The Effects of Tax Holiday on Investment Decisions: An Empirical Analysis

To promote rapid industrialization, developing countries haveemployed a variety of fiscal incentives to attract resources into themanufacturing sector. Perhaps the one incentive most frequently used hasbeen that of protective tariffs. However, many developing countries,including Pakistan, have encou¬raged the creation of new manufacturingunits through tax exemption, often referred to as tax holiday. Althoughthe basic idea is the same in each country, all or part of a firm'scorporate income is exempted from taxes for a specified period oftime—each tax exemption scheme is tailored to meet a particularcountry's resources and development objective. During the period from_1959_to. 1972 a tax holiday scheme was used in Pakistan to accomplishtwo basic objectives: (i) to increase the overall level of investment inthe industrial sector, and (ii) to encourage industry to locate in theless developed regions of the country. The principal objective of thisstudy is to determine whether the tax holiday scheme has been successfulin achieving its objetives. For the first objective it is necessary tofind out whether the exemption scheme actually stimulated newinvestments that would not have otherwise taken place or whether firmsthat would have been established without the tax incentive received awindfall. Increasing the level of investment by creating high cost andeconomically inefficient industries, offers no real advan¬tage to adeveloping country. The effectiveness of any tax exemption scheme must,in part, be judged on the basis of the basic economic merit of theindust¬ries stimulated by the exemption scheme. For the secondobjective, the success of the scheme can be measured by the extent ofthe diversion of industry to less developed regions as a result of taxexemption.