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April 08, 2012, Sunday

Investment incentives arrived at right moment

The New Investment Package (NIP), which has been impatiently expected by the business community for some time, was revealed by Prime Minister Recep Tayyip Erdoğan last Thursday.

I believe the package arrived at the right moment because growth is expected to be sluggish both this year and even the next. The reason is well known: The Turkish economy is actually in a correction phase, due mainly to its high current account deficit (CAD).

Economists are often suspicious about incentives. Indeed, in trying to encourage new investments, one risks transferring scarce resources to some of these new investments which would have been done anyway without incentives. But this time the wasted resources can be minimized, given the lack of enthusiasm among investors. In terms of the risk of wastage, let me point out that the large benefits decided in the NIP will start to diminish after 2013. This is a good point to start with, but more is needed.

NIP has two main objectives: Diminish the current account deficit and mitigate the huge disparities that exist between regions. The tools -- in other words, promised benefits -- are quite comprehensive and there are some novelties. Standard investment incentives on tax remissions to lower investment costs are present. But the most innovative feature of the NIP lies in the social security premiums aiming to lower labor costs. Firms fulfilling the NIP's criteria will be exempted from employers' premiums at the minimum wage level, and even from employees' premiums and income taxes for many years if the investment takes place in the least developed provinces -- the sixth region. The exemption periods vary from two to 12 years depending on the sectors and regions.

Will the NIP be able to reach the objectives announced? I am rather optimistic regarding the mitigation of regional disparities but less optimistic about the CAD issue. On the subject of regional disparities, let me first note my support for the new regional ranking at the provincial levels (NUTS-3 level), with six categories. The old incentive scheme determined four categories of regions at NUTS-2 level (26 regions). Now, important development levels exist among the provinces constituting a NUTS-2 region. Just to give an example, the Kayseri region formed by the Kayseri, Sivas and Yozgat provinces, is now broken down into three different categories, with Kayseri placed in the second category, Sivas in the fourth and Yozgat in the fifth. This new setup will implement, for sure, a more efficient allocation of investments regarding the catch-up process for the least developed provinces.

The critical catch-up tool will be the exemptions from social security premiums. Given the very unequal distribution of skills, income per capita, unemployment and labor force participation rates among provinces, the minimum wage set at the national level constitutes a formidable handicap for the least developed regions. Indeed, the average productivity from labor is below the national minimum wage paid to workers in many provinces, a factor that deters new investments. The Organization for Economic Cooperation and Development (OECD) defended a regional minimum wage set up to tackle this problem, but after some hesitation the government abandoned this solution and opted for the premiums exemptions, which will lower labor costs fairly consistently, particularly in the least developed provinces. The Ministry of Economy, the instigator of the NIP, estimates that the labor cost will be lowered by up to 38 percent for firms investing in the sixth category. This may work, but do not forget that this will also be a partial solution. The existing firms will not benefit from the exemptions. Some objections about unfair competition should be foreseen in the near future.

Considering the CAD issue, I have some doubts. The basic idea is to launch a process of import substitution and encourage high scale investments in the strategic sectors. In order to benefit from the NIP, an import substitution investment has to respond to the following criteria: More than half of the market share of the goods must be imported (“high import dependency”); the importation value must be higher than $50 million in the last year; the production must create at least 40 percent value added. This is in order to secure a minimal local contribution; finally, the cost of the investment must be higher than $50 million. Another way to address the CAD problem is to encourage investments in strategic sectors such as the defense industry and chemical industry, including refined oil products, medicines, machinery, spare car parts, etc. But for each sector a minimal scale is required.

The targeted goods designated to substitute imports, as well as so-called “strategic sectors,” require both large scale and capital incentive production using highly skilled workers. Given these properties, one should expect that investments in these fields would mostly take place in developed provinces, as is already the case for obvious reasons. Now, social security premium exemptions are quite restrictive in terms of the generosity and duration of the benefits: In provinces ranked first and second, only employers' premiums at the minimum wage level will be at stake, over a period of two to three years. Under these conditions, I think the profitability of investments and competitive power of new firms will not be so evident. Other ingredients, such as comprehensive labor market reforms and a competitive exchange rate, would be needed. Only time will tell.

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