Should countries promote foreign direct investment

Abstract

This paper examines whether policies to promote foreign direct investment (FDI) make economic sense. The discussion focuses on whether existing academic research suggests that the benefits of FDI are sufficient to justify the kind of policy interventions seen in practice. For small open economies, efficient taxation of foreign and domestic capital depends on their relative mobility. If foreign and domestic capital are equally mobile internationally, it will be optimal for countries to subject both types of capital to equal tax treatment. If foreign capital is more mobile internationally, it will be optimal to have lower taxes on capital owned by foreign residents than on capital owned by domestic residents. Absent market failure, there is no justification for favouring FDI over foreign portfolio investment. In practice, countries appear 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. FDI appears to be sensitive to host-country characteristics. Higher taxes deter foreign investment, while a more educated work force and larger goods markets attract FDI. There is also some evidence that multinationals tend to agglomerate in a manner consistent with location-specific externalities. There is weak evidence that FDI generates positive spillovers for host economies. While multinationals are attracted to high-productivity countries, and to high-productivity industries within these countries, there is little evidence at the firm or plant level that FDI raises the productivity of domestic enterprises. Indeed, it appears that plants in industries with a larger multinational presence tend to enjoy lower rates of productivity growth over time. Empirical research thus provides little support for the idea that promoting FDI is warranted on welfare grounds. Subsidies to FDI are more likely to be warranted where multinationals are intensive in the use of elastically supplied factors, where the arrival of multinationals to a market does not lower the market share of domestic firms, and where FDI generates strong positive productivity spillovers for domestic agents. Empirical research suggests that the first and third conditions are unlikely to hold. In the three cases we examine, it appears that the second condition holds, but not the first or third conditions. This suggests that Brazil’s subsidies to foreign automobile manufacturers may have lowered national welfare. Costa Rica appears to have been prudent in not offering subsidies in the case of Intel. There clearly is a need for much more research on the host-economy consequences of FDI. The impression from existing academic literature is that countries should be sceptical about claims that promoting FDI will raise national welfare. A sensible approach for policy makes in host countries is to presume that subsidizing FDI is unwarranted, unless clear evidence is presented to support the argument that the social returns to FDI exceed the private returns.

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