A recent issue of Columbia Perspectives on FDI asks whether foreign direct investment subsidies are good or bad for the countries that offer them (see Investment incentives and the global competition for capital).

Investment incentives (subsidies designed to affect the location of investment) are a pervasive feature of global competition for foreign direct investment (FDI). They are used by the vast majority of countries, at multiple levels of government, in a broad range of industries. They take a variety of forms, including tax holidays, grants and free land.

In general, I am opposed to such government incentives, as I believe it results in distortionary outcomes.

Like all subsidies, investment incentives tend to be economically inefficient and make income distributions more unequal (by transferring funds from average taxpayers to owners of capital).

The result is not just the transfer of funds from average taxpayers to the owners of capital, but also the transfer of funds from domestic taxpayers to foreigners.

Not only that, but the foreign entrants often magnify the distortionary outcomes by aggressively negotiating for incentives – effectively pitting country against country (locale against locale) in a horse race. The article acknowledges this as well:

Bargaining over incentives is characterized by major information asymmetries, leading to the likelihood of a government paying more than needed to attract an investment. Companies often conduct an incentives auction even when they have already made their location decision, a clear sign of rent-seeking behavior.

All of this, and we haven’t even broached the topic of whether the foreign entrant’s presence truly benefits the local economy. The answer to that question, so far, is inconclusive. Although some academic studies demonstrate that foreign entrants can stimulate the local economy through increased employment, the development of upstream and downstream support industries, and knowledge spillovers to local firms; others (including some of my own research) are beginning to demonstrate that foreign fims can have deleterious consequences for the local economy as well. For example, foreign firms may dampen local innovation and hinder the long-term economic growth prospects of the host economy.

It’s for all these reasons that I am skeptical of the efficacy of subsidies for FDI. It even reminds me a bit of Bastiat’s satire of protectionism in The Candlemakers’ Petition (see the Candlemaker’s Petition), but in perverse reverse. Instead of subsidizing domestic owners of capital at the expense of ordinary taxpayers, local lawmakers end up subsidizing foreign owners of capital at the expense of local taxpayers.

I wish lawmakers, and other interested parties, would take the high road and adopt policies of abstention when it comes to FDI subsidies. Unfortunately, local officials often engage in these kinds of practices for their own near-term political gain, using them to tout their own records on job creation. We, however, need to start asking more questions about the long-term implications of such practices…

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This entry was posted on Thursday, January 19th, 2012 at 3:29 pm and is filed under International Business, International Strategy. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.