Policy competition for attracting foreign direct investment (hereafter FDI) has become commonplace in the past twenty years. For instance, in 2007, Texas Instruments Inc. announced its intention of establishing an assembly plant with an investment of $1 billion in Asia. Competition for this investment was fierce among Thailand, Vietnam, China and the Philippines. China and the Philippines comprised the final shortlist, and the Philippines beat out China for the site of the plant. Though it is not clear what tax breaks or other incentives the Philippine government may have offered Texas Instruments, the new facility is located in a special economic zone, which typically does provide considerable investment incentives. In March 2007, Intel Corp. announced in Beijing that it would build a $2.5 billion chip-fabrication plant in Dalian, China. CEO Paul Otellini said Intel’s choice of China for the plant reflects in part the advantages of building such facilities in places that offer better financial incentives than the U.S. does. Mr. Otellini cited testimony that he gave before a U.S. government panel in 2005 estimating that, because the U.S. offers less-favorable tax breaks and incentives, it costs $1 billion more to build a fab in the U.S. than elsewhere.
Other cases involve central-European transition economies. By the end of 1998, they all have adopted investment incentives to attract foreign investors. A typical incentive package contains exemption or significant reduction of income tax up to 10 years, grants for retraining of labor force or other subsidies. Such a policy proved to be successful and really increased the inflow of FDI to these countries. In particular, Poland ranked fifth place in the table, “Top 15 locations for FDI in Europe by number of FDI projects in 2008”; while it ranked second place in the table, “Top 15 locations for FDI job creation in Europe in 2008”.
Countries have an economic incentive to attract foreign investors since possible benefits of FDI include job creation, technological spillover and import substitution effects. In addition, when a country succeeds in attracting FDI in one sector, it can help encourage other manufacturing industries to follow and unleash a flow of new investments to that country. Thus, the beneficial effects of FDI will be reinforced. At the same time, there are also a number of reasons why multinational firms wish to launch new overseas plants. The investments may be driven by the market seeking motive. The access to cheap inputs and resources, such as labor, both unskilled and skilled, land, raw materials and parts and components for assembling into final goods is also relevant. When evaluating possible investment locations, multinational firms may also have a logistical concern.
In this paper, we analyze policy competition for a foreign-owned monopolist firm between two asymmetric countries. In particular, one country has a larger economy than the other country does. At the same time, the small country produces an intermediate good for the final good production, while the large country does not. We ask the following questions. On the positive side, (i) under what condition will a country win the multinational firm? (ii) how is the equilibrium subsidy for attracting FDI determined? On the normative side, (i) is allocative efficiency achieved? (ii) what is the distribution effect of competition for FDI? (iii) compared to the case when countries do not provide any financial incentive to attract FDI, does FDI competition Pareto improve the welfare of the competing countries?
We show that whether a country will win FDI competition is determined by the interaction between relative transport costs of intermediate and final goods and the market size of the large country relative to that of the small country. We also characterize the condition under which the winning country will subsidize/tax the multinational firm. On the welfare effects of FDI competition, we first show that allocative efficiency is always achieved when countries engage in competition to attract the multinational firm. After analyzing its distribution effect, we show that policy competition for FDI may Pareto improve the welfare of the competing countries.
Download
PDF Ebook Market Size, Local Sourcing and Policy Competition for Foreign Direct Investment
