Foreign Direct Investment Incentives

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.

Foreign Direct Investment Incentives

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.

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