Denying the acceptance of forces that shape growth and investment

By growth we mean economic expansion as measured by any of a number of indicators such as GDP. Economic growth is an increase in the production and consumption of goods and services. It refers to an economy that is getting bigger.1

Investment, on the other hand, is considered as an engine of economic growth, job creation and industrial development. Thus growth and investment are linked with each other. Investment is needed for growth that is why governments are sensitive in attracting investments and the states compete for attracting domestic and foreign investments.2

However, there are many impediments to attract investment and unfortunately, the decision-makers in many developing countries are not sensitive enough to view investment phenomena as an outcome of competing interests. Resultantly many sensitive areas remain unattended and lead towards a failure to attract the investment.

This careless attitude contributing to inefficiency on the part of decision-makers in the developing countries emerged due to pressures exerted by the authoritarian regimes on the bureaucracy. A lack of professionalism on the part of decision-makers also contributed towards making wrong decisions.

The behaviour of money is also very strange, it moves to places which suits it and it does not like controls. Unpredictability frequent policy changes and lack of enforceability of regulations or laws does not suit it. For example, Bermuda-based captive insurance companies dramatically lowered insurance costs for extending benefits to its customers attracting huge insurance business. Cayman Island is the hub of structured finance arrangements and since 1990s hedge funds are predominantly domiciled there. By bringing in changes in their tax laws, the Netherlands Antilles attracted the business of finance subsidiaries of leading corporations as it reduced their global cost of capital.4 These examples show how innovative and creative approach leads to attraction of investment.

Why some of the developing countries are failing to attract businesses and investment? May be we have to ask that how states obliterate growth and investment resultantly denying their citizens better quality life, employment and higher rate of consumption.

Let us float the proposition that how acts of state affect the businesses and individuals and keep investors away from making investments. Factors which contribute to keep the business and investment away are manifold and include amongst them the following:

Denying the enforcement of a commercial contract, this denial causes losses to business as contracts ensure manufacturing or production at a cost-effective price for a defined time period. Businesses also use these contracts to hedge against the potential cost increase of resources. A wrong decision in this regard can backfire, particularly when the state regulations deny the acceptance of mutually-agreed contracts.

The refusal of the state to accept a legally-binding contract causes an increase in the cost of doing business. For example, denying a contract means that the agreed price between the two parties is rejected without any basis by the customs administration of the importing country. Because tax administrations are in the habit of making assessments of duty and taxes on the basis of a fixed or on indexed prices, which in many cases results in the increase of the landed cost of imported goods.5 This increased burden is ultimately passed on to the consumers making the goods much costlier.

Unpredictability of laws and their frequent changes also affect businesses very badly. A business endeavours to proactively identify risks in order to implement concrete and appropriate countermeasures before they materialise. Nevertheless, occurrences of incidents, which are unforeseeable or beyond the scope of prediction, affect the business performance and its financial conditions. For example, unpredictable revisions of taxes, a common practice witnessed in this regard is the levy of regulatory duty. For example, in Pakistan, the law has authorised government to impose regulatory duty equivalent to 100% of the value of goods.6 Even an additional customs duty can also be imposed up to 50% of the value of goods. All this can be done without going to the Parliament.7 These unpredictable revisions of taxes are very common in developing countries and these uncertainties affect the investment decisions.8

A business only operates under the domain of laws and regulations of the countries in which it conducts business. Changes in laws and regulations, or the unexpected introduction of new laws and regulations, affect the performance of business and its financial conditions. The objectivity demands that laws and regulations be meant to minimise the litigation, because the businesses always face a risk of litigation in their undertakings and these litigations lead to increase in costs.9

A common pattern witnessed amongst developing countries is that no serious effort was made to modernise their commercial laws. The existing outdated commercial laws create hindrances and obstacles for smooth running of local and foreign businesses. That is why developing countries often face the challenge either they have to modernise their commercial laws or to lose investments. States may opt for updating the existing norms but complete modernisation, probably is the best solution. However such decisions are often blocked by powerful local interests, nevertheless the modernisation of institutions is necessary to facilitate trade and investment.10

A key issue in any legal system involving long-distance trade is the creation of mechanisms to overcome bias, which may be a problem no matter how similar the relevant legal systems may be.

The question then is the ability of a legal system to accommodate businesses. For example, the most required institution for streamlining today is the debt collection.11 Debt collection comprises activities of creditors in the process of trying to recover the debts owed to them. It is the primary mechanism of contract enforcement in consumer credit markets and affects millions of consumers.12 Creditors can try to collect on their own, or they may outsource collections to third-party firms. However, the experience shows where debt collection is made by third party, these parties try to use harsh and undemocratic methods not authorised by law.13 There should be a check on such abuse of law.

Then there arises the situation where taxpayer’s money is withheld by the state on different pretexts. This money becomes due either by making payment due to mistake or an error or due to an available balance resulting from export operations, use of multiple rates, use of zero-rating,14 or making investment in fixed assets. Delay of these payments increases the business expenditures as the money has its own costs. It may be kept in mind that taxes are meant on consumption of goods and the same cannot be treated as business tax. Converting a tax into business tax would mean eroding profitability of the business. It is thus necessary to return what has been taken wrongly to the taxpayer immediately since it is as much a duty and grace of Government as to levy relentlessly and fully what is due to the state. However, where a party has been put to too expensive costs for refunds is regrettable.15

Another issue relates to bureaucratic procedures which can be complex, arbitrary and unpredictable leading to delay in contract enforcement and for making decisions on pending issues. That is why we need business enabling environment (BEE).

The business enabling environment includes norms and customs, laws, regulations, policies, international trade agreements and public infrastructure that either facilitate or hinder the movement of a product or service along its value chain. At one end of the spectrum, conventions, treaties, agreements and market standards shape the global business enabling environment. The business enabling environment at the national and local level encompasses policies, administrative procedures, enacted regulations providing simplicity, ease to apply and certainty.

Every day an entrepreneur spends filling out paperwork or in line at a government office is a day not making sales or finding new customers. Burdensome and unpredictable regulation is costly both in terms of the time and money required for compliance as well as in opportunity cost. In many countries, these costs are substantial.16

A growth-oriented businessperson faces a choice: comply with regulations and incur costs so high that they jeopardise the business’s viability or try to survive in the informal sector without bank credit or enforceable contracts and at constant risk of harassment from authorities.17 They are limited in their ability to grow, attract investment and hire more workers.18

From what has been stated above, it emerges out that forces that shape attraction for growth and investment include honouring the business contracts, making the tax laws more predictable, predictable tax schemes, transparency and streamlining the bureaucracy. By adopting these norms we can foster the era of growth and investment.

(The writer is an advocate and is currently working as an associate with Azim-ud-Din Law Associates Karachi)

1. Not necessarily one that is getting better.

2. In 2010, for the first time ever, the majority of Foreign Direct Investment (FDI) went to developing countries. UNCTAD, World Development Report, 2011.

3. The government and policy makers are to recognise the fact that market behaviour does not depend on our idealism.

4. Andrew P. Morriss, Offshore Financial Centres and Regulatory Competition, AEI Press Washington DC (2010)

5. Attention is invited to the provisions of section 31-A of the Pakistan’s Customs Act, 1969, whereby the contractual obligations can be denied and duty is assessed on a fixed value of goods by not implementing the true intention of Section 25 of the Customs Act, 1969 thereby obliterating the intention of GATT’s customs valuation agreement by denying the acceptance of transaction value. Even exemption in taxes available on the day of contract if subsequently with drawn, will not be available to an importer when his goods arrive.

6. See sub-Section (3) of section 18 of the Customs Act, 1969.

7. See sub-Section (5) Section 18 of the Customs Act, 1969

8. A lax commitment to fair and consistent tax collection is not only a problem for foreign investors; it creates a serious fiscal problem for the government. A 10 percent tax to GDP ratio means there is not enough money to invest in education and healthcare, roads and bridges, power plants and new sources of fuel.

9. The impact of frequent litigation may affect their performance and financial conditions.

10. Daniel Klerman, the Emergence of English Commercial Law: Analysis Inspired by the Ottoman Experience, http://www.usc.edu/schools/college/crcc/private/ierc/conference_registration/papers/Klerman_final.pdf, Visited on April 11, 2015

11. Id.

12. Vilctar Feldaseyeu, The Economics of Debt Collection, Enforcement of Consumer Credit Contracts, Research Department Federal Reserve Bank of Philadelphia, March 2014.

13. See the provisions of Article 4 of the Constitution of Islamic Republic of Pakistan 1973. An agency can deviate from the accepted norms in one of two ways: either by using lenient debt collection practices or by using harsh debt collection practices.

14. For example, as per income and sales tax law, supply of milk is zero rated; hence the sales tax paid by tax payers on the purchase of goods and services becomes refundable. However, as per reports currently Rs 500 million is stuck up in pending refund claims causing loss to dairy sector. (See report on ‘Dairy Sector’ Published inBusiness Recorder dated April 12, 2015).

15. The regulations and procedures must provide a solution to these kinds of problems.

16. In Brazil, for example, not only is the tax rate nearly 70 percent, but the procedures are so complicated that the average amount of time required to prepare, file and pay taxes is estimated to be 325 days.

17. Approximately 60 percent of urban businesses in Africa, 40-60 percent in Asia and 58 percent in Latin America remain outside the formal sector.

18. Without informal enterprises’ tax contributions, government is limited in its ability to provide services and the tax burden on registered businesses is greater than it should be.