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Opinions of Friday, 19 February 2010

Columnist: Ampong, Charles Horace

Global Drop in Direct Foreign Investment ....

Global Drop in Direct Foreign Investment (DFI) may decelerate Job creation in Ghana! (Part 2)

In the first part of this article, I elaborated on some incentives, disincentives and factors that can affect the flow of investments into Ghana. Furthermore, I discussed some shortfalls and ended with the issue of a high corporate tax of 25%. In this segment of the article, I would like to discuss some pertinent issues regarding the country’s high corporate tax of 25%. The discussion will also include the rudiments of two risk-oriented factors namely cost of debt (also called cost of credit) and cost of equity which are likely to be affected by the high corporate tax and interest rates. The two risk factors constitute what is called cost of capital. Generally, investors cost of capital is made up of the cost of debt (of credit) and the cost of equity. Cost of debt results from the borrowed funds incurring an interest rate made up of risk-free rate and a risk premium based on credit rating. Cost of equity depends on retained earnings or funds obtained from issuance of stock. Foreign investors (namely those listed on the Ghana Stock Exchange or major international Stock Exchanges) tend to use both equity and debt financing so their cost of capital is predominantly made up of cost of debt and cost of equity. Local investors (presumably small businesses) tend to use debt financing so the cost of capital is primarily the cost of debt or better still the cost of credit. Tighter credit system due to high interest rates coupled with insufficient supply of loanable funds in Ghana will definitely result in higher cost of debt or credit. Subsequently, it becomes more difficult for local businesses or entrepreneurs or small scale businesses to thrive. Small scale businesses are engaged in projects categorized as short-medium term (duration of less than 10 years). Such businesses borrow short-term loans from banks and so incur a cost of debt (or credit). However, for large companies listed on the Stock exchange, equity financing is mostly used resulting in cost of equity. Generally, such companies incur cost of debt and cost equity because their short-term projects are mostly pursued using debt financing whilst long-term projects such as the expansion of a plant e.t.c are executed using equity financing which is the issuance of stocks or bonds to obtain the necessary capital for the project. Ultimately, the cost of debt together with the cost of equity gives the cost of capital for these large businesses.

Whichever method of financing is used by investors in Ghana, the high corporate tax does affect the cost of capital because any investor aspiring to invest in the country will think of how earnings from the project will be affected by the taxes and most importantly the corporate tax. The higher the corporate tax, the higher the cost of capital and the higher the expected returns from the investor or shareholders of the multinational corporation investing in Ghana. If the expected rate of return does not exceed that of the cost of capital, the investor may abandon the plan of investing in Ghana. For those multinational companies or foreign investors that will want to borrow locally from Ghana, the high interest rate would mean increased cost of debt (credit) and subsequently cost of capital even though debt financing is tax deductible. As matter of fact, the high interest loans is big setback and that in tandem with the high corporate tax will increase the cost of capital which puts the investors in position to expect higher rates of return. Obviously, the expected rate of return must exceed the cost of capital before an investor will accept the offer to invest in Ghana. Some may argue that cost of capital is difficult to calculate but at least an estimate can be made to serve as a guideline for the investor. They may also argue the leverage of corporate tax because of the presence of corporate tax differential among the companies and industries in Ghana but the fact remains that the country’s corporate tax generally is relatively high. Also, the high corporate tax of 25% is likely to have a heavier impact on the older and more profitable industries because of their bigger tax base. This will increase their cost of capital. On the other hand, the impact on the small firms is marginal because of their lesser profitability. Research by OECD has documented this defect of corporate tax. Consequently, mining companies such as AngloGold Ashanti, Newmont e.t.c may feel the tax pinch more compared to small scale mines in Ghana. Likewise Vodafone compared to small scale businesses in the agricultural and service sectors. Again, some analysts may argue that the high corporate tax may be overridden by the low cost of factors of production namely labor and land. However, I must caution them that the stringent labor laws of Ghana do not suggest low cost of labor. These laws make it difficult for multinational companies to discharge redundant employees when it is appropriate to do so thereby increasing cost. Remember, redundancy pursued by these companies is a re-engineering process meant to clean up and reduce cost for profitability.

Now, it appears the central bank and government of Ghana are enthusiastic about bringing down inflation probably for two reasons. First, to show to the world that Ghana’s inflation rate is low and that the environment is conducive for investment. Second, to produce an enabling environment where the current high interest rate can be lowered for investors (especially local investors) tentatively making borrowing easier. Judiciously, this will ease the tight credit system currently prevailing in the country. Now, the question that needs to be asked is what will happen to the high corporate income tax of 25% which is a risk to cost of capital and consequently the flow of DFI. If the government is interested in pursuing inflation reduction with subsequent interest rate reduction, then it must also consider the high corporate tax even if nothing is done about the high personal tax or VAT. The fact is investors are interested in the cost of doing business which primarily depends on the cost of capital. They know that cost of capital is not only affected by interest rate and inflation but also by corporate tax. It is really absurd for the country to hold onto this high corporate tax when every analyst and people in authority know that the higher the corporate tax, the higher the cost of capital and the lesser the investment inflow in the longer term. I must emphasize again that the relatively high corporate tax of 25% will stamp economic growth in Ghana. One may argue that a corporate tax of 25% is not that high. But the facts must be made clear here. Several countries have cut down on their corporate income tax as a reliable means to stimulating DFI flow. The following are some statistics. China has had to cut its corporate income tax from 33% to 25% in the last few years. South Africa also did cut its already low corporate tax from 12.5% to 10% to further stimulate investment inflow. Hong Kong did cut its corporate tax from 17.5% to 16.5% in order to remain competitive for DFI inflow in Asia. In 2008, Germany cuts its corporate tax by a whooping 8.7% (from 38.9% to 30.18%) in order to maintain its leadership as one of Europe destination for DFI. Countries such as Poland, Iceland, Ireland and Czech Republic have had to cut their already low corporate tax to 19%, 15%, 12.5% and 21% respectively in 2008 just to stimulate DFI and remain competitive on the global front. What stops Ghana from joining the corporate tax reduction “wagon”? As matter of fact, there is a host of countries that have reduced their corporate tax that were not mentioned here but the fact remains that there is strong pursuit of corporate tax revision taking place in several countries globally right now. I am of the view that these changes in taxes are a direct response to the global fall in DFI and also the long-term goal to stay competitive.

The good news is that the strong currency of Ghana will be a big incentive for investors as returns will be high and cost of capital low for a lowered corporate tax and interest rate. In fact, a lowered corporate tax will be the “icing” on the cake for investors. The country cannot continue to maintain a high corporate tax of 25% and still attract DFI considering what is happening in other economies. On the continental front South Africa and Botswana have strategic low-tax nets that makes them more attractive to DFI. No wonder their economies are ahead of Ghana based on GDP per capita estimates. Botswana also has a corporate tax of 25% for foreign investors yet its strategic tax-net has numerous exceptions for capital gains, local investors and even liquidated companies. The strategic low-tax nets of these countries makes productivity gains very high in them which no investor will refuse. Based on my deliberations so far, I would like to suggest that a revision be made to the corporate tax in Ghana in terms of leverage across all sectors in Ghana. For a long time preference has been given to the mining and agricultural companies because of the ideology that they provide most of the jobs in Ghana. It is time for change from this biasness and to seek for leverage of taxes concomitant with a strategic low-tax net for all sectors of the economy.

Finally, Ghana has done very well to become an epitome of democracy in Africa. Now is the time to become an archetype of economic prowess by revising some aspects of the fiscal policies especially the country’s tax-net to make it more lucrative for investors.

Source: Charles Horace Ampong Blog: