Marginal Effective Tax Rate Study Report Dec 21 2018_Final.pdf

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THE REPUBLIC OF ZAMBIA

Ministry of Finance

MARGINAL EFFECTIVE TAX RATE STUDY

Consultancy for an METR Analysis

Contract No: PFMRP/101/1/6-28-2017

December 2018

Dr. Uzma Ashraf Barton Fiscal & Financial Governance Specialist

George Mason University, Arlington, Virginia, USA

METR – Report, Tax Policy Unit, Ministry of Finance, Lusaka ii

Ms. Barton conducted preliminary mission to Lusaka in July- August 2018 and collected data, discussed issues with the various stakeholders including the Ministry of Finance (the Tax Policy Unit), Zambia

Revenue Authority, the Zambia Development Agency, the World Bank office (Lusaka), and with local think-tanks including the IGC, the ZIPAR etc. and completed the Inception Report for this study.

I am thankful to the agencies listed above and many others based in Lusaka (not named here), for their support in making time for discussions, and for sharing relevant research that helped in completing the report. I am in particular indebted to the interventions made by the Project Direct to help procure relevant data and meetings with external stakeholders.

The full METR report was presented, and draft submitted to the TPU, Ministry of Finance during the mission November-December 2018. During this final mission, in addition to presentation of the main results, we conducted multiple workshops to disseminate skills and complete knowledge transfer to the staff of Tax Policy Unit, Zambia. This final report benefited from the valuable open discussions during these workshops and has incorporated comments from the participants of the workshops. For this report, Mr. Andrew Mumbi Chisopo helped in data collection (locally) and data processing.

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Foreign Investment Advisory Service (FIAS) of the World Bank conducted a study on the effective tax burden in 2004 at the request of the Government of the Republic of Zambia (GRZ). The results of the study suggested that, overall, the sectorial effective tax burden, in terms of both rates and application of the tax regime, was quite low on average except for the financial services sector in Zambia. In the subsequent years, Zambia has implemented various changes to its taxation system which now require a comprehensive assessment to determine the actual implications of these policy changes in terms of effective tax burden and in particular, the effects of tax policy changes on investment climate and economic growth.

The Purpose of this study is therefore, to assess the efficacy of the existing tax regime in Zambia and to evaluate its effects on Zambia’s wider development objectives, which include the promotion of private and foreign direct investment and economic growth. For consistency in interpretation of the results, this report follows closely the format and model description from the

2004 report where applicable and relevant within the terms of reference for this study. The findings of the report provide the tax policy unit this information by investigating the effective tax burden through the use of METR calculations in key sectors namely: manufacturing, mining, agriculture, tourism and financial services. The study establishes whether the current tax and incentive structure is growth enabling in Zambia. It also aims to provide a cross-country analysis that will reflect on the international competitiveness of Zambia in the identified four sectors in the

SADC region.

This study requisitioned by the Tax policy Unit (Budget Office) is part of Public Financial

Management Reform Strategy (2013-2017) - Phase I, of which Component 6 is Strengthening Tax

Policy Formulation.

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Table of Contents

Table of Contents ......................................................................................................................................... iv

List of Graphs .............................................................................................................................................. vi

ABBREVIATIONS AND ACRONYMS ................................................................................................... vii

EXECUTIVE SUMMARY ....................................................................................................................... viii

I. Introduction

1. Context of the Study

2. Zambia: Economic Landscape

A. Growth and Performance

B. Sectoral Share to Growth and Employment

C. Foreign Direct Investment and Business Climate

D. Regional and Global Economic Outlook

E. Macroeconomic Outlook and Tax Policy in Zambia

II. MARGINAL EFFECTIVE TAX RATES

1. Overview of the METR

2. METRs and the Tax System in Zambia

3. Tax and Non-Tax Parameters in Estimating METRs

4. The METR Model

III. SECTORAL ANALYSIS OF THE MARGINAL EFFECTIVE TAX RATES IN ZAMBIA

1. Manufacturing Sector

A. Overview

B. Tax Parameters and Incentives

C. Quantitative METR Analysis

D. Recommendations

2. Mining Sector

A. Overview

B. Tax Parameters and Incentives Available to the Mining Sector

C. Quantitative METR Analysis

D. Recommendations

3. Agriculture Sector v

A. Overview

B. Tax Parameters and Incentives

C. Quantitative METR Analysis

D. Recommendations

4. Tourism Sector

A. Overview

B. Tax Parameters and Incentives

C. Quantitative METR Analysis of Tourism

D. Recommendations

6. Financial Services

A. Overview

B. Tax Parameters and Incentives

C. Quantitative METR Analysis

D. Recommendations

IV. COMPARATIVE REGIONAL STRUCTURES

1. Regional Marginal Effective Tax Rates

2. Regional Incentive Structures

3. Regional Investment Outlook

ANNEXURES

Annexure I: METR Model – Calculating Marginal Effective Tax Rates

Annexure II: An Overview of the METR Methods

Annexure III: Illustration

Annexure IV: List of Meetings and Documents

Annexure V: List of References

Lit of Tables

Table 1: FDI Inflows: Zambia and the DRC ............................................................................... viii Table 2: Sector-wise Contributions to GDP, Employment and METRs ....................................... ix Table 3: Detailed METR by the Sector and Assets ....................................................................... ix Table 4: Summary of Key METR Issues, Sectoral Analysis and Recommendations ................... ix

Table 5: Growth and share of real GDP in 2016 and 2017 Table 6: Percent Share of Employment by the Sector in Zambia, 2015

Table 7: Sectoral Contribution to GDP (% share of GDP) Table 8: Annual Average Inflation Rate 2014-2017 Table 9: FDI Flows in Zambia 2012-2017 Table 10: Zambia's FDI Inflows by Sector, 2011 - 2016 (In US $ million) Table 11: Tax Revenue Performance in 2017 (K' Million) Table 12: Principal tax and non-tax parameters used in the METR calculations vi

Table 13: Mineral Royalty Tax Scales Table 14: Mineral royalty rates Table 15: Three-tier Copper Royalty Regime (on norm value) Table 16: METR Analysis of Mining Table 17: METRS for the Agriculture Sector

Table 18: METRs for Tourism Sector Table 19: Interest rate and in Inflation rates Table 20: METRS for the Financial Services Sector Table 21: METRs Results – Regional Comparison Table 22: Regional Incentive Structure

List of Graphs

Graph 1: Sectoral Labor Force Participation

Graph 2: Hierarchy of factor in Investment Decision-making Graph 3: Proportion of Tax-type to Total Revenue 2013-2017

Graph 4: VAT Tax Revenue Performance from 2013 - 2017 (K' million) vii

ABBREVIATIONS AND ACRONYMS

CIT: Corporate Income Tax

CSO: Central Statistics Office

DRC: Democratic Republic of Congo

EBITDA Earnings Before Interest, Tax, Depreciation and Amortization

FDI: Foreign Direct Investment

FIAS: Foreign Investment Advisory Service

GDP: Gross Domestic Product

GOZ: Government of Zambia

GST: General Sales Tax

K: Kwacha

METR: Marginal Effective Tax Rate

MFEZ: Multi Facility Economic Zones

MSMEs: Micro, Small and Medium Enterprises

PAYE: Pay As You Earn

SADC: Southern African Development Community

TPU: Tax Policy Unit

VAT: Value Added Tax

WHT: Withholding Tax

ZDA: Zambia Development Agency

ZRA: Zambia Revenue Authority viii

EXECUTIVE SUMMARY

The previous FIAS study (2004) found Zambia’s Marginal Effective Tax Rates (METRs) mostly low and regionally competitive. However, the lower rates offered through a multi-tiered incentives structure did not translate into a proportionate increase in the Foreign Direct Investment (FDI) compared to the region. The Government of Zambia during the last 17 years has implemented various changes to its taxation system (both policy and administrative reforms) to formalize the incentive structure and has streamlined tax incentives to channel foreign and private investments in priority sectors. As the government is employing tax policy tools to stimulate more investments, it makes it pertinent to evaluate the existing marginal effective tax burden in priority economic sectors.

Incentive Structures and FDI

Incentive structure, if not periodically evaluated and adjusted, can cause significant distortions in the production and investment patterns in the country and consequent revenue losses. Tax incentives can be an important factor in attracting FDI however the World Bank’s Global Investment Competitiveness report finds political stability, legal and regulatory environment, and size of the domestic market as the top three factors in the hierarchy of factors that drive investment decisions with tax incentives ranking at sixth. Regional competitor, the DRC surpassed Zambia in

2012 as the leading copper producer in Africa and despite having relatively higher METRs managed to attract more

FDI than Zambia. There is an imminent need to understand the interrelationship of tax incentives and FDI inflows in order to rationalize the lower effective tax burden and maintaining an investment-friendly outlook.

Table 1: FDI Inflows: Zambia and the DRC

Foreign Direct Investment

USD million 2015 2016 2017

DRC - FDI Inward Flow 3,802 3,565 1,159

ZAMBIA - FDI Inward Flow 1,305 663 1,091

METRs

METRs provide a useful tool to assess the effectiveness of tax system as a whole at a given point in time. METR analysis provides a measure of the actual tax burden on a prospective investment attributable to the existing tax system. Generally, a higher METR than the statutory rate act as a deterrent to investment whereas lower METRs (in negative) suggest that the tax system is stimulating investments that are socially undesirable because they earn a return lower than the opportunity cost of funds. A negative METR indicates presence of subsidies and implies that the tax system of the country is essentially subsidizing the investments.

This METR analysis in this report provides a measure of the actual tax burden on a prospective investment attributable to the current tax system in Zambia. This study finds METRs in the key five sectors, namely, manufacturing, mining, agriculture, tourism and financial services lower than the prevalent statutory tax rates in

Zambia. The mining sector offers the lowest effective tax burden indicating essentially that the tax system is subsidizing new investments into this sector. Given the recent decline in copper prices and in international demand of the commodity, the government of Zambia in order to diversify exports has prioritized the manufacturing sector, which also offers one of the lowest METR. The highest METRs are for the financial services. A detailed look at the ix various asset-classes within these sectors reveals the lowest METRs are arising from capital allowance deductions for plant and machinery.

Table 2: Sector-wise Contributions to GDP, Employment and METRs

Contributing sector METR %age %age share in real GDP Total Employment

Manufacturing 0 to -6.8 8 211,685

Mining 0 to -7.2 10.4 83,548

Agriculture 0 to 5 8.2 2,937,928

Tourism 0 to 3.5 1.8 83,500

Financial Sector 5.0 to 14 3.5 39,722 Source: ZRA Annual Report 2017, LCMS 2015; LFS 2014; own calculations1

A detailed sectoral-level and asset-wise analysis reveals that similar assets across the economic sectors are offered different tax rates. Manufacturing sector assets in general carry lower rates whereas plant and machinery as an asset class drive the lower METRs due to expedited depreciation rates and other allowance provided under the tax laws.

Inventories on the other hand carry higher rates across all sectors and more in the banking and financial sector.

Table 3: Detailed METR by the Sector and Assets

Asset Manufacturing Mining Agriculture Tourism Financial

Services

Land 0.99% 2.1% 0.7% 9.7% 10.4%

Buildings -4.2% 5.7% -3.2% 5.1% 6.4%

Plant and machinery -24.2% -11.9% 6.2% -16.8% 21.1%

Inventories 16.5% 14.8% 5.8% 24.6% 29.6%

METR range 0% -6.8% 0% -7.2% 0% 5% 0% 3.5% 5% 14%

In Zambia’s case, statutory rates are higher than most of the regional countries whereas effective tax burden is either lower or comparable with the neighboring countries. It is important to note that higher statutory rates may signal potential investors to negotiate special deals, especially in the priority sectors. Separately negotiated tax packages add to the complexity of the tax system and can result in loss of revenues over a period of time.

Table 4: Summary of Key METR Issues, Sectoral Analysis and Recommendations

Issues Comments

Economic indicators in

Zambia

Economy grew at 4 percent in 2017 reflecting a steady recovery (from 2.9 % in 2015) driven by rise in international markets, stability in domestic economic indicators including Kwacha’s exchange rate, inflation, electricity supply, and growth in services sector. The medium term expenditure framework aims to reduce the fiscal deficit to

1 During 2004-2016, FDI inflows as percentage of GDP averaged 6% in Zambia – much higher than the sub-Saharan African average of 3% (Botswana 4%; Zimbabwe 2%; Malawi 4%; South Africa 1%) over the same period. According to WTTC report:

3.2% to GDP in 2017, and to rise by 6.5% to 7.9bn in 2018 448,000 jobs –5.3% of total employment – indirect jobs are almost same as direct jobs in tourism with an additional 80% more induced employment.

x less than 5.1 percent of GDP by 2021.

Sectoral Contributions:

In GDP –

In Employment –

The GDP contribution from the mining sector has increased during the past twenty years primarily due to large foreign investments whereas agriculture sector has seen the largest drop in the corresponding period. Tourism share in GDP remained on a steady slow decline mainly because of rising competition from regional neighboring countries

(whose tourism industry is generally contributing more to the GDP, for example, Kenya).

Growth in mining and agriculture sector remained mostly subdued. However, mining sector contributed the highest share in real GDP at 10.4 percent (growth in mining sector declined from 7.3 percent to merely 3.0 percent from 2016 to 2017). Financial services registered a positive growth in 2017 (from a negative real growth in 2016), whereas the share in GDP from tourism declined by 0.2 percentage point from 3.7 to

3.5 in 2017.

Agriculture showed a big boost from a 3.7 percent growth to at 16.6 percent in 2017 and about one percent increase in share of GDP from 7.3 to 8.2 percent. Agriculture sector provides the highest employment in the country (formal and informal sectors).

Manufacturing sector picked up over a 100 percent increase in growth – from 1.9 percent in 2016 to 4.4 percent in 2017 maintaining a GDP share at 8.0 percent. This sector provides second largest share in both formal and informal sector employment.

According to the LFS 2014, 83 percent are employed in informal sector in Zambia while 92.2 percent of people in the rural areas are employed in the informal sectors. A whopping 92 percent employment within financial services comes from formal sector.

Agriculture sectors accounts for the largest share in the informal employment however, the huge share (both in formal and informal sector), and lowest METRs stand in contrast to the GDP share arising from the agriculture sector activities.

Revenue Performance Since 2010, both public spending and revenues have grown but expenditure has far exceeded the revenues, adding to high debts. To manage the debt burden, domestic resource mobilization is an essential tool as grants provided only 1.4 percent of revenue compared to 98.6 percent from domestic revenues in Zambia.

The medium term expenditure framework (and 2019 budget) aims at increasing domestic revenue to upwards of 19 percent of GDP.

Significance of Tax

Incentives

Multiple studies provide evidence to the fact that tax incentives are not the most crucial factor in a firm’s decision to invest.

Incentives granted outside the tax system make the system more complex, less transparent – rendering it difficult to gauge tax expenditures (revenue losses/gains arising from the investment). In Zambia:

- the ZDA promotes/administers investments with other countries; the M/o Finance proposes the changes through drafting statutory instrument/national budget; and, the

ZRA enforces the incentives granted (under the formal tax system) and collects revenues within its mandate. Mining/infrastructure and priority sector incentives have been (used to be) granted by multiple government agencies (outside formal tax codes).

It is recommended (a) to cancel incentives granted with no sun-set clauses, (b) frequent reviews to phase out “expired” /non-productive incentives, and, (c) harmonize and standardize incentives regime for transparency, simplicity and efficient enforcement.

Provide the net effect of current tax system (of all tax laws) on an investment decision in a country. METR analysis and investment pattern can provide an insight on the effectiveness of the existing incentives granted under a particular tax system.

“Marginal” signifies the tax rate based on an analysis of a prospective incremental investment to calculate the effective tax burden, and it captures the net effect of all the taxes taken together;

The “tax rate” in METR is a rate that differentiates the gross of tax and net of tax returns to an investment, that is, the tax wedge between gross and net returns.

A higher METR can discourage further investments in that sector. A negative METR xi

Higher/Negative/Zero

Limitations indicates presence of subsidies granted through generous tax provisions and may encourage investments into that sector if costs are the only consideration. A zero

METR indicates neutrality, i.e. the net impact of existing tax provisions would be zero on investment decisions.

The METR calculations capture only the effects of the formal tax rules, and provide an understanding of the incentive effects of the existing tax system on businesses; METR model does not capture the individually negotiated or preferential tax treatments. It doesn’t take into account prospective tax/incentive changes.

Manufacturing Sector

Recommendations

This sector accounts for about 8 percent of the GDP in Zambia with an average growth rate of 4.71 percent during 2002-2017. Priority areas for investment include: agro processing, textiles and leather subsectors.

Statutory rates are higher while METRs lower than regional average; plant and machinery’s expedited depreciation and initial allowances bring down the sector’s

METRs in negative range.

The multi-layered incentives-- under the ZDA Act (Multi-Facility Economic

Zones/Industrial parks/ rural investment incentives/duty drawbacks/expedited refunds etc.) –favor large enterprises over SME sector.

Harmonize METRs and statutory rates; uniform incentives for the SME/domestic sectors at par with foreign investor esp. in priority areas including the MFEZ;

Changing VAT “exempt” status to “zero-rating” for manufacturing input products will enable businesses below VAT threshold to claim input refunds.

Mining Sector

Zambia is one of two largest Copper producers in Africa (highest production in 1970s, lowest in late 1990s); the sector brings about 70 percent foreign exchange for Zambia and 22 percent of formal sector employment; cost of mining slightly higher than the regional competitors.

Mining share in GDP has increased steadily over the last ten years.

Mining companies may have individualized incentive packages but for the purposes of calculating METRs this report assumes a general case of a large scale mining company liable to corporate tax, royalties, property transfer tax etc.

Overall mining sector METRs are in negative – primarily due to capital expense deductions on heavy machinery; exemption of custom duties and VAT;

The METRs for mining are low and regionally competitive.

Main issues: uncertain/unstable tax policies; power supply shortages; unavailability of

100 percent capital deductions; mining rights transfer tax; and, rising indirect costs including the various levies and insurance premiums (Budget 2019 increases mining royalty taxation rates– and if approved, Zambia should make an annual assessment of the effects of the new changes (higher rates) on revenues.

However, it must be noted that worldwide natural resource taxes tend to be about 25 to

40 % of exports for major resource-rich developing countries; these amount to only 3 to 5 percent in Zambia.

The issues of lack of access, transparency in reporting, false reporting and thereby under-estimation of total mining revenue in Zambia will be greatly addressed with the successful implementation of MVCMP. The MVCMP can improve resource mobilization, reduce complexity of mining taxation and thereby costs to the ZRA (cost of monitoring + regulation) and to the businesses (less complex + more attractive investment destination), and can increase revenues.

Increased certainty and continuity in tax policy can strengthen investment/business climate – Zambia in general has favorable business climate than Sub-Saharan Africa.

Agriculture Sector

Challenges

Offers 87 percent of labor force employment (93 percent of informal employment in rural sector is in agriculture); however, contribution to the GDP is shrinking – currently around 8 percent (agriculture value added 5.25 percent while annual value addition in growth for 2016 was in negative at 7.74 percent).

Must promotion the sector especially to achieve economic diversification; tech-based initiatives (FSIP/Import Export Permit Module) are facilitating expansion in the sector xii beyond maize;

A preferential rate of 10 percent CIT along with generous capital allowances drives the low METRs; VAT is at 16 percent but most of farming is exempt, not eligible to input refunds. METRs range between 0-3 percent; competitive with regional average however in Tanzania despite higher METRs agriculture brings much higher GDP contribution.

The sector offers potential for diversification, and for an increased GDP growth on account of favorable agriculture climate. Zambia has 40 percent of Sub-Saharan water resources, an access to EU markets, the US market, and strategic location in COMESA and SADC region.

Lost opportunity: Zambia’s territory is about 75 million hectares out of which 58 percent (42 million hectares) is classified with medium to high potential for agriculture production – only 15 percent of this land (1.5 million hectares) is being used currently cultivation and agriculture.

Policy intervention can remove bottlenecks: government can encourage self-sustainability for farmers; facilitate investments especially in capital intensive agriculture to establish large commercial farming entities and increase exports.

Furthermore:

Participation of commercial banks in SME agriculture must be enhanced, Food Reserve Agency’s mandate to be reduced to only act as strategic grain reserve, and buyer of last resort for restricted purchases while letting private traders handle the business

Simplified regulatory requirements

Tourism

The sector contributed about 3.7 percent to the GDP (from a 2.2 in 1998), and employs about 300,000 (both formal/informal sector) persons.

In order to make Zambia in top five tourist destinations in Africa by 2030, non-traditional export status has been awarded to Tourism sector;

Incentives and support programs to encourage private sector participation include

Tourism Development Fund which aims to increase spending on sector’s development.

The service sector (which constitute primarily from tourism and finance) is the largest contributor to national income despite the electricity shortages, increased cost of borrowing, and slower consumption during 2016.

Challenges include limited tourism products, lack of diversification in tourist destinations; tough regional competition; perceived high cost of living than regional average; potentially higher informality within the sector both in employment and in

GDP share; potential higher tax evasion and avoidance (as some businesses still operate outside of the tax net – esp. payments made abroad for tourist packages remain outside of tax net).

METRs range higher than the other sectors (except financial services) but remain low, and regionally competitive. Budget 2019 proposes: (a) to abolish CIT incentives granted to Sun International Limited since 1999; (b) introduction of casino taxation;

(c) zero import duties, zero-rated tourist packages as well as deferred VAT option;

largest asset category is “buildings” which enjoy various allowances, and “machinery” is offered accelerated depreciation.

High statutory CIT rate of 35 percent which can be lowered given low METRs for the sector in the region; proliferation of EFD will formalize the sector faster;

Tourism, an important economic sector, is not accounted for in the ZRA’s annual report/other publications for its contributions to the GDP/revenues under a separate head. This report uses “food & accommodation” head to draw figures for the tourism sector.

Financial Services

Significant growth registered in the sector; 3.5 percent contribution to the GDP – with a steady decline from 9.85 percent in 2000. Weak Kwacha and high inflation caused

Bank of Zambia to tighten monetary policy resulting into liquidity shortages, and high xiii interest rates (that led to an increase in non-performing loans).

Zambia is making headway in digital financial services however access points for mobile financial services remain fewer especially in rural areas. Consumers of financial services are required to filing tax returns (to broaden formal sector) – the initiative requiring every consumer may negatively impact on the pace of digitalization

(due to communication gap, low tax thresholds, low tax literacy etc).

Not a favorable sector tax-wise; highest statutory tax rates (up to 40 percent) within

Zambia and in the region; non-permissibility of VAT input claims has made banks to expand into non-banking services. Base erosion due to deductibility of interest.

Highest METRs in the sector and in the region– with highest rate in inventories; high rates and low incentives/capital deductions drive MERTs high in tourism; Budget

2019 proposes to limit interest deduction to 30 percent and proposes to increase withholding on dividends, interest income and branch remittances.

Lowering statutory tax rate;

Relying on pilot exercises for new initiatives aimed at increasing the tax base (for example, as first step requiring only urban consumers of financial services for tax filing); other options may include levying a small fee for those withdrawing cash above certain thresholds.

Comparative Regional

Regional Investment outlook

Zambia has higher statutory rates than regional average; Zambia offers competitive incentives with lower METRs regionally both in general and sector-wise especially on capital deduction.

Positive elements: Global FDI fell by 23 percent in 2017, however, the FDI flows to the 16 African LLDCs increased by 4 per cent to $8.2 billion. Investment flows grew robustly to Botswana, Burkina Faso, the Central African Republic, Uganda and

Zambia (in contrast, FDI declined in Mali, Swaziland and Zimbabwe due to political uncertainty). In 2017, Zambia became the second largest African LLDC host of FDI.

Ranked by the volume, top FDI host LDCs were Myanmar, Ethiopia, Mozambique, the DRC, Tanzania, and Zambia – attracting about 60 per cent of aggregate FDI; only

DRC and Zambia (+11 per cent) and Zambia (+65 per cent) posted a gain in investments

Lowering statutory tax rates and bring it at par with the region: given the share of CIT in the total tax revenue at about 1.9 percent lowering of statutory CIT rates would not affect revenues greatly;

Looking at the FDI in Zambia and comparing it to the FDI in the regional competitors, it appears that the tax component is not the most significant barrier to further investments in Zambia.

Caveat: the estimates for regional countries are extremely tentative and may be used for rough comparisons due to incomplete, dated, inaccessible and/ unavailable data.

Conclusions

1. Generally the Zambian tax system seems conducive to investment and economic growth. It provides sufficient incentives in all five sectors, namely, manufacturing, mining, agriculture, tourism, and financial services. There are no significant tax barriers to attracting investments in the major sectors.

2. The tax-incentives as identified are facilitating growth however it appears from the METRs that the tax system is subsidizing some of the economic sectors at the cost of others. Incentives are neither the only nor the top factor that an investor considers in making investment decision. A careful use of incentives however can direct investments in areas which can further generate taxable economic activity – thereby still resulting into more revenues despite lower METRs but this requires careful selection of incentives.

3. Given a lower significance of “tax incentives” in investment decisions, and the findings that the METRs are quite low in Zambia, this report recommends rationalizing statutory rates (especially the corporate income tax which is significantly higher than the regional competitors).

4. Harmonizing tax incentives: some of the economic sectors which carry natural advantages and will attract investments nonetheless may not require incentivizing. For example, given the climate and usable fertile land, xiv agriculture sector may continue to keep comparable contributions even if the incentive structure is tightened gradually.

5. Zambia is regionally competitive given it very comparable (generally lower) rates than its neighboring countries and has attracted more investments than many of the other SSD countries in certain years.

On sectoral Level:

1. METRs have huge variations for asset-type within the economic sector and across the sectors.

2. Financial Services sector seems to carry the highest METRs whereas agriculture seems to carry the lowest tax burden – essentially conveying that the agriculture sector is being subsidized by the tax system 9whereas agriculture’s contribution to the GDP and to the formals sector employment is not significant).

3. Although inflation is much controlled however, inventory deductions may be allowed on LIFO method.

4. Mining sector METRs have been quite low historically. The 2019 budget proposes increase in royalty payments, if enforced; a periodic evaluation must be made for potential increase in tax revenues and investments.

5. Financial Services and the telecommunications sector) faces statutory tax rates as high as up to 45 percent which is higher than any other sector in Zambia as well highest in the regions. This must be brought at par with the CIT rate existing in other economic sectors.

I. Introduction

1. Context of the Study

In 2004, the Government of the Republic of Zambia asked the Foreign Investment Advisory Service

(FIAS) of the World Bank to conduct a study on the effective tax burden on selected sectors as an input into the evolving set of policies in support of the government’s private sector development goals. The sectors that were considered were agriculture, mining, manufacturing, finance, and tourism. The results of the study suggested that, overall, the sectoral effective tax burden, in terms of both rates and application of the tax regime in Zambia, was quite low on average except for the financial services sector. A comparison of the five sectors with neighboring SADC countries revealed that Zambian sectors were broadly competitive in the tax/incentive areas.

Zambia has implemented various changes to its taxation system since 2004 which now require a comprehensive assessment to determine the actual implications of these policy changes in terms of tax burden, and particularly its effect on investment and growth. The Government of Zambia is implementing the Public Financial Management Reform Strategy for 2013-2017 with support from the various cooperating partners including the World Bank. A number of components have been identified under the

World Bank’s implementation support of the Public Financial Management Reform Program – Phase I, of which Component 6 is Strengthening Tax Policy Formulation. The objective of this component is to enhance the capacity and capabilities of the Tax Policy Unit in the Ministry of Finance. The METR study has been identified as one of the key studies to be undertaken under this component.

The FIAS study found Zambia’s METRs mostly low and the METR structure quite competitive regionally. The study further found that the low tax rates offered through a multi-tiered incentives structure (special tax regime for mining and in priority sectors; multi-facility economic zones under the

ZDA Act; and public sector donor-funded projects, and tax holidays) did not translated into an anticipated increase in the FDI.

The DRC surpassed Zambia in 2012 as the leading copper producer in Africa. The regional competitors with higher METRs attracted more FDI than Zambia at occasions. This requires investigation into the effectiveness of the prevalent incentive structure and to rationalize METRs in attracting investments. The incentive structures, if not periodically evaluated and adjusted, result into revenue losses and can significantly distort the production and investment patterns of the country.

Generally, higher effective tax rates than the statutory rate act as a deterrent to investment, whereas effective rates far below the statutory rate suggest that the tax system stimulates investments, which are socially undesirable (producing a lower return than the opportunity cost of funds). The METR can be negative which implies that the tax system of the country is subsidizing the investments. Fiscal policies are adjusted through an incentive structure to stimulate economic growth and investment in priority sectors.

The remainder of the report is organized as follows. The Section I defines the context of the study, Zambia’s economic landscape, and tax sector. Section II elaborates on Marginal Effective Tax Rate concept and indulges in the details of the quantitative aspects of effective tax burden. Section III provides detailed sectoral analysis for five sectors of Zambia: Manufacturing, Mining, Agriculture, Tourism, and

2 Given the debt burden, and intentions to secure an IMF package, if Zambia enters into the IMF’s bail-out package that may transmit positive signals to the international investment community – Ghana’s annual FDI during 2012-2015 fell by 0.3 percent per year on average however the FDI rebounded to 9.2 percent in 2016 after securing the IMF support.

Financial Services. This section, for each of the economic sector defines tax parameters used in the model, and sketches the quantitative METR analysis, and provides detailed recommendations. Section IV provides comparative regional overview of METRs and investment incentives.

2. Zambia: Economic Landscape

The 2017 Zambia Plus program aims at economic recovery through an inclusive and sustainable economic growth and job creation by private sector investments.

The government is employing tax policy tools to stimulate more investments, for example, it has already removed several duties in the agro-processing sector. However, it is important to realize that the tax rates are only one of the top factors in that drives investment decisions. Governments therefore need to periodically evaluate the incentive structure to rationalize the revenue expenditure (revenue forgone) with the actual economic growth and investment benefits. This METR analysis will provide a measure of the actual tax burden on a prospective investment attributable to the existing tax system in Zambia. An appropriately weighted average of the

METRs on specific types of investments can reveal the excess burden on the economy and distortions in investment decisions due to the inefficiencies of the tax system.

Zambia has instituted many tax reforms over the last decade or so and has not had an evaluation of the effective tax burden and the incentive structures since 2004. The previous study evaluating effective tax rates has become obsolete. It is tremendously important to determine whether the tax policy and tax administration regimes in Zambia are conducive to such economic growth by looking at the domestic and international competitiveness of sector-specific effective tax impact in the key sectors. This study bridges that gap in assessing the efficacy of the current tax regime and its contribution to Zambia’s wider development objective by providing clear and specific, short, medium and long term, recommendations and interventions to enhance the effectiveness of tax policy implementation in Zambia.

A. Growth and Performance According to the IMF DataMapper, global economy grew by 3.8 percent in 2017 compared to 3.2 percent in 2016. Zambia’s domestic economy grew at 4 percent in 2017 reflecting steady recovery for the third consecutive year since the low growth rate of 2.9 percent in 2015 (and 3.8 percent in 2016). This rise has been driven partly by the rise of international markets and partially due to stability in some of the domestic economic indicators including inflation, Kwacha exchange rate stabilization, and improvement in the supply of electricity. Despite a recent uptick in growth in the services, mining and agriculture public investment remained mostly subdued. Rapid rise in debt accumulation can remain a source of vulnerability over the medium term.

3 Zambia Plus, the economic recovery program targets five pillars: Pillar 1: Moving to a sustainable fiscal path by improving domestic resource mobilization through strong tax policy and administration, and reducing subsidies; Pillar II: Increasing allocation to social protection. Pillar III: Cutting wastage through improved economic and fiscal governance by improving transparency and enforcing more punitive measures to abusers of public funds; Pillar IV: Improving budget credibility by rationalizing over-spending in some budget lines and under-spending in others; Pillar V: Promoting greater economic stability to boost market confidence and reduce constraints to private sector development, for example, by investing in energy and transport infrastructure; reducing costs of doing business; facilitating better access to credit; clearing arrears and diversifying the economy.

See, WB (Dec 2016) 8th Zambia Economic Brief.

4 See, IMF (2018). World Economic Outlook Report

B. Sectoral Share to Growth and Employment Mining sector contributes the highest share in real GDP at 10.4 percent however the growth in mining sector has declined from 7.3 percent to merely 3.0 percent from 2016 to 2017. Financial services registered a positive growth in 2017 (from a negative real growth in 2016), whereas the share in GDP from tourism declined by 2 percentage point from 3.7 to 3.5 in 2017. Agriculture sector showed a big boost from a 3.7 percent growth to at whooping 16.6 percent in 2017 and a one percent increase in share of GDP from 7.3 to 8.2 percent. Manufacturing sector picked up over a 100 percent increase in growth – from 1.9 percent in 2016 to 4.4 percent in 2017 maintaining a GDP share at 8.0 percent.

Table 5: Growth and share of real GDP in 2016 and 2017

Economic activity/ nature of industry

Real growth percentage

Share of Real GDP percentage

2016 2017 2016 2017

Manufacturing 1.9 4.4 8.0 8.0

Mining 7.3 3.0 10.5 10.4

Agriculture 3.7 16.6 7.3 8.2

Tourism 1.0 5.0 3.2

Financial services (2.4) 0.7 3.7 3.5

Real GDP Growth 3.8 4.1 Data Source: ZRA Annual report (2017); Travel and Tourism (Economic Impact 2018, Zambia) Pg. 3 & Pg. 8

Agriculture sector provides the highest employment in the country (both in formal and informal sectors).

The chart below reflects the percentage distribution of the employed population by economic sector in

Zambia for 2014. According to the LFS 2014, 83 percent are employed in informal sector in Zambia while 92.2 percent of people in the rural areas are employed in the informal sectors.

Table 6: Percent Share of Employment by the Sector in Zambia, 2015

Sector

Employment Sector Total number of persons employed (12 years or older)

Formal Sector Informal sector

Number Percent Number Percent

Manufacturing 78,022 36.9 133,662 63.1 211,685

Mining (and quarrying) 71,647 85.8 11,901 14.2 83,548

Agriculture (incl. forestry & fishing)

159,066 5.4 2,778,862 94.6 2,937,928

Tourism 83,500** 115,500*

Financial Services 36,632 92.2 3,090 7.8 39,722 Source: LCMS 2015; *Stats for tourism are not available in the LCMS; this figure is derived from WTTC 2018. LFS 2017 reports total employment at 5,049,059 persons.

The CSO reports that informal sector in Zambia accounts for 56.1 percent of the informal sector employment in agricultural-related activities leaving 43.9 percent in non-agricultural activities.

Manufacturing provides second largest share in both formal and informal sector employment. A whopping 92 percent employment within financial services comes from formal sector.

Graph 1: Sectoral Labor Force Participation

Source: LFS 2014

Table 7: Sectoral Contribution to GDP (% share of GDP)

Economic Sector Contribution % age of GDP - Years

1998 2000 2003 2011 2015 2016 2017

Manufacturing 11.5 10.2 10.9 9.1 8.1 8.1 8.0

Mining & quarrying 6.3 4.1 2.8 9.4 10.2 10.5 10.4

Agriculture, forestry & fishing 18.7 19.9 20.8 12.6 7.3 7.0 8.2

Tourism 2.2 2.1 2.5 1.6 1.8 1.8 1.9

Financial Services & Insurance 9.1 9.8 9.2 7.1 3.9 3.7 3.5

Source: CSO Zambia; ZRA Annual Reports

The contribution to GDP from the mining has increased during the past twenty years primarily due to large foreign investments whereas the agriculture sector has seen the largest drop in the corresponding period. Tourism remained on a gradual slow decline almost mainly because of rising competition from regional neighboring countries. A decline in copper prices internationally has adversely affected the GDP growth in 2015 and since then the economic growth has steadily picked up partly because of improvement in the broader economic indicators, tax policy changes and the external factors such as price stability.

Inflation in Zambia showed stability and remained in single digit for both food and non-food items.

Table 8: Annual Average Inflation Rate 2014-2017

Year Overall Food Non-Food

2014 8.4 7.2 8.4

2015 9 11 9

2016 14.4 21.8 14.4

2017 7.5 5.8 7.5

Source: CSO 2018 (Zambia in Figures)

C. Foreign Direct Investment and Business Climate Empirical studies reflect a strong association in market size, economic growth, and in FDI inflows.

Market potential is considered far more important factor in developing and transition economies than the market size. Sub-Saharan Africa with a potential of higher GDP growth rate can be a candidate to attract much more FDI opportunities than any other developing region, however, “potential” is not the only factor. Investment Climate drives the location of the FDI.

Investment climate factors such as presence of strong institutions, investor friendly regulations, trade openness and infrastructure quality are prime considerations. Growth potential, proximity to markets and/ customers, investment climate, availability of skilled labor, presence of partner/suppliers were the five top factors in determination of location in a study of 28,814 new high-value-added FDI projects between Jan 2003- July 2011. Financial Times, FDI

Markets database). Consideration of “lower cost” was the seventh factor in the study.

Global investment competitiveness report 2017-2018 states that investment incentives may help attract

FDI only in specific circumstances, such as when investors are deciding between similar locations as a new base for their exports. However, when investment is motivated by a desire to access a domestic market or extract natural resources, incentives are generally ineffective.

Political stability, a business friendly regulatory climate, large domestic market size, macro stability, availability of skilled labor were considered the top factors investors take into account while making investment decisions.

Furthermore, Klemm and Parys found evidence for strategic interaction in tax holidays, and the corporate income tax (CIT) rate however, they find no robust evidence, however, for competition over investment allowances and tax credits. They also find that lower CIT rates and longer tax holidays were effective tools in attracting FDI in Latin America and the Caribbean but not in Africa. None of the tax incentives is effective in boosting gross private fixed capital formation.

5 Hornberger, Battat, & Kusek (Aug 2011). Attracting FDI: How much Does Investment Climate Matter? See also, for database of empirical studies, Investing Across Borders, at http://hdl.handle.net/10986/11060 & http://iab.worldbank.org/data/references 6 World Bank (2018). Global Investment Competitiveness Report 7 See, Klemm and Parys (June 2012). Empirical Evidence on the Effects of Tax Incentives http://hdl.handle.net/10986/11060 http://iab.worldbank.org/data/references

Graph 2: Hierarchy of factor in Investment Decision-making

Source: Global Investment Competitiveness Report: Foreign Investor Perspectives and Policy Implications 2017/2018. World

Bank Group.

This is not to negate the benefits of FDI for developing countries. FDI brings in “technical know-how, enhancing work force skills, increasing productivity, generating business for local firms, and creating better-paying jobs”, says, the World Bank report, “How Developing Countries Can Get the Most Out of

Direct Investment”.

Table 9: FDI Flows in Zambia 2012-2017

Year FDI Inflows FDI Outflows

2012 1732 -702

2013 2100 409

2014 1489 -1706

2015 1305 127

2016 663 177

2017 1091 -149 Data Source: World Investment report 2018 (UNCTAD)

Zambia, in 2017 attracted significantly more FDI than other African economies. In fact FDI rose in case of Zambia (reaching to $1.1 billion, an increase of 65 percent by total FDI volume) primarily due to mining activities (copper) and manufacturing investments from China. Success of a country in attracting more FDI inflows is determined by the country’s ability to “bring in, retain, and leverage” private

P o lit ic al

S ta b ili ty a n d se cu ri ty

Le ga l a n d r eg u la to ry en vi ro n m e n t

La rg e d o m es ti c m ar ke t si ze

M ac ro S ta b ili ty a n d Ex ch .r at e

A va ila b ili ty o f sk ill ed la b o u r

Lo w t ax r at e s

P h ys ic al In fr as tr u ct u re

Lo w c o st o f la b o u r

A cc es s to la n d

Fi n an ci n g in d o m e st ic m ar ke ts

P e rc e n ta ge

Critically important important somewhat important Not at all important Don't know investment for sustainable economic growth. The government of Zambia is cognizant of the fact to diversify the economy away from single commodity-base (ie. Copper) announced building of a $548 million cement plant in a joint venture between the country’s mining investment arm and China’s

Sinoconst (Sinoconst will raise financing for the project locally and from international financial institutions). The report also finds that political stability, security, and regulatory environment are leading factors driving decisions to invest in developing countries.

Table 10: Zambia's FDI Inflows by Sector, 2011 - 2016 (In US $ million)

2011 2012 2013 2014 2015 2016

Other 1.00 0.80 0.00 0.00 0.00 0.00

Manufacturing -177.80 469.60 1,489.20 2,108.20 2,189.20 1,943.80

Finance and Insurance -0.20 0.00 108.50 164.00 109.40 22.90

Electricity, gas and steam 13.30 6.50 90.00 337.50 263.10 569.80

Accommodation and food 0.00 0.00 90.80 155.60 123.60 -160.90

Construction 39.20 54.60 81.90 114.10 99.60 168.10

Agriculture, forestry and fishing 31.70 28.30 163.10 181.90 297.80 345.30

Information and communications 0.00 -18.40 252.90 76.60 70.20 254.30

Real estate activities 42.80 4.90 278.30 343.70 392.40 279.30

Wholesale and retail trade 76.60 38.30 659.00 668.90 537.20 674.60

Deposit taking corporations 71.10 184.40 832.10 852.10 539.00 766.70

Mining and quarrying 955.60 933.70 10,611.40 11,019.30 11,132.30 12,256.00 Source: Foreign Private Investment and Investor Perceptions in Zambia 2016.

D. Regional and Global Economic Outlook Driven by advanced, emerging and developing economies, the global growth is projected to rise to 3.9 percent in 2018 from 3.7 percent in 2017. In advanced economies, growth is projected at 2.4 percent

(same as in 2017) except the US which is expected to rise 2.9 percent in 2018 from 2.3 percent in 2017 due to tax cuts and higher domestic consumption. The continuing crises in economic activity and a tightening of financial condition in Italy are slowing down Euro area growth to 2.2 percent in 2018 from

2.4 percent in 2017. Emerging market and developing economies are projected to grow at 4.9 percent in

2018 compared to 4.7 percent in 2017 with Chinese economic growth receding to 6.6 in 2018 percent from a 6.9 percent in 2017. The biggest rise in growth is projected for Sub-Saharan Africa: growth to rise to 3.4 percent in 2018 from 2.8 percent in 2017 primarily supported by the rise in some commodity prices.

The commodity prices were higher in the first half of 2018 compared to the same period in 2017. For example, copper prices averaged US $6,878 per tonne compared to US $5,827 per tonne in 2017.

However, due to the rising tariff and trade tension between the United States and China, the commodity prices have moderated post mid-2018. Also, crude oil prices averaged US $68 per barrel in the first half of 2018, compared to US $47 per barrel in 2017 and the rise is expected to continue due to the re-imposition of US sanctions on Iran.