Tax Concessions and Investment Behaviour

The Government of Pakistan, like many other developing countries, has opted for tax holidays as an important fiscal measure to encourage rapid industrialisation in the backward areas. This concession is also supplemented by several other economic and non-economic measures including import duty, and depreciation allowances. Mintz (1990) discusses the efficacy of tax holidays in the presence of accelerated depreciation allowances concludes that tax holidays which are designed to increase capital formation may end up penalising capital formation. Mintz’s (1990) conclusion is based on the assumption that if the assets are long-lived, and the income tax system allows deductibility of accelerated depreciation but cannot be deferred, then the tax holidays, by preventing depreciation deduction in the early period may actually penalise investment during the tax holiday period. If on the other hand the depreciation allowance is deferred till the end of tax holiday period, the tax system is genuinely generous and provides a real incentive for capital formation. In Pakistan the tax code are such that the firms in the tax holidays region are not allowed to claim or defer accelerated depreciation allowance but can claim normal depreciation allowance only after the expiry of tax holidays period. Whereas the firms in developed areas can claim both accelerated (25 percent) and normal depreciation allowances (10 percent) annually. Import duty concession is given for most of the underdeveloped areas and few of the developed areas. These different sets of incentives affects the cost of capital and hence investment differently. The purpose of the present paper is to see these effects by computing the cost of capital for developed and under developed areas. This will help us to examine whether the tax holidays as an incentive is effective or act as a barrier to claim other generous concession like the depreciation allowance.