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

To promote rapid industrialization, developing countries have employed a variety of fiscal incentives to attract resources into the manufacturing sector. Perhaps the one incentive most frequently used has been that of protective tariffs. However, many developing countries, including Pakistan, have encouraged the creation of new manufacturing units through tax exemption, often referred to as tax holiday. Although the basic idea is the same in each country, all or part of a firm’s corporate income is exempted from taxes for a specified period of time—each tax exemption scheme is tailored to meet a particular country’s resources and development objective. During the period from _1959_to. 1972 a tax holiday scheme was used in Pakistan to accomplish two basic objectives: (i) to increase the overall level of investment in the industrial sector, and (ii) to encourage industry to locate in the less developed regions of the country. The principal objective of this study is to determine whether the tax holiday scheme has been successful in achieving its objectives. For the first objective it is necessary to find out whether the exemption scheme actually stimulated new investments that would not have otherwise taken place or whether firms that would have been established without the tax incentive received a windfall. Increasing the level of investment by creating high cost and economically inefficient industries, offers no real advantage to a developing country. The effectiveness of any tax exemption scheme must, in part, be judged on the basis of the basic economic merit of the industries stimulated by the exemption scheme. For the second objective, the success of the scheme can be measured by the extent of the diversion of industry to less developed regions as a result of tax exemption.