throughout the history of the BOI there have been several changes in the Regulations governing the eligibility and magnitude of Tax Incentives. These have to be taken into account when attempting to assess cost to State, so a summary is provided below.,

1978-1994: 7 - 10 years Corporate Income Tax (CIT) holiday based on performance. 1994-1995: CIT holidays suspended, lower level of CIT introduced (15%). 1996-199: CIT holidays re-introduced, in 4 major investment brackets, from 5 to 20 years for Advanced Technology and Large Scale arojects. 1998 -2002: Regional Industrialization incentives introduced ‘(Difficult Areas, Thrust Industries, etc. (5 - 20 years CITH depending on investment). 2002 todate:All non-traditional products - 5 years CITH Infrastructure - 6 to 12 years CITH based on investment Large Scale > Rs. 500M - 3 years CITH (Local Market)

Based on a process of estimation and averaging, and erring on the conservative side, we arrived-at the following tentative estimates of revenue loss:

Customs Duty forgone on import of Capital Goods and Raw Material (assuming all investment would have taken place) - 239 Billion Rupees

Capital Expenditure on Infrastructure - 7 Billion rupees Tota 1 revenue foregone exceeds 257 Billion rupees, indicating a cost of some 233,000 rupees per employment opportunity.

The above are the estimated tangible benefits and cost in the ideal situation.

Non-tangible benefits Include township and regional development, infrastructure development, skills development, technology and knowledge transfer, entrepreneurship development, logistics and support services development, and improved quality of life from employment creation.

Non-tangible costs are primarily socio-economic issues; migration of 1 labourr to city and suburbs, leading to health and sanitary issues, transport and security issues, environmental degradation and conflict management issues.

This may be an appropriate point to digress into an area of apparently serious public concern - the social impact of the eligibility criteria for BOl status. BOl incentives are only, awarded to companies qualifying under current regulations pertaining to Section 17 of the Act, These companies have passed through stages of assessment by the Board, are generally above an investment threshold, and well-defined lines of business.

There are, however, smaller companies that involve foreign collaboration but do not meet the criteria for Section 17 projects, either by business model or investment quantum. These companies are simply registered with the B0I, which permits granting residence visas at a minimum investment of USD 50,000 per foreigner. These companies are only given a cursory vetting since they operate under the normal laws of the country, and are not entitled to use the title "BOI Approved", simply because there is no approval process.

On the subject of visas, 1 would further like to share with you that due to the investment requirement, 3-month tourist visas considerably outnumber BOI issued expatriate visas, and are an exploitable loophole.

The apparent total cost of incentives, Rs. 257 Billion, assumes no tax evasion or leakage. We all know this is hardly the case. We can therefore assume that the true total cost is much higher.

On to the total realized FDI of Rs. 186 Billion. How much of this was actually retained in the country? Much of it must surely have been remitted back out as payment for Capital Goods. We have not segregated this amount from the FDI that went into local goods and services and strengthened our balance of payments. Perhaps it is only this element that should have been recognized for concessions? Further, no account is made of the foreign currency loans from local banks that have run to default.

Of the local investments, how much of it would have happened anyway, due to general economic progress? It is widely acknowledged that much investment would have taken place without tax incentives in place. This simply means that we have rewarded investors at cost to State, and unconfirmed benefit to the end users. To make matters worse, the qualifying companies were typically larger organizations, and the benefits denied the smaller players allowed them to grow even more. An unnatural state of affairs in a nation where more than half of it’s GIDP comes from more than 125,000 Small and Medium enterprises.

It is worth making a regional comparison of economies in terms of their CIT regime, revenue collection, and attracted investment. The countries sampled include Sri Lanka, Singapore, India, Indonesia, Malaysia, Philippines, Thailand and Vietnam. It is regrettable to note that Sri Lanka is the worst performer by a good margin in terms of both revenue to GIDP and Efficiency Ratio (defined as revenue to GDP divided by the standard tax rate, expressed as a percentage).

To add to the hemorrhage, Sri Lanka stopped requiring export receipts to be repatriated within 180 days in 1994. It is worth noting that 6 of the above group of countries still regulate this. The Central Bank has estimated that around 12% of export proceeds did not make it back to our shores annually over the last 10 years. This sounds modest enough until one puts the figure of 6 Billion USD on it, or 3 times our current reserves. Was this not part of the foreign exchange income we actually provided those tax incentives for?

The above discussion leads us to the clear conclusion that the general fiscal regime Sri Lanka has practiced over the years may not have been in our best long-term interests. We therefore need to use the benefit of hindsight to make the necessary rationalization. Much study has been done to recommend different methods of tax incentives other than straight CIT holidays and blanket duty exemption, and these should be evaluated carefully for the correct mix, possibly on a time variant sector-by-sector basis.

No discussion on Sri Lanka’s economic aspirations would be complete without mentioning her natural resources. We often complain that little has been done to exploit them. While this may be a justifiable lament, we must accept that many of the world’s richest countries have few territorial resources. They simply have the financial power to buy what they need. So is the real issue proximity or purchasing power parity? What is the glue that will bind these two together so that our non-renewable resources can be carefully depleted with minimal environmental and cultural impact but with maximum benefit to our economy? That glue is comprised of many ingredients, only one of which is an efficient and effective tax regime. Others are effective legislation, strong law and order enforcement, and transparent governance. Without these, our natural resources will get exploited

In a word of caution Wickremasinghe said, I would like us to remember that progress, while broadly beneficial, often brings with it some undesirable side effects. We owe it to ourselves to anticipate these and take precautionary measures - in fact to turn these measures into revenue opportunities.

We could consider tax shifting - lowering income taxes while raising taxes on environmentally or socially destructive activities. This forces the market to tell the truth, and reflects the indirect cost to society of an economic activity. For example, a tax on coal would incorporate the increased healthcare costs associated with breathing polluted air, the costs of damage from acid rain, and the costs of climate disruption and ground water pollution.

Environmental tax reform is spreading, along with other forms of tax like congestion tax. Introduced effectively by Singapore decades ago, London implemented it in early 2003. Since then, traffic in the city has been reduced by 24%, permitting freer flow, less pollution, and more revenue from public transportation mechanisms.

A stumpage tax is in place in Bulgaria and Lithuania. Anyone wishing to cut a tree would have to pay a tax equal to the value of services provided by the tree. This will force the market to decide, as forest services may be worth many times more than the timber or pulp, which will in turn encourage wood and paper recycling.

The Danish Government’s tax incentives for wind generated power have made Denmark, a country of only 5 million people, the world’s leading manufacturer of wind turbines.

A trash tax of $1.20 per bag introduced by the city of Victoria, British Columbia, has reduced daily garbage flow by 18%.

It is clear therefore that there are measures we can take to increase protection from the undesirable effects of development, and that these must be considered alongside incentives that strive to bring it about.

"We have examined the position of Sri Lanka as a potential destination for FDI in a modern context. We have analyzed the structure of our current tax incentives and found them to be wanting in both the areas of local investment and FD qualityl. We have realized that the revenue losses to State they cause may be unsustainable for long-term economic growth, and have recognized the need to revise both the type and application of tax incentives offered if we are to achieve our development goals. We have also had a glimpse of what innovative measures we can take to leave a better Sri Lanka for our children, in partnership with a socially responsible corporate sector.