Incentives are any measurable economic advantage afforded to specific enterprises or categories of enterprises by (or at the direction of) a government, in order to encourage them to behave in a certain manner. They include measures either to increase the rate of return of a particular FDI undertaking, or to reduce (or redistribute) its costs or risks. They do not include broader nondiscriminatory policies, relating to the availability of physical and business infrastructures, the general legal regime for FDI, the general regulatory and fiscal regime for business operations, free repatriation of profits or the granting of national treatment. While these policies certainly bear on the location decisions of TNCs, they are not Foreign direct investment incentives. The main types of Foreign direct investment incentives used are fiscal incentives (e.g. reduction of the standard corporate income-tax rate, investment and reinvestment allowances, tax holidays, accelerated depreciation, exemptions from import duties), financial incentives (e.g. government grants, subsidized credits, government equity participation, government insurance at preferential rates) and market preferences (e.g. granting of monopoly rights, protection from import competition, closing the market for further entry, preferential government contracts). Other types of foreign direct investment incentives frequently used include preferential treatment on foreign exchange and subsidized dedicated infrastructure and services.
Economic Rationale for Incentives
The economic rationale behind incentives is to correct the failure of markets to reflect the wider benefits arising from externalities in production – for example, those resulting from economies of scale, the creation of widely diffused knowledge and the upgrading of skills of mobile workers. Incentives can thus be justified to cover the wedge between the private and the social returns on an investment. In a more dynamic context of growth and development, incentives can be justified to correct the failure of markets to reflect the gains that can accrue over time from declining unit costs and learning by doing the classic infant-industry argument used in a very different context. Incentives can also be justified to compensate investors for lost return due to other government interventions (for example, duty remissions on imports or performance requirements) or for carrying certain public costs where a government lacks the institutional capacity to bear them itself. In sum, incentives can serve a number of development purposes. However, they also have the potential to introduce economic distortions (especially when they are more than marginal) that are analogous to subsidies on trade, and they involve financial and administrative costs. It is not in the public interest that the cost of incentives granted exceed the value of the benefits to the public.
Competition for FDI with Incentives
Governments use incentives to attract FDI, to steer investment into favored industries, activities or regions, or to influence the character of an investment, as, for example, when technology- intensive investment is being sought. Today, most investment incentives are directed to domestic and foreign investors alike, although sometimes only foreign investors can access certain incentives (as when special incentive packages are geared towards large projects or specific foreign investors, or where advanced technologies are involved that can only be provided by foreign investors). The range of incentives available to foreign investors and the number of countries that offer incentives have both increased considerably since the mid 1980s, as barriers to FDI and trade have declined. In addition, many countries are experiencing increasing incentives competition among regional or even local authorities to attract FDI. Also, incentives are becoming increasingly focused and targeted and are sometimes contingent upon certain conditions being met by the investor. In fact, countries often offer a broad array of options linked to different objectives. Thus further multiplying the number of incentive programmes available to foreign investors. However, it is difficult to discern clear patterns across countries and regions on the type of industries or activities favored by incentive programmes. An increasing number of countries target investment activity in industries involving technology and high value-added (such as electronics, robotics, computer software) and in infrastructure projects. While manufacturing industries are still the main focus of incentive programmes, some governments continue to offer incentives in agriculture, fisheries, mining and oil exploration. Some countries are also offering incentives to encourage companies to locate specific corporate functions within their territories (say, to set up regional headquarters). As a general rule, developed countries make more use of financial incentives than of fiscal ones, partly because fiscal incentives are less flexible and their adoption involves more difficult parliamentary procedures. However, this pattern is reversed in developing countries, presumably because these countries lack the resources needed to provide financial incentives. Market incentives have played an important role until recently, although market reforms and the introduction of competition policy in an increasing number of countries are narrowing the scope for these incentives.
Whatever the rationale for Foreign direct investment incentives, they are ultimately successful only to the extent that they succeed in attracting investment to a country away from another; if it were otherwise, and the investment were to take place anyway, the incentive would be superfluous. In an open world economy, in which barriers to FDI are falling, many countries have increased their incentives with the intention of diverting investment away from competing host countries. Competition for FDI with incentives is pervasive not only among national governments but also among sub-national authorities. When governments compete to attract FDI, there will be a tendency to overbid, if bidders may offer more than the wedge between public and private returns. The effects can be both distorting and inequitable since the costs are ultimately borne by the public and hence represent transfers from the local community to the ultimate owners of the foreign investment. In such competition for FDI, the poorer countries are relatively disadvantaged.
The Effect of Foreign Direct Investment Incentives on Investment Decisions
In spite of this competition, there is considerable evidence to suggest that incentives are a relatively minor factor in the locational decisions of TNCs relative to other locational advantages, such as market size and growth, production costs, skill levels, adequate infrastructure, economic stability and the quality of the general regulatory framework. For example, in many companies incentives are frequently not considered and simply made an already attractive country more attractive. Investment decisions are made mainly on the basis of economic and long-term strategic considerations concerning inputs, production costs and markets. However, as regards individual investment projects, there is increasing evidence that when the location is broadly determined, e.g. a member country of the European Union or a country with a large national market, then incentives can play a decisive role in choosing. Foreign investors may respond differently to different types of incentives depending on their-strategies. Generally, the export-oriented investors seeking inexpensive labor valued fiscal incentives more highly than market protection or other incentives. Market seeking investors, on the other hand, value market protection more than fiscal incentives. In the case of regional incentives, financial incentives, particularly grants seem to have a greater impact on investors’ decisions than fiscal incentives. In recent years, a wide variety of incentives are being offered for foreign investors to transfer advanced technologies and attract R&D facilities (including tax reductions, subsidized infrastructure and land and industrial parks); governments have also intervened through the creation of markets (with defense expenditures and government purchasing) and research funding. However, a fiscal incentives and financial aid did not influence location, while the establishment of enterprise zones and research parks did.
In brief, while incentives do not rank high among the main FDI determinants, their impact on locational choices can be perceptible at the margin, especially for projects that are cost-oriented and mobile.