Should Countries Promote Foreign Direct Investment?

A number of academics and policy makers have speculated whether foreign direct investment (FDI) helps accelerate the economic development process. This paper investigates this statement and tests whether policies that promote FDI make economic sense. It examines whether the benefits of FDI are enough to justify the policy interventions that are seen in practice.

For small open economies, efficient taxation of foreign and domestic capital depends on the relative mobility. That is, if foreign and domestic capital are both mobile internationally, it will be best to expose both types of capital to equal tax treatment. If foreign capital is more mobile, it will be best to have lower taxes on capital owned by foreign residents than on capital owned by domestic residents. If market failures are not present, FDI should not be favoured over foreign portfolio investment. Countries tend to tax income from foreign capital at rates lower than those for domestic capital and to subject different forms of foreign investment to very different tax treatment.

Promotion of FDI in Practice

Existing government policies to promote FDI in G-24 and other countries were summarized using data from the annual editions of Corporate Taxes: A Worldwide Summary by Price Waterhouse. It was observed that policies have different forms. The most common are partial or complete exemptions from corporate taxes and import duties, policies that are usually enacted through legislation. Direct subsidies and other types of concessions which are often negotiated between multinational firms and host governments are also common, but they are hard to document.

It was observed that tax rates in G-24 countries are comparable to the averages for other countries. Also, it was detected that most of the said countries give corporate income tax exemptions to foreign corporations which usually lasts for less than a decade. Others also offer exemptions to foreign corporations on import duties. Even poor countries in Europe have been seen to pursue multinational firms.

While many countries tax domestic income earned by foreign corporations at lower rates than domestic income earned by domestic corporations, the former rates are in most cases above zero in the long run (though often not during the first few years following the establishment of a project).

FDI and Host-Country Economic Performance

Multinational enterprises arise from three types of advantages: a firm must own or control a unique mobile asset it wishes to exploit; it must be cost efficient to exploit the asset abroad in addition to the firm’s home country; and it must be in the firm’s interest to control the asset’s exploitation itself – rather than contracting out use of the asset to an independent foreign firm.

If factor prices are not equalized across countries, then a firm has an incentive to become a multinational in order to exploit differences in factor costs between countries. This would give way to vertical FDI - the creation of a multinational whose country operations specialize each in a distinct vertical stage of production. On the other hand, the case is different when factor prices are equalized across countries but shipping goods abroad are costly. When trade costs are low, a firm will produce all its output in domestic plants and serve foreign consumers through exports. When trade costs are high, it is optimal for the firm to build production plants both at home and abroad, so that it serves domestic consumers from its domestic plants and foreign consumers from its foreign plants (Markusen, 1984). This is a case of horizontal FDI, where multinationals undertake similar production activities in all countries.

The existence of externalities associated with FDI raises the possibility that promoting FDI may be welfare-enhancing. Rodriguez-Clare (1996) suggests that the arrival of multinationals increases an economy’s access to specialized intermediate inputs, which raises the economy’s total factor productivity. Meanwhile, Gao (1999) proposed that the creation of multinational firms spreads industry from more to less industrialized countries, which in turn reduces the industrial concentration in the former. This is similar to Markusen and Venables’ (1999) explanation of the “catalyst” effect of multinationals on a host economy. Multinationals also create forward and backward linkages, as well as worker trainings.

Theory predicts that firms will infiltrate foreign markets using FDI when trade costs are low, firm-level scale economies are high, and plant-level scale economies are low. Firms will also penetrate foreign markets when factor-cost differences between countries are large (through vertical FDI) and when countries are similar in terms of market size and factor cost (through horizontal FDI). Brainard (1997) found that higher trade costs and stronger firm-level scale economies encourage FDI relative to exports, while stronger plant-level scale economies discourage FDI relative to exports. Furthermore, she found that higher host-country taxes encourage affiliate sales over exporting.

The work of Wheeler and Mody (1992) suggests that US outward FDI is higher in countries with larger markets, a large stock of initial FDI, higher quality of infrastructure, and more industrialized economies. The observed correlation between current and past FDI to shows that multinationals are attracted to locations with a larger concentration of industrial firms. This supports the idea that agglomeration economies are associated with FDI.

However, the hypothesis that FDI generates positive spillovers for host economies is weakly supported. While multinationals are attracted to high-productivity countries and to high-productivity industries, there is little evidence at the firm or plant level that FDI raises the productivity of domestic enterprises. Plants in industries with a larger multinational presence appear to enjoy lower rates of productivity growth over time. Little support is given by empirical studies for the idea that promoting FDI is merited on welfare grounds.

Evaluation of FDI in practice

FDI key results indicate that:

        i.            The only reason for choosing FDI over foreign portfolio investment and domestic investment is the existence of market failure that is specific to multinational production;

      ii.            G-24 and other countries offer numerous tax concessions to FDI. This violates the residence principle and causes unequal tax treatment for FDI and foreign portfolio investment;

    iii.            FDI raises national welfare by bringing foreign technology and other foreign resources into an economy because they raise the productivity of domestic factors. But without externalities, there is no justification for taxes or subsidies that are specific to FDI;

    iv.            Externalities associated with FDI may raise or lower national welfare, depending on whether positive productivity spillovers from multinationals more than offset the loss in profits;

      v.            FDI is sensitive to both host-country tax policies and economic conditions (e.g. the education  level of the labour force, overall market size, and the size of the local industrial base); and

    vi.            FDI generates positive spillovers for domestic industries, while multinationals tend to be high-productivity firms that pay high wages.

A simple theoretical model of multinational production was used to derive conditions under which subsidies to FDI would be more likely to raise host-country welfare. It assumes that factors are in inelastic supply. It further specifies that the unit factor demands of the foreign firm may differ from those of the domestic firm. This allows for the possibility that multinationals may have relatively weak or strong linkage effects. Furthermore, it is assumed that a domestic firm’s revenue is increasing in its own output, decreasing in the output of its foreign rival, and increasing (decreasing) in the domestic output of the foreign firm if that firm is a source of positive (negative) spillovers to the industry.

Subsidies to FDI are more justified in the following cases: 1) where multinationals are intensive in the use of elastically supplied factors; 2) where the arrival of multinationals to a market does not lower the market share of domestic firms; 3) and where FDI generates strong positive productivity spillovers for domestic agents. Three cases were used to study the promotion of FDI in practice: General Motors in Brazil; Ford Motor Co. in Brazil; and Intel in Costa Rica.

Empirical evidences indicate that the first and third conditions are unlikely to hold, while the second condition holds. Results show that Brazil’s subsidies to foreign automobile manufacturers may have lowered national welfare. Meanwhile, Costa Rica appears to have been prudent in not offering subsidies in the case of Intel.

There is a need for more research on the host-economy consequences of FDI. Academic literature indicates that countries should be doubtful about claims declaring that promoting FDI will raise national welfare. Policy makers in host countries should presume that subsidizing FDI is unnecessary, unless evidences show that social returns to FDI exceed the private returns. Deviations would be justified only when there is substantial positive spillovers associated with multinational production and when multinationals cannot choose the optimal level of production without a subsidy or other incentives.

Host-country governments still offer multinationals special treatment even if the benefits of FDI for host countries are inadequate to justify FDI promotion policies. This may be because governments feel obliged to offer privileges as multinationals subject their location decisions to bidding. However, instead of validating auctions, international cooperation must be sought among governments to prevent multinationals from obtaining gains associated with their presence. Another reason for pursuing FDI is the self-interests of host-country politicians. Attracting multinationals may benefit those who actively support politicians. It may also fit into certain political strategies. Regardless of the reason, countries must be careful in promoting FDI, until strong empirical evidence indicating that the social rate of return on FDI exceeds the private rate of return is found.

Source:

Hanson, Gordon, “Should Countries Promote Foreign Direct Investment?” G-24 Discussion Paper Series, No. 9, February 2001, United Nations Publication.