**35 |** P a g e

tires and tubes, motor spare parts, furniture, ceramics, glassware of the mineral based products, cosmetic products, edible products manufactured out of the cultivated agricultural products, and construction materials.<sup>37</sup> Import-substitution drives the choice of preferential sectors as the explicitly stated goal is to “... encourage manufacturers which substitute the imported products.” In-between two extremes, other criteria used to determine a preferential status include a combination of minimum investment outlays, export orientation, and sectoral characteristics. Under the current arrangements,<sup>38</sup> industries that were singled out in addition to ‘import-substituting’ ones include industrial tools, machinery, agriculture and agro-processing industries all subject to a minimum $150 thousand-investment. These three have to meet only the minimum investment requirement. They receive a five-year tax holiday with a preferential tax of 10 percent in the 6th and 7th year after the “zero-tax” holiday.<sup>39</sup> In addition, textile fabric manufacturing and processing with a minimum investment of $500 thousand to $10 million may obtain tax holidays ranging from 5 to 15 years. In addition, state-owned land is made available at concessionary rates.

Other sectors may qualify for similar treatment provided they meet also exports-related conditions. These include exporters of non-traditional manufactures,<sup>40</sup> suppliers of exporting companies, and export oriented services providers investing at least $500 thousand. In addition to the tax holiday, they are exempt from duties and other border charges on imports during the life of the project for exportoriented projects, and during the project implementation period for others. Exporting companies and export-oriented services are also exempted from exchange control regulations and are entitled to free repatriation of profits and dividends and free transferability of shares.

Hence, regulatory infrastructure offers many ways of avoiding the hassle cost of doing business in Sri Lanka provided that firms engage in activities chosen as preferred in government policies. The wisdom of this approach hinges critically on the extent to which the government has knowledge of comparative advantage or disadvantage of various sectors of the government and the cost of special treatment to Sri Lanka’s economy. While we have not done any research to assess whether this approach meets this test, there are reasons to doubt this is the case. First, comparative advantage is usually revealed in confronting competition from imports. Furthermore, private investors risking their own capital rather than bureaucrats are better placed to discover sectors and areas where a country has comparative advantage. Second, preferences are subsidies that ultimately have to be financed from taxes levied on other businesses and people. The result of granting tax exemptions is a narrower tax base and higher tax

> 37 The list as of December 2, 2011 posted on the website of Sri Lankan Board of Investors. See

> <u>http://www.investsrilanka.com/key_sectors_for_investment/export_manufacturing_sector_overview.html</u> 38 Based on information derived from the website of Sri Lanka Board of Investment accessed on 11/30/2011 at <u>http://www.investsrilanka.com/</u> 39 An economic service charge at 0.25 percent of income applies to all companies including BOI-approved companies with tax holidays.

> 40 According to the Board of Investment, “... under this category, projects to manufacture and export of all nontraditional products other than black tea in bulk, crepe rubber, sheet rubber, scrap rubber, coconut oil, desiccated coconut (other than desiccated coconut manufactured using continuous scale automated process technology and marketed with a quality guarantee) copra, fresh coconuts, coconut fiber will be promoted.” Downloaded from the website http://www.investsrilanka.com/ accessed on 11/30/2011.