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A REVIEW ON THE “OMNIBUS INVESTMENTS CODE” (EO 226) AND ITS IMPACT TO THE ECONOMY

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A Public Policy Paper

Presented to

Prof. Saviniano M. Perez, Jr.

Adviser

Graduate School, José Rizal University, Mandaluyong City

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In Partial Fulfillment

of the Requirements of the Course of

Philippine Administrative and Legal System

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By

John Chen-Te Ko

January 2007


CHAPTER I

INTRODUCTION

1.1 Background of the Study

Stimulation of investment as a means of financing economic growth is an integral part of the development plan of any nation. Investment and its positive economic effects may serve to achieve particular societal goals, to correct market imperfections, to guide domestic production and to underscore comparative advantage. Foreign direct investment (FDI) may provide the additional advantages of allowing access to new markets and technologies and increasing competition in the domestic market.

A developing nation attempts to encourage and mobilize domestic savings for investment, but is often faced with inadequate levels of domestic savings. Therefore, they develop economic policies which attract foreign investment as well, within the confines of their stated national development objectives. The Philippines fits this pattern.

When the Aquino administration assumed power of the Philippines in 1986, the country was facing massive external debt, high poverty and unemployment levels, a large public sector deficit, and low levels of savings and investment, due to a general lack of confidence among the foreign and domestic business communities. The negative investment environment has been exacerbated by the continuing pressures on the economy from high population growth (2.4% per year), rural-urban migration, deteriorating agricultural production, continued political instability and a worsening infrastructure. The Philippine government was therefore confronting a need to attract the investment which would stimulate economic growth without having obvious lures for investors. The solution, as practiced by most developing countries, is to design a package of incentives which enhance the revenues or reduce the costs for firms, thus compensating them for some of the local deficiencies. A successful package creates an environment conducive to both the foreign and the domestic investors. The Philippines is reassessing their investment policy in this light, with the goal of creating consistent and clear inducements meeting well-articulated objectives.

The reassessment was triggered by a belief that investment, both domestic and foreign, is not being promoted in an efficient and effective way. While current incentives cost the Government through foregone revenue, the resulting investment levels continue to disappoint and are lower than those in other ASEAN countries. The reassessment has opened active debate over the direction of their investment policy and has produced numerous proposals for change in the investment regime, the most important of which are examined in this study. The Government of the Philippines has already made significant progress toward reform of the investment environment; this report is designed to be a tool that will assist with the analysis and efforts underway.

It is clear that the major obstacles to the attraction of foreign investment in particular are the political instability and the lack of adequate infrastructure, areas which will not be improved within the short run. While some Filipinos are calling for the redirection of resources from incentives toward improvement of the infrastructure, this is not a realistic scenario. In fact, the investment regime can and should be redesigned to attract both domestic and foreign investment.

Currently, the framework for investment is embodied in the “Omnibus Investment Code of 1987” also known as Executive Order 226 (EO 226), the policies of the Board of Investments, various executive orders and laws, and the Constitutions of 1987. As a package, the message being sent to the investor is somewhat contradictory and obtuse. The lack of clarity is partially the result of the effects of two factors influencing the investment environment; the exigencies of economic conditions and a historic pull toward protectionism. While there is a recognized need to attract investment, foreign investment is potentially deterred by limitations on equity participation, land ownership, borrowing, and the seemingly discretionary interpretation of certain policies. Because many of these policies can be circumvented, their existence may be seen as an unnecessary deterrent by investors. The domestic investor may perceive a bias toward the foreign investor either in their access to domestic credit or a slant in incentives toward capital intensive investment. Other incentives appear to be redundant, contradictory or unduly arbitrary, of concern to both foreign and domestic investors.

1.2 Objectives of the Study

The general objectives of this study are: (1) to review the investment incentives provided to industry in the EO 226; (2) to determine the need for the continuation of investment incentives based on standard economic efficiency and equity criteria, and (3) to formulate appropriate recommendations for the removal/phase out or for the improvement of the existing system. In specific terms, the study will provide an economic framework for evaluating the need for investment incentives. Based on this framework, it will re-assess the existing fiscal incentives to industries in terms of their social cost and benefits, their competitiveness vis-à-vis the incentives provided by other countries in the regions, and their effectiveness in stimulating the desired response from affected economic agents, and the impacts to the national economy.

This study aims to assist the Government of the Philippines in their design perfection of an investment incentive package which is not unduly influenced by either side of the debate, but adheres to objectives consistent with the overall development policy of the Philippines. According to the Medium-Term Development Plan of the Philippines (2004-2010), the creation of 6 millions of jobs is one of the goals to be achieved. Investments shall be encouraged in employment-generating, export-oriented, agro-based, and import-substituting industries where the country has comparative advantage and where productive capacity is adequate. Domestic and foreign investments shall be encouraged particularly in areas where domestic resources are lacking and where contribution to the economy is maximized in terms of generating employment and promoting export-oriented activities, and encourage activities that pave the way for the desired transfer of technology and access to foreign markets. The role of foreign investment is complementary to that of domestic investment and should be channeled to activities generating high value-added. Additional guidelines are given in the Constitution which gives Congress the authority to reserve certain areas of investments to Filipino citizens or Filipino-owned corporations.

The objectives of investment incentive policy in the Philippines are to attract investment in areas that generate employment, exports, rural-development, technology transfer and generally contribute the economy. New foreign investment is restricted from entering into areas already sufficiently exploited by Filipinos or into areas specified by Congress as being in the national interest, including retail trade, exploitation of natural resources, national defense and fishing etc. The restriction to foreign investment will be discussed in the following chapter.


CHAPTER II

THE POLICY

This Section summarizes and describes the foreign investment policy and the investment incentives policy of the Government of the Philippines. Following this description, this study describes also the types of incentives granted by various government agencies, and the administrative mechanisms involved in the provision of incentives to specific activities and sectors. It traces as well the changes in the incentive system over time, presenting the existing system in historical perspective so as to engender a better appreciation of the need reforms, and evaluating the effectiveness and cost of the existing policies.

2.1 Historical Review on Changes in the Investment Incentives

Since the beginning of the post-war period, various tax incentives laws have been enacted as part of the country’s industrialization strategy. The first such law was Republic Act (RA) 35 which was enacted in 1946. It granted “new and necessary” industries exemptions from certain internal revenue taxes (including the income tax, the sales tax, the advance sales tax on imported materials, the real estate tax, the fixed privilege tax on business and the residence tax) for a period of four years from the date of organization of the enterprise.

RA 901 amended RA 35 in 1953. It broadened the tax incentives granted to new and necessary industries by including exemptions from customs duties for capital equipment. Subsequently, these two laws were superseded by RA 3127, also known as the “Basic Industries Act of 1961”. It provided tax exemptions on machinery, equipment and spare parts made by “basic industries” until December 1970. Initially, 18 industries were classified as basic. Later, RA 4093 deleted 12 industries from the original list and added 10 more.

In 1967, the ”Investment Incentives Act” (RA 5186) granted a wide range of tax incentives (including accelerated depreciation, net operating loss carry over, tax deduction for expansion reinvestment, tax exemption on imported capital equipment, tax credit for domestic capital equipment, tax credit for withholding tax on interest, tax credit for the sales, compensating and specific taxes and duties on raw materials used in export production) and other benefits (like post operative tariff protection, anti-dumping protection, protection from government competition, liberalized rules in the employment of foreign nationals, preference in grant of government loans) to firms investing priority industrial sectors. It created the Board of Investments (BOI) to administer the program. The BOI classified registered investments as either “pioneer” (those which introduce new products or new processes) or “preferred” (those in which existing capacity was deemed to fall short of domestic market demand and estimated export potential).

The “Export Incentive Act” (RA 6135) was legislated in 1970 as a complementary measure to RA 5186. While it provided largely the same incentives to exporters as RA 5186, it liberalized the rules governing the eligibility of exporting firms to such incentives[1]. Under RA 6135, export firms whose products were not listed under the Export Priorities Plan were automatically eligible to register if they export 50 percent or more of their output in contrast to RA 5186 which required that the activity be listed in the Investment Priorities Plan before it may be considered for BOI registration.

A number of presidential decrees issued during “Martial Law” amended RA 5186 and RA 6135. PD 92 (1973) expanded the list of tax incentives to include the additional deduction from taxable income of one-half of the value of labor training expense and extended the availability of the tax credit on taxes and duties on raw materials from 10 years to an indefinite period. However, it abolished the double deduction of promotional expense and shipping costs and limited the expansion reinvestment allowance. On the other hand, PD 485 (1974) allowed for the additional deduction from tax income of direct labor cost and local raw material cost and granted partial, instead of full, exemption from duties and taxes on capital equipment to firms whose imported capital equipment per worker ratio exceeds a given level.

It has been noted that because the principal type of incentives provided are based on the amount of investments being made, both RA 5186 and RA 6135, as amended, favor the use of capital relative to labor in the preferred industries.

In 1981, Presidential Decree 1789, otherwise known as the “Omnibus Investment Code”, consolidated RA 5186 and RA 6135, as amended. However, it did not introduced significant changes in the fiscal incentives provided to industries.

PD 1789 was again repealed in 1983 by Batas Pambansa (BP) 391, also known as the “Investment Incentive Policy Act”. The promulgation of BP 391 represented a major revamp of the fiscal incentive system. It withdrew a number of the incentives granted under PD 1789. the accelerated depreciation allowance, the expansion reinvestment allowance, and the double deduction of training expense, direct labor cost and local raw material cost, the deduction of operational and operating expense, deduction of 1 percent of incremental export sales and the exemption from all national taxes aside from the income tax were abolished. On the other hand, it introduced the tax credit for net value earned and the tax credit for net local content. Aside from the new tax credit provisions, BP 391 granted the following incentives: exemption/deferment of taxes and duties on imported capital equipment, net operating loss carry over, tax credit for domestic capital equipment, exemption from export taxes, tax credit for withholding tax on interest payments on foreign loans and tax credit for taxes and duties on imported raw materials for export production. Thus, there was a shift from investment-based incentives to performance-based incentives. Consequently, the bias towards greater capital intensity in BOI-registered projects was mitigated.

Parallel to the legislation mentioned above, a number of laws likewise provided incentives to specific industries or activities. The more important ones pertain to the firms located in the Export Processing Zone (PD 66), to cottage industries (RA 3470), firms located in the PHIVIDEC Industrial Estate, mining (RA 137), and shipbuilding (RA 1407). However, PD 1155 (1984) withdrew all tax incentives except those granted by the BOI and the Export Processing Zone Administration (EPZA). In recent years, new legislation providing special incentives to various industries were passed once again.

2.2 Overall Description of Current Policies

The Philippines has one of the most liberal policy and regulatory frameworks for investments in Southeast Asia. When investing in the country, businessmen are guided by clearly spelled out laws, rules, and regulations that govern the making of investments in the country. The following are six important laws that investors need to consider when contemplating an investment in the Philippines:

1.  Executive Order No. 226 (E.O. No. 226), otherwise known as the “Omnibus Investments Code” of 1987: Implemented by the Board of Investments (BOI), the “Omnibus Investments Code” of 1987 provides a comprehensive set of incentives for local and foreign enterprise engaged in activities considered by the government as high priority for national development.

2.  Republic Act No. 7042 (R.A. No. 7042), also known as the “Foreign Investments Act” of 1991: The “Foreign Investments Act” (FIA) of 1991 liberalized the entry of foreign investments Into the Philippines. Its passage by Congress marked the end of decades of protectionism for local businesses. This law established the Foreign Investments Negative List which enumerates the activities where foreign equity participation is limited.