This article first appeared in The Edge Malaysia Weekly on December 11, 2017 - December 17, 2017

FOREIGN direct investment (FDI) is highly sought after by developing countries around the globe, not so much as capital infusions but for the potential of the foreign party bringing in technical know-how and organisational skills and reach that can help local businesses flourish, create better paying jobs and boost the country’s economic competitiveness and productivity gains.

Malaysia, which was an exporter of commodities in the 1960s before turning into a bustling manufacturing hub in the 1980s and 1990s and is now an advanced developing country on the verge of attaining high-income status, has also benefited and continues to benefit from such investments.

Between 2010 and 2015, FDI accounted for nearly 40% of gross fixed capital formation in the country. In fact, FDI firms hired 848,000 workers and accounted for RM290.2 billion or 35.5% of total exports of goods and services in 2015.

Yet, as the world goes through the fourth industrial revolution and countries compete to stay ahead amid the advent of automation and artificial intelligence, Malaysia needs to ensure that every incentive and tax dollar it gives up to attract foreign investments bring in the right amount of intended benefit to safeguard its future-readiness.

“It is timely to review holistically the costs and benefits of the country’s foreign tax regime, given the changing national and regional economic landscape,” says Dr Yeah Kim Leng, economics professor at Sunway University’s Business School.

A new strategy on incentives is needed fast as “there is growing evidence to suggest that the net benefits [from FDI] have reach a plateau in recent years amid substantial costs to attract them in an increasingly competitive environment”, according to a recent study by Bank Negara Malaysia. The study notes how FDI made up close to 60% of the value of manufacturing investments that were given incentives between 2010 and 2015, be it corporate tax exemptions, tax allowances for capital expenditure and financial assistance such as training and R&D grants.

Indeed, the cost of incentives (including foregone taxes) has ranged from RM10 billion to RM15 billion annually over the past five years, which is equivalent to 0.8% to1.3% of GDP or 6% to 8.9% of the government’s tax revenue, as indicated by the central bank’s comparison of operating surpluses and manufacturing sector tax collection.

Additionally, the central bank’s research found that the hiring of locals had declined from 74% in 2011 to 68% in 2014 as more low-skilled foreign workers were brought in, dampening wage growth for local low-income earners.

What’s worse, reliance on cheap labour has impeded technology adoption that can help Malaysia move up the value chain.

“Technology transfer has plateaued, as evidenced by the lower spending on R&D by the US multinational corporations in Malaysia, relative to other countries in the region,” the central bank’s study says, noting continued heavy dependence on imported inputs and how growth in domestic value-add in gross exports have also stagnated relative to regional economies.

Overall reliance on foreign workers in the manufacturing sector has also led to large remittance outflows, which have doubled in the past 15 years, according to Bank Negara.

The fragmented nature of Malaysia’s investment promotion landscape is one area that needs improvement — while the Malaysian Investment Development Authority is the sole agency responsible for managing investments and incentive approvals, there are 32 investment promotion agencies at the national, regional and state levels with their own objectives and criteria for accessing investments and monitoring results.

“At the same time, there is growing evidence to suggest that the effectiveness of the current incentive instruments to attract FDI may be diminished by growing regional competition and reforms in the international regulatory environment. As countries compete against each other to attract FDI, they tend to offer similar incentive packages. This gives MNCs the upper hand in negotiating even more generous incentives, leading to a ‘race to the bottom’,” the central bank says, citing a World Bank study that showed tax-based incentives lead to tax competition and downward pressure on tax rates among regional peers.

Noting the fast-changing global environment, Lee Heng Guie, executive director of the Socio-Economic Research Centre, says Malaysia has to weigh the costs and benefits because foreign investors are not heterogeneous and can have multiple motivations when investing.

“Not all the benefits from all FDI are guaranteed [or necessarily] generate the desired impact on the local economy. In some cases, the costs in the form of tax revenue foregone, rent-seeking, transfer pricing would outweigh the incentives offered,” Lee says.

While incentives cannot be completely eliminated, he believes that the design of investment incentives “must take into account the priorities of Malaysia’s industrial and economic development policies”, which include net foreign exchange retention, quality of jobs created, value-add and productivity enhancement via R&D investment.

Investment incentives, Lee says, should also not be applied uniformly to all types of FDI as some investors are attracted by the availability of natural resources and may be looking at participation in strategic infrastructure developments and may not necessarily be looking for incentives to lower production costs.

“In the Global Investment Competitiveness Survey, investment incentives ranked fourth (out of six) in the order of importance to investors … what’s more important is to maintain an investment climate that is politically and economically stable as well as a transparent, business-friendly legal and regulatory environment,” he adds.

Yeah concurs, noting how the availability of the right talent pool and skills and other factors, such as the ease of doing business, government delivery system, infrastructure quality as well as the efficiency of the supply chain and supporting services, have all become important considerations for investment decisions.

“The government should focus on these factors and tailor the incentive packages according to the targeted sectors without sacrificing too much tax revenue from overly generous fiscal incentives,” he says, recommending that policymakers measure the effectiveness of FDI in helping the country move up the value chain.

“Access to world markets, introduction of new technologies, improving skills and wages in the domestic workforce and contribution to government revenue and overall economic efficiency are some of the metrics that could be used to assess the benefits versus the cost of attracting foreign investment,” adds Yeah, who is for a holistic metric that integrates sustainable development goals with an economic, social and environmental cost-benefit assessment.

Save by subscribing to us for your print and/or digital copy.

P/S: The Edge is also available on Apple's AppStore and Androids' Google Play.