Should Countries Promote Foreign Direct Investment?

Transcription

1 UNITED NATIONS CONFERENCE ON TRADE AND DEVELOPMENT UNITED NATIONS CENTER FOR INTERNATIONAL DEVELOPMENT HARVARD UNIVERSITY G-24 Dscusson Paper Seres Should Countres Promote Foregn Drect Investment? Gordon H. Hanson No. 9, February 2001

2 UNITED NATIONS CONFERENCE ON TRADE AND DEVELOPMENT CENTER FOR INTERNATIONAL DEVELOPMENT HARVARD UNIVERSITY G-24 Dscusson Paper Seres Research papers for the Intergovernmental Group of Twenty-Four on Internatonal Monetary Affars UNITED NATIONS New York and Geneva, February 2001

3 Note Symbols of Unted Natons documents are composed of captal letters combned wth fgures. Menton of such a symbol ndcates a reference to a Unted Natons document. * * * The vews expressed n ths Seres are those of the authors and do not necessarly reflect the vews of the UNCTAD secretarat. The desgnatons employed and the presentaton of the materal do not mply the expresson of any opnon whatsoever on the part of the Secretarat of the Unted Natons concernng the legal status of any country, terrtory, cty or area, or of ts authortes, or concernng the delmtaton of ts fronters or boundares. * * * Materal n ths publcaton may be freely quoted; acknowledgement, however, s requested (ncludng reference to the document number). It would be apprecated f a copy of the publcaton contanng the quotaton were sent to the Edtoral Assstant, Macroeconomc and Development Polces Branch, Dvson on Globalzaton and Development Strateges, UNCTAD, Palas des Natons, CH-1211 Geneva 10. UNCTAD/GDS/MDPB/G24/9 UNITED NATIONS PUBLICATION Copyrght Unted Natons, 2001 All rghts reserved

4 Should Countres Promote Foregn Drect Investment? PREFACE The G-24 Dscusson Paper Seres s a collecton of research papers prepared under the UNCTAD Project of Techncal Support to the Intergovernmental Group of Twenty-Four on Internatonal Monetary Affars (G-24). The G-24 was establshed n 1971 wth a vew to ncreasng the analytcal capacty and the negotatng strength of the developng countres n dscussons and negotatons n the nternatonal fnancal nsttutons. The G-24 s the only formal developng-country groupng wthn the IMF and the World Bank. Its meetngs are open to all developng countres. The G-24 Project, whch s admnstered by UNCTAD s Macroeconomc and Development Polces Branch, ams at enhancng the understandng of polcy makers n developng countres of the complex ssues n the nternatonal monetary and fnancal system, and at rasng awareness outsde developng countres of the need to ntroduce a development dmenson nto the dscusson of nternatonal fnancal and nsttutonal reform. The research carred out under the project s coordnated by Professor Dan Rodrk, John F. Kennedy School of Government, Harvard Unversty. The research papers are dscussed among experts and polcy makers at the meetngs of the G-24 Techncal Group, and provde nputs to the meetngs of the G-24 Mnsters and Deputes n ther preparatons for negotatons and dscussons n the framework of the IMF s Internatonal Monetary and Fnancal Commttee (formerly Interm Commttee) and the Jont IMF/IBRD Development Commttee, as well as n other forums. Prevously, the research papers for the G-24 were publshed by UNCTAD n the collecton Internatonal Monetary and Fnancal Issues for the 1990s. Between 1992 and 1999 more than 80 papers were publshed n 11 volumes of ths collecton, coverng a wde range of monetary and fnancal ssues of major nterest to developng countres. Snce the begnnng of 2000 the studes are publshed jontly by UNCTAD and the Center for Internatonal Development at Harvard Unversty n the G-24 Dscusson Paper Seres. The Project of Techncal Support to the G-24 receves generous fnancal support from the Internatonal Development Research Centre of Canada and the Governments of Denmark and the Netherlands, as well as contrbutons from the countres partcpatng n the meetngs of the G-24.

5 SHOULD COUNTRIES PROMOTE FOREIGN DIRECT INVESTMENT? Gordon H. Hanson Department of Economcs and School of Busness Admnstraton Unversty of Mchgan, Ann Arbor, USA G-24 Dscusson Paper No. 9 February 2001

6 Should Countres Promote Foregn Drect Investment? v Abstract Ths paper examnes whether polces to promote foregn drect nvestment (FDI) make economc sense. The dscusson focuses on whether exstng academc research suggests that the benefts of FDI are suffcent to justfy the knd of polcy nterventons seen n practce. For small open economes, effcent taxaton of foregn and domestc captal depends on ther relatve moblty. If foregn and domestc captal are equally moble nternatonally, t wll be optmal for countres to subject both types of captal to equal tax treatment. If foregn captal s more moble nternatonally, t wll be optmal to have lower taxes on captal owned by foregn resdents than on captal owned by domestc resdents. Absent market falure, there s no justfcaton for favourng FDI over foregn portfolo nvestment. In practce, countres appear to tax ncome from foregn captal at rates lower than those for domestc captal and to subject dfferent forms of foregn nvestment to very dfferent tax treatment. FDI appears to be senstve to host-country characterstcs. Hgher taxes deter foregn nvestment, whle a more educated work force and larger goods markets attract FDI. There s also some evdence that multnatonals tend to agglomerate n a manner consstent wth locaton-specfc externaltes. There s weak evdence that FDI generates postve spllovers for host economes. Whle multnatonals are attracted to hgh-productvty countres, and to hgh-productvty ndustres wthn these countres, there s lttle evdence at the frm or plant level that FDI rases the productvty of domestc enterprses. Indeed, t appears that plants n ndustres wth a larger multnatonal presence tend to enjoy lower rates of productvty growth over tme. Emprcal research thus provdes lttle support for the dea that promotng FDI s warranted on welfare grounds. Subsdes to FDI are more lkely to be warranted where multnatonals are ntensve n the use of elastcally suppled factors, where the arrval of multnatonals to a market does not lower the market share of domestc frms, and where FDI generates strong postve productvty spllovers for domestc agents. Emprcal research suggests that the frst and thrd condtons are unlkely to hold. In the three cases we examne, t appears that the second condton holds, but not the frst or thrd condtons. Ths suggests that Brazl s subsdes to foregn automoble manufacturers may have lowered natonal welfare. Costa Rca appears to have been prudent n not offerng subsdes n the case of Intel. There clearly s a need for much more research on the host-economy consequences of FDI. The mpresson from exstng academc lterature s that countres should be sceptcal about clams that promotng FDI wll rase natonal welfare. A sensble approach for polcy makes n host countres s to presume that subsdzng FDI s unwarranted, unless clear evdence s presented to support the argument that the socal returns to FDI exceed the prvate returns.

7 Should Countres Promote Foregn Drect Investment? x Table of contents Page Preface Abstract v I. Introducton... 1 Settng the stage: foregn versus domestc nvestment... 2 II. Promoton of FDI n practce... 3 III. FDI and host-country economc performance... 9 A. What explans multnatonal producton? B. What determnes the locaton of multnatonal producton? C. Does FDI generate postve spllovers for the host economy? IV. Evaluaton of FDI n practce A. A theoretcal model B. The promoton of FDI n practce: three cases C. Evaluaton of FDI promoton cases V. Concludng remarks Notes References Appendx: Dervaton of the welfare effects for the host economy... 28

8 Should Countres Promote Foregn Drect Investment? 1 SHOULD COUNTRIES PROMOTE FOREIGN DIRECT INVESTMENT? Gordon H. Hanson * I. Introducton There s a presumpton among many academcs and polcy makers that foregn drect nvestment (FDI) s somehow specal. 1 One common vew s that FDI helps accelerate the process of economc development n host countres. Optmsm about the economc consequences of foregn nvestment, coupled wth heghtened awareness about the mportance of new technologes for economc growth, has contrbuted to wde-reachng changes n natonal polces on FDI. Durng the last two decades, many emergng economes have dramatcally reduced barrers to FDI, and countres at all levels of development have created a polcy nfrastructure to attract multnatonal frms. 2 Standard tactcs to promote FDI nclude the extenson of tax holdays, exemptons from mport dutes, and the offer of drect subsdes. Snce 1998, 103 countres have offered specal tax concessons to foregn corporatons that have set up producton or admnstratve facltes wthn ther borders (Av- Yonah, 1999). Typcally, these concessons are appled to multnatonal enterprses but not to local frms n the same lnes of actvty. In ths paper, we examne whether polces to promote FDI make economc sense. Whle elmnatng barrers to foregn nvestment s a means of achevng global market ntegraton, promotng FDI goes one step further by favourng one form of ntegraton expanded foregn control of productve assets over others, such as ncreased trade n goods, more nternatonal lcensng of technology, or larger cross-border flows of portfolo captal. Assessng the consequences of promotng FDI for natonal welfare s a bg task and one we n no way pretend to complete n full. We focus on whether exstng academc research suggests that the benefts of FDI are suffcent to justfy the knd of polcy nterventons seen n practce. Ths wll help to dentfy a set of practcal gudelnes for when and where promotng FDI mght be welfare-enhancng. In the remander of the ntroducton, we frame the dscusson by outlnng the condtons under whch economc theory suggests that government polces favourng foregn over domestc captal are justfed. In secton II, we brefly revew the types of polcy ncentves that the Group of 24 (G-24) and other countres offer to multnatonal frms; 3 ths wll help to establsh notons of standard practce. In secton III, we survey the theoretcal and emprcal lterature on FDI, wth emphass on research whch examnes whether FDI s a source of postve exter- * I should lke to thank James Hnes, Mustafa Mohaterem and Dan Rodrk for helpful comments and dscussons, as well as Poh Boon Ung for provdng excellent research assstance.

9 2 G-24 Dscusson Paper Seres, No. 9 naltes for host countres. In secton IV, we develop a smple theoretcal model of FDI, whch we then use to evaluate three cases n whch developng-country governments have offered specal ncentves to multnatonal frms as n the cases of Ford and General Motors (GM) n Brazl and Intel n Costa Rca. The purpose of these case studes s to see whether economc theory and relevant emprcal lterature would suggest that polcy nterventon n favour of FDI was justfed. Fnally, n secton V we offer concludng remarks on factors to consder when tryng to determne whether promotng FDI wll rase host-country welfare. Settng the stage: foregn versus domestc nvestment To begn, t s helpful to specfy what we mean by promotng FDI. The benchmark one adopts depends on whether t s optmal for countres to subject foregn and domestc captal to equal tax treatment. Countres may have reason to tax domestc and foregn captal dfferently. For a small open economy facng an mmoble supply of labour and an nternatonally moble supply of captal, the optmal factor ncome tax falls entrely on labour (Gordon, 1986; Razn and Sadka, 1991). Not taxng captal s sensble because the mmoble factor bears the ncdence of any tax on factor ncomes, makng t more effcent to tax the mmoble factor drectly. 4 By extenson, f foregn captal s perfectly moble but domestc captal s not, then the optmal tax on factor ncomes falls on domestc labour and captal but not on foregn captal. More generally, f foregn captal s elastc n ts supply relatve to domestc captal, then t s optmal for countres to tax ncome from domestc captal at hgher rates (where the optmal tax rate on ncome from foregn captal may be postve f ts supply elastcty s less than nfnte). 5 If one presumes that domestc and foregn captal are equally elastc n supply (for example, f they are equally moble nternatonally), then promotng FDI means any polcy whch subjects FDI to favourable tax treatment relatve to domestc nvestment and foregn portfolo nvestment (whether n the form of debt or equty). If, on the other hand, one presumes that foregn captal s more elastc n supply than domestc captal, then promotng FDI means any polcy whch favours drect nvestment nflows over portfolo nvestment nflows, holdng constant a country s relatve tax treatment of domestc nvestment ncome and foregn nvestment ncome. For FDI to mert specal treatment, there needs to be market falure that s specfc to producton by multnatonal frms. 6 Asymmetrc nformaton between domestc and foregn nvestors s one commonly mentoned source of market falure, though one that s not specfc to FDI. If domestc nvestors are better nformed about domestc nvestment opportuntes than foregn nvestors, then, all else equal, a captal-mportng country would rase welfare by subsdzng foregn captal nflows (Gordon and Bovenberg, 1996). Could asymmetrc nformaton justfy favourng FDI over foregn portfolo nvestment? Razn et al. (1998) suggest the answer s no. Snce FDI, but not portfolo nvestment, gves a foregn nvestor a controllng nterest n a domestc frm, multnatonal frms are lkely to be at an nformatonal advantage relatve to foregn portfolo nvestors (though not relatve to domestc ones). In ths case, the optmal tax polcy s to subsdze foregn portfolo nvestment and to leave FDI untaxed. 7 There are other sources of market falure whch could justfy specal treatment of FDI (Caves, 1995). A much cted possblty s that FDI generates productvty spllovers for the host economy (Blomstrom and Kokko, 1998). One dea s that multnatonal enterprses possess superor producton technology and management technques, some of whch are captured by local frms when multnatonals locate n a partcular economy. 8 A related source of spllovers s forward and backward lnkages between multnatonal and host-economy frms (Rodrguez-Clare, 1996), whch may result from multnatonals provdng nputs at lower cost to local downstream buyers or by ther ncreasng demand for nputs produced by local upstream supplers. A further possblty s that FDI shfts rents earned by multnatonals to the host economy (Glass and Sagg, 1999; Janeba, 1996). Multnatonals may have global market power and may share monopoly rents wth managers and workers n ther varous operatonal unts. By attractng multnatonal frms, the host economy may capture a porton of the rents that these frms generate. 9 Whle these and other types of market falure are plausble, each s also subject to controversy. Spllovers assocated wth FDI are supported by casual evdence from many countres, but ther exstence and magntude are, as we shall see, dffcult to establsh emprcally. Indeed, mcro evdence from large samples of manufacturng plants n developng countres fals to support the exstence of postve productvty spllovers related to FDI. There s also reason to beleve that multnatonal enterprses tend

10 Should Countres Promote Foregn Drect Investment? 3 to have market power n ther respectve ndustres. Whether or not they share rents wth employees n ther foregn afflates s an emprcal queston. Attractng FDI may shft a porton of the rents that multnatonals earn to the host economy, but t may also reduce the profts of local frms that compete wth multnatonals at home or abroad. 10 Arguments for promotng FDI are based on clams concernng the economc envronment, whch can and should be subject to emprcal verfcaton. Before decdng to promote FDI, t s essental to evaluate possble sources of market falure assocated wth multnatonal frms. It s ths task to whch we devote much of the paper. II. Promoton of FDI n practce In ths secton, we summarze current government polces to promote FDI n G-24 and other countres. We begn wth a bref revew of corporate taxaton at the natonal level and then dscuss the range of tax and other ncentves whch countres offer to multnatonal enterprses. The source for all data, except where noted, are annual edtons of Corporate Taxes: A Worldwde Summary by Prce Waterhouse. Polces to promote FDI take a varety of forms. The most common are partal or complete exemptons from corporate taxes and mport dutes. These polces are typcally the result of formal legslaton or presdental decree, whch apply to all foregn corporatons that meet certan restrctons. These restrctons vary consderably across countres. In many cases they requre multnatonals to establsh producton facltes n the host country n specfed lnes of actvtes or desgnated regons, such as export-processng zones (EPZs), and to export output embodyng nputs mported duty-free. Drect subsdes and other types of concessons are often negotated between multnatonal frms and host governments on a case-by-case bass. Such ndvdualzed subsdes appear to be common, but are hard to document systematcally. Table 1 shows corporate tax rates n 1990 and 1998 for each G-24 country for whch data are avalable and averaged across regons for other selected countres. 11 Snce some countres have progressve tax rates (lower rates for smaller corporatons) or rates whch vary across sectors, we report the mnmum and maxmum tax rates whch apply to corporate ncome. In 1998 the maxmum tax rates on corporate ncome n the G-24 countres ranged from a hgh of 57 per cent n Iran to a low of 25 per cent n Brazl. Several countres ncludng Argentna, Columba, Guatemala, Peru, the Phlppnes and Sr Lanka tax corporate ncome at a flat rate, whle others ncludng Ghana, Iran, Mexco, and Trndad and Tobago tax ncome earned by small corporatons at rates much lower than for large corporatons. Between 1990 and 1998 most countres reduced ther maxmum corporate ncome tax rates, wth hgh-tax countres undertakng the largest cuts n absolute terms. Tax rates n ndvdual G-24 countres are roughly comparable to the averages for other countres n ther respectve regons. A few outlers are apparent. On a regon-by-regon bass, tax rates n 1998 were relatvely hgh n the Republc of the Congo, Inda, Iran and Pakstan. Tax rates n North Amerca, Oceana and Western Europe are on average smlar to those n Latn Amerca, and lower than those n Afrca and Asa. Tables 2 5 gve a bref descrpton of how G-24 and a sample of fve other countres treat foregn corporatons that operate wthn ther borders. 12 Most countres for whch data are avalable grant corporate ncome tax exemptons to foregn corporatons makng nward drect nvestments. Typcally, these exemptons last for less than a decade from the ntaton of a new project, though n some cases they are long-lved. Most countres also offer exemptons to foregn corporatons on mport dutes, where these tend to be restrcted to nputs that are used to produce exports or, n a few cases, captal goods. Exemptons from value-added taxes are a somewhat less common tax concesson that countres grant multnatonal frms. Smlar tax concessons are also avalable to domestc frms n some countres, though these concessons are for the most part ted to partcpaton n EPZs, export actvtes outsde of such zones, or producton n offcally desgnated prorty sectors or regons. Comparng 1990 wth 1998, there s a slght ncrease n the number of countres offerng exemptons from valued-added taxes and mport dutes and supportng EPZs. 13 Not ncluded n the tables are detals on drect subsdes whch host governments offer to multnatonal frms on a case-by-case bass. These arrangements are frequently unpublczed, but the practce appears to be relatvely common. Brazl s one country whch actvely pursues multnatonal frms and has offered generous subsdes n a number

11 4 G-24 Dscusson Paper Seres, No. 9 Table 1 CORPORATE TAX RATES FOR G-24 AND OTHER COUNTRIES, 1990 AND Mn. rate Max. rate Mn. rate Max. rate Group of 24 Congo Egypt Gabon Ghana Ngera Inda Iran Pakstan Phlppnes Sr Lanka Argentna Brazl Colomba Guatemala Mexco Peru Trndad & Tobago Venezuela Other countres (regonal averages) Afrca East Asa Eastern Europe Latn Amerca Mddle East North Amerca Oceana South East Asa Western Europe Source: Prce Waterhouse (1990). Note: Ths table shows mnmum and maxmum corporate ncome tax rates for selected countres. See text for detals. Data s more detaled for some countres than others. Approxmatons are made n certan cases. of nstances (see the GM and Ford examples n secton IV). For nstance, the country gves generous tax ncentves to frms that locate manufacturng facltes n the Amazon regon. Unspecfed government subsdes appeared to be mportant n lurng Multbras (a US-owned frm) to construct a $400 mllon plant to manufacture ar condtoners and mcrowave ovens n Manaus n Investment subsdes also appeared to be mportant n convncng Honda to buld a motorcycle plant n the area. In the absence of tax breaks, there appears to be lttle reason why multnatonals would locate n the regon. Poorer countres n Europe have also been aggressve n pursung multnatonal frms. To gve a few examples: n 1991 Portugal provded a lumpsum subsdy and promsed tax breaks on future

12 Table 2 TAX CONCESSIONS FOR INWARD FDI IN G-24 COUNTRIES, 1990 (I) (II) (III) (IV) Avalable to domestc corporatons? Corporate ncome Value-added Import duty EPZ Country tax exempton Perod Sectors tax exempton Items exempton Items provson (I) (II) (III) (IV) Egypt X 5 20 years a All b X Gabon X 0 10 years All X c Ngera X 0 5 years A, M, P X d E, M X e E, M, R X X X Congo X 5 15 years P Argentna X E, R X Brazl X E, P X E, P X f Guatemala X g P X h P X X j Mexco (tax credts) X E, P Peru X A, P * P X X Venezuela X A Inda X 5 years All k X E X X X Pakstan X 2 8 years K, A, P * l E, M X E X X X X X Phlppnes X 3 6 years All m X E, K, P, R X X X X Source: Prce Waterhouse (1990). Note: * = taxed at lower rate. A = agrculture. E = exported goods/exportng. K = captal. M = manufacturng. P = prorty companes/ndustres. R = raw materals. X = country offered concesson n ndcated year. Data s more detaled for some countres than others. Approxmatons are made n certan cases. a Maxmum of 20 years f t s a project for medum-szed and economcal housng, whose whole unts are leased vacant for dwellng. b In July 1989, a new nvestment law was ssued and t offered a projects profts to be exempt from tax on ndustral and commercal profts and from corporate tax. c More restrctons apply on domestc corporatons than on foregn corporatons. d Excse duty pad on export manufactures s refundable. e Refund of mport duty. f Excse and sales and servce tax exemptons are granted to exporters of manufactured goods. g The government may grant exemptons from dutes and taxes f the enterprse s classfed as ether basc, necessary or useful, or f t s to be located outsde the muncpalty of Guatemala. h See 7. Exemptons from ncome taxes and mport dutes (up to 100 per cent for a maxmum 10-year perod) may also be granted to ndustres orgnally located (or, f exstng, transferred) outsde of the Department of Guatemala, ste of the captal cty. j See 9. k New ndustral undertakng n free trade zones, or a 100 per cent export-orented undertakng s entrely exempt from ncome tax, subject to certan condtons. l Companes exportng goods manufactured n Pakstan can clam a rebate of 50 per cent on the tax attrbutable to such export sales. However, n respect of certan specfed goods, the tax rebate s avalable at 25 per cent or 75 per cent. m Income tax holday gvng full exempton from corporate ncome tax for sx years for poneer frms and four years for non-poneer frms from date of commercal operaton; expandng frms are gven three years. Should Countres Promote Foregn Drect Investment? 5

13 Table 3 TAX CONCESSIONS FOR INWARD FDI IN COMPARISON COUNTRIES, 1990 (I) (II) (III) (IV) Avalable to domestc corporatons? Corporate ncome Value-added Import duty EPZ Country tax exempton Perod Sectors tax exempton Items exempton Items provson (I) (II) (III) (IV) Chle X a P X b E X Ireland X All c Japan South Afrca Thaland X 3 8 years P X d E, R, K X X X Source: Prce Waterhouse (1990). Note: * = taxed at lower rate. A = agrculture. E = exported goods/exportng. K = captal. M = manufacturng. P = prorty companes/ndustres. R = raw materals. X = country offered concesson n ndcated year. Data s more detaled for some countres than others. Approxmatons are made n certan cases. a Tax benefts and other ncentves for companes operatng n northernmost and southernmost parts of the country. Tax benefts to forestry companes also. b Rembursement of taxes pad. c Companes that commenced operaton wthn the Shannon Free Arport before 1 January 1981 can obtan full exempton from corporaton tax untl 5 Aprl 1990 f the ncome s derved from the carryng on of certan actvtes, ncludng exportng goods and a wde range of servces. d Ether exempton or reducton. 6 G-24 Dscusson Paper Seres, No. 9

14 Table 4 TAX CONCESSIONS FOR INWARD FDI IN G-24 COUNTRIES, 1998 (I) (II) (III) (IV) Avalable to domestc corporatons? Corporate ncome Value-added Import duty EPZ Country tax exempton Perod Sectors tax exempton Items exempton Items provson (I) (II) (III) (IV) Côte d Ivore X 5 8 years All X All Egypt X 5 20 years All a X Gabon X 0 10 years All X b Ngera X 0 5 years P, E, A, M X All c X E, R X X X X X Congo X d 0 10 years A, P, M Argentna (tax credt bonds) X E X E, R X X Brazl X E, P X E, P X e Guatemala f X E X K, E, R X X X X Mexco (tax credts) X E Peru X All g X All h X X Inda X 5 years All X E X X X Phlppnes X 3 6 years All j X All k X All X X X X X Sr Lanka X P X P X X Source: Prce Waterhouse (1998). Note: * = taxed at lower rate. A = agrculture. E = exported goods/exportng. K = captal. M = manufacturng. P = prorty companes/ndustres. R = raw materals. X = country offered concesson n ndcated year. Data s more detaled for some countres than others. Approxmatons are made n certan cases. a An nvestment and guarantee law effectve as of 11 May 1997 offers the profts of a project formed under t to be exempt from tax on ndustral and commercal profts and from corporate tax. b More restrctons apply on domestc corporatons than on foregn corporatons. c 1998 budget abolshes payment of excse dutes. d Tax prorty status gvng exempton (or a reducton ) from varous taxes and custom dutes for up to 10 years can be obtaned by notfcaton of agreement. e Excse and sales and servce tax exemptons are granted to exporters of manufactured goods. f In general, exempton from payment of mport dutes on machnery and equpment and on raw and packagng materals and from ncome tax s avalable for those corporatons classfed as exportng companes. These exemptons also apply to free trade zones. g Industral enttes establshed n the jungle, fronter zones and free trade zones are exempt from ncome tax. h Exempton from value-added tax (VAT) s provded for ndustral enttes establshed n the jungle and fronter zones. New ndustral undertakngs satsfyng certan condtons establshed n a free trade zone, software technology park, or electronc hardware technology park, or a 100 per cent export-orented undertakng s entrely exempt from ncome tax. j Income tax holday gvng full exempton from corporate ncome tax for sx years for poneer frms and those locatng n less-developed area, and four years for non-poneer frms from the date of commercal operaton; expandng export-orented frms are gven three years. k Local purchases of goods and servces from VAT-regstered enttes are ether VAT exempt or zero rated. Should Countres Promote Foregn Drect Investment? 7

15 Table 5 TAX CONCESSIONS FOR INWARD FDI IN COMPARISON COUNTRIES, 1998 (I) (II) (III) (IV) Avalable to domestc corporatons? Corporate ncome Value-added Import duty EPZ Country tax exempton Perod Sectors tax exempton Items exempton Items provson (I) (II) (III) (IV) Chle X a X b E X Ireland * c Japan (tax credts) d X South Afrca X e X Thaland X 3 8 years P X f K, R, E Source: Prce Waterhouse (1998). Note: * = taxed at lower rate. A = agrculture. E = exported goods/exportng. K = captal. M = manufacturng. P = prorty companes/ndustres. R = raw materals. X = country offered concesson n ndcated year. Data s more detaled for some countres than others. Approxmatons are made n certan cases. a Tax benefts and other ncentves for companes operatng n northernmost and southernmost parts of the country. Tax benefts to forestry companes also. b Rembursement of taxes pad. c Reduced rate of corporaton tax of 10 per cent of profts from manufacturng operatons arsng between 1 January 1981 and 31 December 2010, regardless of whether the goods are exported. Defnton of manufacturng operatons s rather lenent. d A corporaton tax credt of 3.5 per cent or 7 per cent of the adjusted acquston cost (25 per cent to 100 per cent) of certan desgnated, energy-savng machnery and equpment, or 7 per cent of the acquston cost of certan desgnated machnery and equpment contanng electronc computer systems acqured by desgnated small or medum-sze corporatons s avalable. The credt s lmted to 20 per cent of the corporaton tax otherwse payable. e Tax holday granted at dscreton to an enterprse wth qualfyng assets n excess of R3 mllon, ncorporated on or after 1 October 1996, for the sole object of carryng out a qualfyng project. f Ether exempton or reducton. 8 G-24 Dscusson Paper Seres, No. 9

16 Should Countres Promote Foregn Drect Investment? 9 earnngs to Ford and Volkswagen n return for ther constructng a jontly operated automoble producton faclty n the country; n 1995 Ireland granted employment subsdes to IBM and Ctbank for locatng data-processng jobs n the country (and granted smlar subsdes to Berg Electroncs the followng year); and n 1996 Turkey entced Honda to buld a new automoble producton faclty n the country by easng tax rules on new plants and relaxng mport dutes on automoble parts. Subsdes are by no means lmted to relatvely low-ncome regons. Germany offered nvestment subsdes to Advanced Mrco Devces n 1995, after t decded to buld a sem-conductor plant n Saxony, and to Motorola n 1998, after t decded to buld a new faclty n Bavara. In the Unted States nvestment subsdes from state governments helped attract Mercedes-Benz to Alabama and BMW to North Carolna. Tables 2 5 ndcate that most countres do not follow the resdence prncple (see note 5) n settng tax polces. 14 Whle many countres tax domestc ncome earned by foregn corporatons at lower rates than domestc ncome earned by domestc corporatons, the former rates are n most cases above zero n the long run (though often not durng the frst few years followng the establshment of a project). Foregn tax credts, whch allow corporatons to deduct taxes pad to foregn governments from ther tax lablty on foregn ncome, complcates the pcture. As of the md-1990s, Japan, the Unted Kngdom and the Unted States granted foregn tax credts to multnatonal corporatons based wthn ther respectve borders, and many other hgh-ncome countres ncludng Australa, Canada, France, Germany, the Netherlands and Swtzerland exempted the foregn earnngs of ther frms from domestc taxaton (Hnes, 1996). Where foregn tax credts apply, and where a country s tax rate on domestc ncome earned by foregn corporatons does not exceed the home-country tax rate for these frms, taxng foregn corporatons merely shfts tax revenue from FDI source countres to FDI host countres and does not necessarly dstort nvestment. One mportant queston s whether the concessons offered to foregn corporatons shown n table 2 represent favourable treatment of nward FDI relatve to nward foregn portfolo nvestment. A full evaluaton of the ssue s beyond the scope of ths paper. Income from nward portfolo equty nvestment, portfolo debt nvestment, and drect nvestment are governed by complcated tax rules, whch vary consderably across countres. 15 We shall, however, hazard a few general comments. Table 2 shows that ncome from nward drect nvestment s subject to myrad tax breaks n G-24 and other countres. Wth regard to nward portfolo equty nvestment, the presence of captal gans taxes, whch vary from country to country, would tend to dsfavour ths vehcle relatve to FDI. 16 Wth regard to portfolo debt nvestment, the recent abolton of wthholdng taxes on portfolo nterest ncome for foregn resdents (Av-Yonah, 1999), whch has occurred throughout the OECD and n many developng countres as well, would tend to favour ths vehcle relatve to FDI. The absence of portfolo nterest ncome wthholdng taxes means that foregners do not pay tax on ncome they earn from corporate or government bonds, bank accounts or certfcates of depost n a country. To summarze brefly, t appears that many countres may have tax polces whch favour FDI relatve to some types of nward portfolo nvestment, but dsfavour t relatve to others. Other polces clearly do favour FDI. A country that offers exemptons to value-added taxes or mport dutes to foregn but not domestc corporatons favours FDI, snce domestc corporatons whch receve foregn bank loans, ssue bonds to foregners, or have a non-controllng porton of ther stock owned by foregners do not receve comparable tax breaks. EPZs do not favour FDI over foregn portfolo nvestment, so long as domestc frms have equal access to EPZs (whch s often the case) and are equally lkely to engage n export producton as are multnatonals (whch s less lkely to be the case). Drect subsdes to multnatonal frms (examples of whch we dscuss n secton IV) also favour FDI relatve to other forms of nward foregn nvestment. III. FDI and host-country economc performance There s mmense academc lterature on FDI and multnatonal frms. Snce our nterests are rather narrow, we focus here on emprcal research whch studes the mpact of FDI on host economes. Wthn ths lterature, we emphasze two strands: one whch examnes the determnants of where multnatonals locate producton facltes and another whch examnes sources of market falure related to FDI. We shall begn wth a bref revew of theores of multnatonal producton.

17 10 G-24 Dscusson Paper Seres, No. 9 A. What explans multnatonal producton? Followng Dunnng (1981, 1993), t s standard practce to vew multnatonal enterprses as arsng from three dstnct types of advantages. A frm must own or control a unque moble asset (e.g. a patent or trademark) t wshes to explot (the ownershp advantage); t must be cost effcent to explot the asset abroad n addton to, or nstead of n, the frm s home country (the locaton advantage); and t must be n the frm s nterest to control the asset s explotaton tself, rather than contractng out use of the asset to an ndependent foregn frm (the nternalzaton advantage). For nstance, GM wll engage n FDI when t has a desgn for a car whch could be manufactured abroad more effcently than at home and whose producton the frm wshes to control through ownershp of the factory n whch t s made. When GM wshes to sell cars n Brazl (a case we wll consder later), t wll choose FDI settng up ts own subsdary n the regon when ths opton domnates exportng to Brazl from GM plants n the Unted States (or elsewhere) and contractng out producton of GM cars (or lcensng ts technology and brand name) to an ndependent Brazlan frm. The general equlbrum theores of multnatonals attempt to explan how envronmental condtons arse whch favour producton by multnatonals over other forms of global market ntegraton. 17 Common to these theores s the dea that to produce a good a frm must ncur fxed costs such as R&D to generate a patent, advertsng to create a brand name, or corporate nvestments to establsh a management structure whch can support producton n many plants. A frm conssts of an upstream faclty, whch undertakes fxed-cost headquarters actvtes, and one or more downstream producton plants. A multnatonal s smply a frm wth upstream and downstream facltes located n multple countres. Suppose that headquarters actvtes are relatvely skll- or captal-ntensve and that producton s relatvely labour-ntensve. If factor prces are not equalzed across countres, then a frm has an ncentve to become a multnatonal n order to explot dfferences n factor costs between countres. It could do so by locatng ts headquarters n a captal-abundant (low-captal cost, hgh-wage) country and producton n a labour-abundant (hgh-captal cost, low-wage) country. Ths would gve rse to vertcal FDI the creaton of a multnatonal whose country operatons specalze each n a dstnct vertcal stage of producton (Helpman, 1984; Helpman and Krugman, 1985). Alternatvely, suppose that factor prces are equalzed across countres, or nearly so, but trade barrers or transport costs make t expensve to shp goods abroad. When trade costs are low, a frm wll produce all ts output n domestc plants and serve foregn consumers through exports. When trade costs are hgh, t s optmal for the frm to buld producton plants both at home and abroad, so that t serves domestc consumers from ts domestc plants and foregn consumers from ts foregn plants (Markusen, 1984). Ths s a case of horzontal FDI, n whch the multnatonal undertakes smlar producton actvtes n all countres. Actvtes at ts headquarters, however, reman concentrated n one country only. Recent work combnes cross-country dfferences n factor and trade costs to develop a general framework for determnng when multnatonals (versus purely natonal frms whch may or may not export) wll be n operaton (Markusen and Venables, 1998 and 1999a). 18 The creaton of multnatonal frms rases global welfare by leadng to a more effcent global allocaton of resources. 19 In the models descrbed above, the absence of dstortons specfc to FDI means that there s no polcy justfcaton for treatng multnatonals dfferently from domestc frms. Nevertheless, polces to promote FDI would encourage multnatonal producton by rasng the advantages of multnatonalty. From the perspectve of a multnatonal frms, subsdzng FDI () lowers producton costs and so rases the ncentve to create patents, trademarks, or other assets whch sustan headquarters actvtes; () enhances the relatve attractveness of locatng producton n the country offerng ncentves; and () rases the economc benefts of FDI relatve to exportng and arms-length producton n the host country. An emergng body of lterature consders how producton externaltes affect the behavour of multnatonals and the mpact of FDI on host economes. The exstence of externaltes assocated wth FDI rases the possblty that promotng FDI may be welfare-enhancng. One lne of work suggests that the arrval of multnatonal frms n an economy may help jump-start the process of ndustral development by ncreasng the scale of operatons n domestc upstream and downstream ndustres that s, by creatng forward and backward lnkages. In Rodrguez- Clare (1996), the arrval of multnatonals ncreases an economy s access to specalzed ntermedate n-

18 Should Countres Promote Foregn Drect Investment? 11 puts (whch are produced n more developed economes and accessble abroad only through multnatonals), whch n turn rases the economy s total factor productvty. The dea s that multnatonals n effect gve less developed economes access to the stock of knowledge captal (whch s one nterpretaton of specalzed ntermedate nputs) n more developed economes. Ths access makes labour and other factors n the host economy more productve. Multnatonals crowd domestc frms out of producton, whch rases the possblty that some domestc factors of producton may lose from FDI. Under some condtons, the demand for labour by the enterng multnatonals s weaker than that for the extng domestc frms, n whch case the arrval of multnatonals may lower natonal welfare. Thus, the lnkage effect of multnatonals on factor demand may be postve or negatve. There are other mechansms through whch multnatonals mpact ndustral expanson n host countres. Gao (1999) offers a model n whch the creaton of multnatonal frms spreads ndustry from more to less ndustralzed countres, thereby reducng ndustral concentraton n the former. By lessenng ndustry agglomeraton, multnatonals rase natonal welfare n less ndustralzed regons, but may lower t n more ndustralzed ones. Markusen and Venables (1999b) offer a smlar model n whch the catalyst effect of multnatonals on a host economy (through forward and backward lnkages) may spur domestc ndustry so much as to drve multnatonals out of the market. Addtonally, whle multnatonals create forward and backward lnkages, they also ncrease competton for local frms, and thus may redstrbute ncome away from some groups e.g. specfc factors n ndustral producton (Matouschek, 1999). If the mpact of multnatonals on the proftablty of domestc frms s suffcently negatve, FDI may lower host-country welfare, n whch case the optmal polcy towards FDI s a tax (Glass and Sagg, 1999). Another mechansm through whch multnatonals may create spllovers for local ndustry s worker tranng. If multnatonals brng new technology nto an economy, then local frms may beneft by beng able to hre workers whose tranng costs have n effect been pad by the multnatonal (Motta et al., 1999). Of course, multnatonals may bd to retan these workers, n whch case domestc labour captures the full beneft of worker tranng. In ether case, multnatonals rase natonal welfare. B. What determnes the locaton of multnatonal producton? A large emprcal lterature examnes the factors whch determne where multnatonal enterprses locate ther producton facltes. We dscuss ths lterature brefly n order to dentfy the potental effcacy of usng tax ncentves to attract FDI. One strand of lterature apples general equlbrum theores of multnatonals to data to see whether FDI s assocated wth varaton n trade costs or factor costs across countres. Theory predcts that frms wll penetrate foregn markets through FDI when trade costs are low, frm-level scale economes are hgh (.e. the fxed costs assocated wth headquarters actvtes are hgh), and plant-level scale economes are low (.e. the costs of havng plants both at home and abroad are low). Conversely, frms wll penetrate foregn markets through exports when trade costs are low and plant level scale economes are hgh. Theory also predcts that frms wll penetrate foregn markets through vertcal FDI when factor-cost dfferences between countres are large, and through horzontal FDI when countres are smlar n terms of market sze and factor cost. A common measure of how frms from a gven source country penetrate a gven host market s the level of sales n the host market by foregn afflates of frms from the source country (normalzed by total sales from the source country to the host country, whch equal afflate sales plus exports). 20 Usng data on exports by US manufacturng ndustres and sales by foregn manufacturng afflates of US multnatonals, Branard (1997) fnds that afflate sales n a gven ndustry and country are postvely correlated wth trade costs (freght rates, tarff rates) to the country and average frm sze n the ndustry, and negatvely correlated wth average plant sze n the ndustry. Branard nterprets these results to mean that, consstent wth theory, hgher trade costs and stronger frm-level scale economes encourage FDI relatve to exports, whle stronger plant-level scale economes dscourage FDI relatve to exports. She also fnds that hgher host-country taxes appear to encourage afflate sales over exportng, whch s counter-ntutve. Yeaple (1999) extends Branard s approach and fnds that for more skll-ntensve ndustres afflate sales are postvely correlated wth average educatonal attanment n the host country. He nterprets

19 12 G-24 Dscusson Paper Seres, No. 9 ths result to mean that countres wth larger supples of human captal are more lkely to attract FDI, especally n sectors whch are relatvely ntensve n the use of sklled labour. In related work, Markusen and Maskus (1999a and 1999b), usng data on aggregate sales by foregn afflates of US multnatonals and aggregate sales by afflates of foregn multnatonals n the Unted States, fnd that afflate sales are hgher when source and host countres have relatvely smlar market szes but are unrelated to dfferences n the relatve supply of sklled labour n source and host countres. They nterpret these results to mean that multnatonals have expanded ther global producton operatons more through horzontal FDI than through vertcal FDI. The emprcal work cted above s general equlbrum n orentaton, n that t s based on estmatng a reduced form relatonshp between exports and/or multnatonal sales and measures of ndustral technology, and country trade costs, sze and factor supples. All prces and outputs are mplctly endogenous. Other research takes a partal equlbrum approach n that t examnes the mpact of polcy or other host-country condtons on FDI, holdng constant at least some prces and sectoral outputs. Ths lne of work focuses on the country characterstcs whch appear to attract multnatonal frms. In a wdely cted paper, Wheeler and Mody (1992) examne outward foregn nvestments by US multnatonal enterprses. They fnd that US outward FDI s hgher n countres wth larger markets, a larger stock of ntal FDI, hgher qualty of nfrastructure, and more ndustralzed economes. These results are broadly consstent wth theory. The authors nterpret the correlaton between current and past FDI to ndcate that multnatonals are attracted to locatons wth a larger concentraton of ndustral frms that s, that there are agglomeraton economes assocated wth FDI. Other results are less consstent wth theory. FDI s slghtly hgher n countres wth hgher labour costs and corporate taxes. These fndngs, whch are representatve of other papers n ths lterature, rase a number of mportant questons. Is FDI truly subject to agglomeraton economes? Can t be that multnatonals do not take labour costs or tax rates nto account n makng locaton decsons? If the answer to both questons s yes, then host-country governments may have lmted ablty to nfluence multnatonal locaton decsons through tax polcy. There are several reasons to be cautous n drawng polcy conclusons from regressons lke those that Wheeler and Mody report. One common problem n emprcal work whch examnes the mpact of tax polcy or agglomeraton effects on frm locaton decsons s that t s often dffcult to control for the mpact of all relevant regonal characterstcs (e.g. effcency of local bureaucracy and local factor productvty). 21 Excluded characterstcs are omtted varables, whose exstence may contamnate regresson results. Calforna, for nstance, attracts multnatonals n part because t has a large pool of labour whch s hghly sklled (and hghly pad). The state s abundant resources may allow t to get away wth hgh corporate tax rates. If there are many nstances lke Calforna n the data (as well as opposte cases lke Arkansas whch s a low wage, low tax, and low FDI regon), we would fnd that FDI s postvely correlated wth tax rates, labour costs and ndustry agglomeraton. But these correlatons would just be pckng up the more fundamental relatonshp between FDI and the local supply of sklled labour. Snce Wheeler and Mody-style regressons do not control for ths sort of possblty, they are dffcult to nterpret. Recent work n publc fnance attempts to address these and other dentfcaton problems. Hnes (1997) summarzes research on the mpact of taxaton on FDI. Contrary to the mpresson gven by Wheeler and Mody (1992), Branard (1997), Yeaple (1999) and others, a growng tax lterature fnds that FDI s lower n regons wth hgher corporate taxes. The elastcty of FDI wth respect to the after-tax rate of return s approxmately unty. One study whch controls for omtted varables n a partcularly convncng manner s Hnes (1996), who examnes the allocaton of nward FDI across US states. He compares nvestment from countres whch grant foregn tax credts wth countres that do not n hgh-tax versus low-tax US states. Relatve to nvestors from countres whch grant foregn tax credts, nvestors from countres whch grant no tax credts should be more senstve to cross-state dfferences n tax rates. Hnes approach allows hm to control for unobserved factors whch nfluence the attractveness of a state to foregn nvestors (and whch are common to nvestors from dfferent countres). Hs results mply an elastcty of captal ownershp wth respect to state taxes of 0.6. Ths suggests that multnatonals are nfluenced by cross-country or cross-regon dfferences n tax rates. Wth regard to agglomeraton effects, Head et al. (1995) examne the locaton decsons of new Japanese manufacturng plants n the Unted States. They fnd that, controllng for the local concentra-

20 Should Countres Promote Foregn Drect Investment? 13 ton of US plants n the same ndustry (among other factors), Japanese plants are more lkely to choose a locaton where the exstng local concentraton of Japanese manufacturng plants n the same ndustry s hgher. Ths fndng s smlar to Wheeler and Mody s that frms are attracted to large concentratons of other ndustral frms. But, by focusng on Japanese plants and controllng for the locaton of overall US manufacturng actvty, ths approach goes further than prevous studes n controllng for the effects of unobserved, ste-specfc characterstcs. 22 Ths suggests that multnatonals (at least the Japanese frms n Head et al. s data) are attracted to locatons wth other frms n ther own or related lnes of actvty. 23 C. Does FDI generate postve spllovers for the host economy? That multnatonal frms are dfferent from purely domestc frms s abundantly clear. Across countres and tme, several emprcal regulartes are apparent. Relatve to ther domestc counterparts, multnatonals are larger, pay ther workers hgher wages, have hgher factor productvty, are more ntensve n captal, sklled labour, and ntellectual property are more proftable and are more lkely to export (Haddad and Harrson, 1993; Atken et al., 1997; Atken et al., 1997; Atken and Harrson, 1999; Blomstrom and Sjoholm, 1999). 24 That multnatonals possess these attrbutes s not surprsng, gven that to become a vable multnatonal a frm must have outperformed domestc and foregn rvals n some dmenson. The relatve technologcal superorty of multnatonals also makes t possble that they would be a drect or ndrect source of technologcal advancement for domestc frms n host countres, especally where these countres are relatvely far from the technologcal fronter. Theory dentfes several channels through whch multnatonals generate externaltes that rase the productvty of host-country factors of producton. It s entrely possble, however, for the net effect of such lnkages on host-country welfare to be negatve, once we take nto account the mpact of FDI on the proftablty of domestc frms. Whether spllovers from multnatonals rase host-country welfare s an emprcal queston. Early lterature s optmstc about the mpact of multnatonals on host-country productvty. 25 Caves (1974) fnds a postve correlaton between ndustry average value-added per worker and the share of ndustry employment n foregn frms for Australan manufacturng n More recent work confrms ths basc fndng n a wde array of envronments. A partal lst of studes whch fnd a postve correlaton between average ndustry productvty and the presence of foregn frms n the ndustry nclude Globerman (1979) for Canada n 1972; Blomstrom and Persson (1983), Blomstrom (1986), and Kokko (1994) for Mexco n the 1970s; and Blomstrom and Sjoholm (1999) for Indonesa n In related work, Borenszten et al. (1998) fnd a weak postve correlaton between FDI nflows and per capta GDP growth for a panel of countres n the 1970s and 1980s (although when they nteract FDI and the level of schoolng, FDI has a negatve drect effect on growth and a postve ndrect effect through schoolng). Takng a slghtly dfferent approach, Mansfeld and Romeo (1980) use a sample of US-based multnatonals to examne whch sorts of technology these frms transfer abroad and whether there s leakage of these technologes to non-us frms n host countres. They report that n 20 out of 26 cases transferred technologes became known to foregn rvals wthn sx years. In nne of the cases, access to US technology appeared to accelerate foregn frms ntroducton of competng products or processes by two years or more. 27 What does t mean for ndustry productvty or ndustry technology adopton to be postvely correlated wth the presence of multnatonal frms n an ndustry? A common nterpretaton of ths fndng s that FDI creates postve productvty spllovers for domestc frms n host countres. Ths nterpretaton, however, s subject to the same concerns about omtted varables and endogenety bas that we encountered n emprcal work on the mpact of taxes and agglomeraton effects on frm locaton decsons. Most emprcal studes n the lterature use crosssecton data on average ndustry characterstcs. A postve smple correlaton between ndustry productvty and the presence of multnatonals s, n prncple, just as lkely to mean that multnatonals are attracted to hgh-productvty ndustres as t s to mean that multnatonals rase host-country productvty. Though most emprcal studes ntroduce addtonal controls n estmatng the correlaton between ndustry productvty and multnatonal presence, the ncluded varables surely do not exhaust the set of factors whch are lkely to nfluence ndustry productvty and multnatonalty. 28

21 14 G-24 Dscusson Paper Seres, No. 9 Recent work attempts to address these dentfcaton problems through usng mcro-level, tmeseres data on ndvdual manufacturng plants. By lookng at how the productvty of domestc plants changes over tme n response to the presence of multnatonals, t s possble to control for the presence of unobserved factors whch nfluence both the productvty of domestc plants and the behavour of multnatonals. Haddad and Harrson (1993), usng data on Moroccan manufacturng plants for the perod , fnd a weak negatve correlaton between plant total factor productvty growth and the presence of foregn frms n the sector. Foregnowned plants do have hgher productvty (though not hgher productvty growth), and the ndustres n whch they are concentrated demonstrate less dsperson n plant productvty. In related work, Atken and Harrson (1999), usng data on Venezuelan manufacturng plants for the perod , fnd that productvty growth n domestc plants s negatvely correlated wth foregn presence n the sector. 29 Based on ther estmates, a domestc plant n a sector wth 50 per cent of employment n foregn-owned plants would on average have 13 per cent lower annual productvty growth than a domestc plant n a sector wth no foregn frms. They also fnd that foregn plants are relatvely productve and that hgher-productvty foregn plants tend to concentrate n certan sectors. Productvty growth n foregn plants, n contrast to domestc plants, s postvely correlated wth multnatonal presence. The results of Haddad and Harrson and Atken and Harrson are consstent wth a smple story, whch s qute dfferent from that derved from older, ndustry-level, analyses. Ths s that multnatonal frms concentrate n hgh-productvty sectors and that domestc plants n these sectors, whle havng hgh relatve levels of productvty, experence even or negatve growth n productvty relatve to plants n other sectors. Mcro-level data, then, appears to undermne emprcal support for postve net productvty spllovers from FDI, perhaps ndcatng that multnatonals confne competng domestc frms to less proftable segments of ndustry. 30 Another strand of lterature examnes whether multnatonals mprove the access of host-country frms to foregn markets. Based on casual observaton and frm-level ntervews, Rhee (1990) and Rhee and Belot (1990) fnd that the arrval of multnatonal frms contrbuted to the eventual export success of one or more labour-ntensve ndustres n 11 developng economes. Usng data on Mexcan manufacturng plants n the 1980s, Atken et al. (1997) fnd that the larger the concentraton of multnatonal frms n ther regon and ndustry, the more lkely Mexcan manufacturng frms are to export. Ths correlaton s robust to controllng for ndustry agglomeraton n the regon and for the endogenety of multnatonal locaton. In nterpretng these results, t s mportant to recognze that these studes examne economes n the aftermath of lberalzaton epsodes, n whch barrers to trade and FDI fell consderably. Hence, the nformaton spllovers these studes detect may be confned to post-reform transton perods and therefore short-lved. 31 IV. Evaluaton of FDI n practce To summarze key results of the lterature on FDI, we have seen that: () the only justfcaton for favourng FDI over both foregn portfolo nvestment and domestc nvestment s the exstence of market falure that s specfc to multnatonal producton; () G-24 and other countres offer myrad tax concessons to FDI, whch volates the resdence prncple (by taxng non-resdent ncome) and subjects FDI and foregn portfolo nvestment to unequal tax treatment; () n theory, FDI rases natonal welfare by brngng foregn technology and other foregn resources nto an economy, whch rases the productvty of domestc factors, but n the absence of externaltes there s no justfcaton for taxes or subsdes whch are specfc to FDI; (v) n theory, externaltes assocated wth FDI may rase or lower natonal welfare, dependng on whether postve productvty spllovers from multnatonals more than offset the loss n profts due to crowdng domestc frms out of the market; (v) emprcal research suggests that FDI s senstve to both host-country tax polces and economc condtons, ncludng the educaton level of the labour force, overall market sze, and the sze of the local ndustral base; (v) emprcal research shows mxed support for the dea that FDI generates postve spllovers for domestc ndustry, whle multnatonals tend to be hgh-productvty frms whch pay relatvely

22 Should Countres Promote Foregn Drect Investment? 15 hgh wages; on average (n at least some countres) ther presence appears to depress the productvty of domestc plants (perhaps by drvng them nto less proftable market segments). In ths secton, we apply nsghts from the lterature to examne several cases of FDI promoton polces. Frst, we buld a smple theoretcal model of FDI. In ths model, FDI rases the productvty of domestc factors and possbly domestc frms, but also ncreases competton wth these frms. The effect of FDI on natonal welfare depends on the relatve magntude of ncreased domestc factor ncome versus the reduced proftablty of domestc ndustry. To show these effects n as transparent a manner as possble, we dentfy some but not all the general equlbrum effects of FDI. In partcular, we assume that subsdes to FDI are fnanced by lumpsum taxes and we gnore other forms of foregn nvestment. Gven that tax polces n many countres may be neffcent [see () and () above], we are n a sense gvng FDI promoton polces the maxmum beneft of the doubt by gnorng some of ther possbly more adverse dstortonary consequences. Second, we descrbe three cases of FDI promoton: projects by GM and Ford to buld automoble producton plants n Brazl, and a project by Intel to buld a sem-conductor factory n Costa Rca. After presentng the relevant detals of the cases, we examne whether the theory developed n the frst part of ths secton and estmates of key behavoural parameters culled from emprcal lterature would suggest that these polces were justfed on welfare grounds. Ths exercse s obvously far from exact, snce there are many detals about the ndustres we cannot observe and so do not address. Our ntent s to dentfy smple gudelnes whch polcy makers should take nto account (under the presumpton that the pont of promotng FDI s to rase natonal welfare), and then see f the facts of the cases examned suggest that polcy makers adhered to these gudelnes. A. A theoretcal model In ths secton we develop a smple model of multnatonal producton, whch we use to examne the condtons under whch subsdzng multnatonal actvtes enhance host-economy welfare. Based on the dscusson n the last secton, the arrval of a multnatonal frm n a host economy potentally () rases the demand for labour and other factors, thus rasng factor ncomes; () crowds domestc frms out of the market, by bddng away resources and capturng the market share from these frms; and () generates spllovers, whch may rase or lower the productvty (and proftablty) of domestc frms. The net effect of FDI on an economy s ambguous; n order to justfy subsdes to FDI, the net welfare effect of FDI should be postve and the socal return to FDI exceed the prvate return. We would lke a model whch captures effects () (), facltates analyss of FDI promoton polces and s tractable. Wth ths n mnd, we extend the framework n Dxt and Grossman (1986) and Glass and Sagg (1999) to allow for spllovers from FDI. Consder a host economy whch has two sectors: an agrcultural one, whch s perfectly compettve and hres unsklled labour only, and a manufacturng sector consstng of N ndustres, each of whch s mperfectly compettve and hres unsklled and sklled labour. Agrculture can be thought of as a composte good, embodyng the rest of the economy. We take agrculture to be the numerare for the economy and defne unts of the good such that t takes one unsklled worker to produce one unt of output. The prce of the good and the wage for unsklled labour are then both equal to one. To begn, we assume that the majorty of manufacturng output s exported, whch avods complcatons nvolved wth calculatng consumer surplus. We later dscuss relaxng ths assumpton. Sklled labour represents a scarce resource, whch s used by relatvely hgh-technology sectors, such as manufacturng. We have n mnd managers, engneers and other hgh-skll workers, who tend to be employed n technology-ntensve, mperfectly compettve ndustres. We could, alternatvely, redefne sklled labour as an nput (management, R&D) whch s produced by a scarce factor and consumed by manufacturng ndustres. Ths would be an equvalent statement of the model. We assume that each of the N manufacturng ndustres contans a sngle domestc frm, whch Cournot-competes wth a sngle foregn frm. The model easly generalzes to the case of more domestc and foregn frms. There may be fxed costs whch account for the ndustres olgopolstc structure, but we do not need to account for them explctly. A sngle foregn frm n ndustry 1 contemplates locatng producton n the host country.

23 16 G-24 Dscusson Paper Seres, No. 9 These assumptons mply that frms n the domestc economy have power to set prces on world markets. Ths may be unrealstc for local frms n many developng countres, but s lkely to apply to many multnatonals whch locate n developng regons (ncludng the frms we shall consder later on n ths paper: GM, Ford and Intel). In the event that multnatonals are the only frms wth global market power n the domestc economy, then the model collapses to the case of a sngle perfectly compettve sector and a sngle mperfectly compettve sector, where the latter s domnated by a multnatonal. Detaled assumptons of the model are as follows: (a1) There are l unts of unsklled labour and k unts of sklled labour n the host economy, where sklled labour earns wage z. Total agrcultural output s x; (a2) To produce one unt of output, a domestc frm n ndustry requres a unts of unsklled labour and one unt of sklled labour. If the foregn frm n ndustry 1 chooses to produce n the host economy, t requres A 1 unt of unsklled labour and D 1 unts of sklled labour per unt of output; (a3) The revenue functon for the domestc frm n ndustry s r (y,y, λ (Y d )), where y s the output of the domestc frm, Y 1 s the output of the rval foregn frm, Y d s the domestc output of 1 foregn frm 1, and the functon λ () captures productvty spllovers from foregn frm 1 s domestc producton to domestc ndustry. As s standard, r 0, r 0, r 0, and r (where subscrpts ndcate partal dervatves by order of argument n the revenue functon). λ may be postve or negatve. The revenue functon for the rval foregn frm n ndustry s R (Y,y ), where R 0, 1 R 0, and 11 R 0. 2 The frst assumpton s that factors are n nelastc supply. Ths assumpton s not essental but does help smplfy the analyss. The second assumpton specfes that the unt factor demands of the foregn frm may dffer from those of the domestc frm, whch allows for the possblty that multnatonals may have relatvely weak or strong lnkage effects. The thrd assumpton says that a domestc frm s revenue s ncreasng (at a decreasng rate) n ts own output, decreasng n the output of ts foregn rval, and ncreasng (decreasng) n the domestc output of foregn frm 1 f that frm s a source of postve (negatve) spllovers to the ndustry. Later n the analyss, we shall ntroduce addtonal assumptons. Before developng the model, we need to specfy the FDI promoton polces that a domestc government contemplates enactng. The obvous alternatves are () a fxed subsdy to multnatonals that set up producton facltes wthn the borders of the host economy, and () a subsdy per unt of domestc output granted to multnatonals. Both are straghtforward to analyse, but to examne the effects of a fxed subsdy requres comparng dscrete changes n equlbrum outcomes, whch n turn requres makng assumptons about functonal forms and parameter values. Addtonally, for a lump-sum subsdy to rase welfare, FDI must generate postve spllovers and not occur n the absence of a subsdy. In most such cases, a per-unt subsdy wll be the optmal polcy, not a lump-sum subsdy (snce the former equates the prvate and socal return to FDI whle the later does not). In lght of these ssues, we consder the effect of a per unt producton subsdy by the host economy on domestc output of foregn frm 1. Ths allows us to examne whether a small ncrease n the subsdy rases or lowers natonal welfare, and so determne whether the lassez-fare level of FDI s too hgh or too low from the perspectve of the host economy. A per unt producton subsdy roughly approxmates many types of actual FDI promoton polces. 32 A related ssue s how we treat producton outsde the host economy by foregn frm 1. Snce the frm s producng for the world market, t would only mantan producton n multple countres f ts unt factor costs were equalzed n those countres. Glass and Sagg (1999) consder the case where FDI equalzes wages between host and source countres for multnatonal frms. We consder ths outcome to be unrealstc, but our model could be easly extended to treat ths case. For smplcty, we assume that the foregn frm moves ts entre producton of good 1 to the host economy. Ths would occur n the event that FDI by foregn frm 1 dd not equalze factor prces between the host economy and the foregn frm s home country. Foregn frm 1 may, of course, have operatons devoted to other products and ndustres at home or n other countres. We gnore these, as they do not mpact on the host economy s welfare. Gven the smple setup of the model, we need to focus on just two sets of equlbrum condtons: those for factor-market clearng and those for proft maxmzaton of frms producng n the host

24 Should Countres Promote Foregn Drect Investment? 17 economy. Factor-market equlbrum requres that supply equals demand n the market for unsklled labour, l = x + ay + A1Y1 and n the market for sklled labour, k = y + D1Y (1) (2) By assumpton, each domestc frm chooses output to maxmze proft, takng as gven the output of ts rval foregn frm. For domestc frm, proft maxmzaton mples the followng frst-order condton: (3) Second-order condtons are standard. There s a smlar frst-order condton for the foregn frm wth whom frm competes. Except possbly for ndustry 1, these foregn frms are located abroad. If foregn frm 1 chooses to manufacture n the host economy, ts output choce s mplctly defned by the frstorder condton, (4) whch reflects the fact that foregn frm 1 may be gven a per unt subsdy for producng n the host economy. Snce pars of domestc and foregn frms compete n a sngle world market, we can summarze ther proft-maxmzng output choces n terms of Cournot Best-Response Functons, y =b (Y ) and Y =B (y ), whch are subject to standard condtons. 33 The arrval of foregn frm 1 n the host economy has three effects. Frst, an ncrease n producton by foregn frm 1 rases the demand for unsklled and sklled labour n the host economy. Snce manufacturng s relatvely ntensve n the use of sklled labour, the relatve demand for and the relatve wage of sklled labour rses. For domestc frms n the host economy, the rse n z ncreases ther margnal costs. All else equal, hgher margnal costs mean lower output and lower profts. Ths effect apples to all frms n manufacturng, and not just to the domestc frm competng drectly wth foregn frm 1. Second, an ncrease n producton by foregn frm 1 generates a productvty spllover for domestc frms. If ths spllover s postve, t wll, all else equal, cause 1 r1 a z = 0 1 = R A1 D1z + s 0 domestc frms to rase ther output and earn hgher profts. The frst and second effects work n opposte drectons, and so have an ambguous mpact on domestc frm output and profts. The thrd effect s solated to domestc frm 1: as foregn frm 1 rases ts output, the prce for domestc frm 1 s output falls, causng t to reduce output and thereby earn lower profts. To consder these effects n more detal, we examne the mpact of a change n the producton subsdy to foregn frm 1 on host-economy welfare. Snce we have assumed that manufacturng frms produce for the world market, we can examne the welfare effects of a subsdy to foregn frm 1 wthout takng consumer surplus n the host economy nto account. As long as the fnal consumers of foregn frm 1 s products are located abroad, ths smplfcaton s reasonable. 34 For our purposes, the relevant components of host-economy welfare are ncomes to unsklled and sklled labour, profts to domestc frms, and the subsdy to foregn frm 1, 35 W = l + zk + [r (a (5) + z)y ] sy1 Usng the factor-market clearng condton for sklled labour n equaton (2), we can rewrte host-economy welfare as: W = l + zd1y1 + [r a y ] sy (6) We turn now to the thought experment that s the motvaton for the model: what s the mpact of an ncrease n the producton subsdy to foregn frm 1 on host-economy welfare? The base case from whch we begn s lassez-fare (zero subsdy). Determnng the welfare consequences of a subsdy to the multnatonal frm wll then also determne whether the socal return to FDI exceeds the prvate return. Totally dfferentatng equaton (6), we obtan: dw = dzd 1 Y 1 + zd 1 dy 1 + [r 1 + r 2 B ' a ]dy (7) + r 3 λ 'dy 1 dsy 1 The frst two terms n equaton (7) represent the change n factor ncome, whch s postve as long as the subsdy causes foregn frm 1 to ncrease ts output. The thrd and fourth terms represent the change n profts for domestc frms, whch depends on the 1

25 18 G-24 Dscusson Paper Seres, No. 9 sgns of the dy terms and whether productvty spllovers are postve or negatve. If the rse n margnal costs s the domnant effect, domestc output and profts fall, whle f the productvty-spllover effect domnates (and spllovers are postve), domestc output and profts rse. The ffth term s the drect cost of the subsdy to multnatonal producton. To help nterpret equaton (7), we smplfy the expresson. Frst, defne φ r B 0, whch s the 2 strategc effect of own-ndustry changes n domestc output on domestc profts. Gven outputs are strategc substtutes (by assumpton), as a domestc frm rases ts output, t nduces a reducton n output by ts rval frm, whch n turn serves to rase domestc frm profts. Next, defne ß r λ, whch s the drect effect of the multnatonal productvty spllover 3 on domestc frm profts. Usng r -a =z from equaton (3) and combnng equaton (2) and assumpton 1 (a1), we see that dk = 0 = dy + D dy (8) Gven that sklled labour s n nelastc supply, any ncrease n output by foregn frm 1 must be met by a net reducton n output by domestc frms, such that the total demand for sklled labour s unchanged. Applyng the defntons and equaton (8) to equaton (7), we obtan dw = (dzd1 ds)y1 + φdy + dy1 β (9) The welfare effects of the subsdy are transparent n equaton (9). The frst term s the effect of the subsdy to foregn frm 1 on factor ncomes, net of the drect subsdy cost. Ths term has to be negatve. We show ths formally n a techncal appendx, but the ntuton s straghtforward. Begnnng from a stuaton where the subsdy s zero, the foregn frm has chosen output to maxmze profts. If t ncreases output, ts profts, net of the subsdy, wll fall. The only way a subsdy can nduce the frm to rase output, therefore, s f t more then compensates the frm for the extra costs t wll ncur by expandng output. The second term n equaton (9) s the strategc mpact of the subsdy to foregn frm 1 on the profts of domestc frms. Absent spllovers, the rse n factor costs would nduce domestc frms to lower output, yeldng them lower profts. Any frm that does not receve a postve spllover, wll wthout 1 1 queston lower ts output, producng a negatve value for φ dy. Even for those frms that do receve a postve spllover, the effect of rsng factor costs may domnate, leadng to a fall n output. We show ths formally n the appendx. From equaton (8), for the foregn frm to rase output the net change n output for domestc frms must be negatve. We antcpate, then, that the only domestc frms whose output wll rse wll be those recevng a substantal postve productvty spllover. The thrd term n equaton (9) captures the mpact of the productvty spllover on domestc profts. The larger the ncrease n foregn frm 1 s output, the larger s ths term. But larger ncreases n foregn frm output also lay upward pressure on demand for sklled labour, makng t more lkely that the second term n (9) wll be negatve. Under what condtons wll a subsdy to domestc producton by a multnatonal frm be lkely to rase natonal welfare? We dentfy four key condtons: () the factors used most ntensvely n producton by the multnatonal frm are n elastc supply; () the domestc frms that compete for resources wth the multnatonal frm earn low to zero economc profts; () multnatonal producton generates large postve productvty spllovers for domestc frms n competng and non-competng ndustres; and (v) the gan n consumer surplus from ncreased competton n the domestc market s small. Condton () guarantees that the mpact of the subsdy on factor costs for domestc frms wll be small; condton () guarantees that the welfare consequences from shftng producton away from domestc frms and towards foregn frms wll be small; and condton () s necessary for a subsdy to be worthwhle under any crcumstances. Condton (v) goes beyond the theoretcal analyss we have presented, but s an obvous pont. We do not emphasze changes n consumer surplus, snce f FDI does happen to rase domestc market competton, then the optmal polcy s not a subsdy to multnatonal frms but a generalzed producton subsdy to offset the dstortonary consequences of mperfect competton. 36 These condtons form the bass for evaluatng actual cases of FDI promoton polces, to whch we turn n the next secton.

26 Should Countres Promote Foregn Drect Investment? 19 B. The promoton of FDI n practce: three cases 1. General Motors n Brazl 37 In the last decade, Brazl captured the attenton of global automoble manufacturers. Wth Mercosur provdng tarff barrers aganst competton from outsde the southern cone, Brazl havng the world s eghth largest automoble market, and strong projected growth n regonal automoble demand (only one n nne Brazlans owns a car), the major automoble producers ether establshed or expanded producton capacty n Brazl and Argentna. By the late 1990s, there were a dozen automoble manufacturers n Brazl alone. In 1998, VW owned 28 per cent of the Brazlan market, Fat 24 per cent, GM 22 per cent and Ford 13 per cent, wth the rest of the market dvded among smaller manufacturers. In the early 1990s, GM began to move aggressvely nto Brazl, focusng ntally on hgher end-products and toutng ts confdence n the country. By the late 1990s, GM had an annual producton capacty of 500,000 unts, up from 170,000 n VW, Fat and Ford, n contrast, were ntroducng new models relatvely slowly, reflectng the cautous approach of many durable-goods manufacturers n the wake of Brazl s contnung struggle aganst hgh nflaton and slow growth. GM decded to make Brazl a showcase for ts new global producton strategy, based on smple and flexble manufacturng plants, global sourcng of automoble parts, rapd ntroducton of new models, and a lean dealer network. Ths strategy had shown success n Europe and the dea was to develop t further n Brazl, wth the goal of applyng t n Asa, Eastern Europe, and perhaps ultmately the Unted States. GM s long-run am s to have half of ts producton capacty outsde the Unted States, compared wth only one ffth n (As GM has stepped up ts Brazlan operatons, t has also expanded automoble producton n other emergng economes, ncludng Argentna, Chna, Poland and Thaland.) By the late 1990s, other automoble makers n Brazl were followng an approach smlar to GM s. VW, Fat and Ford, among others, decded to buld new plants or add capacty to ther exstng plants n the country. In 1997 GM made the Blue Macaw project the centerpece of ts Brazlan strategy. The project revolved around a new automoble assembly plant, whch would be GM s thrd n the country, wth an annual capacty of 150,000 unts. The plant would produce a strpped-down verson of the Opel Corsa, a subcompact car, wth an under $10,000 prce tag. Much of the producton of the car would be outsourced to supplers, who would delver entre subassembles of components to GM for fnal assembly. GM s plan was to develop ths concept of modular assembly n Brazl and then apply t to other producton facltes n Europe and North Amerca. GM chose the state of Ro Grande do Sul as the ste for the $600 mllon plant, wth the dea of completng the faclty by the end of However, Brazl s currency crss n early 1999 and the ensung recesson caused GM s sales n Brazl to fall by 27 per cent and delayed completon of the project untl early GM s plant, whch recently opened, employs 1,300 workers, and locally based supplers employ another 1,300 workers. The plant houses 20 supplers, the most mportant of whch are US, French and Japanese companes. GM outsources all components except powertrans, body weldng, body panels, pant, and fnal assembly. The advantages of locatng n Ro Grande do Sul s that the state s close to the southern cone s major markets n southern Brazl, the Buenos Ares regon of Argentna and Uruguay. The state has a more educated work force compared to the rest of Brazl, but lower wages than n the hghly ndustralzed nearby regon of Sao Paulo. (Total compensaton for GM workers n Ro Grande do Sul s expected to be $9 per hour, compared to $13 for automoble workers n Sao Paulo.) In return for agreeng to buld a plant n a lghtly ndustralzed area, GM receved a package of subsdes from the state government of Ro Grande do Sul. These ncluded promses for drect subsdes to GM to offset the costs of buldng roads, ports and other nfrastructure related to the plant; temporary exemptons from value-added taxes; and a waver of mport dutes on machnery used n the constructon of the plant. Whle nether GM nor the state government s wllng to gve precse fgures, the subsdes were reported to amount to $250 mllon, and the tax breaks appeared to have the potental to equal $1.5 bllon over a 15-year perod. GM executves mantan that n the absence of these subsdes, the frm would have located the plant n a more developed part of Brazl. In May 1999, the government of Ro Grande do Sul, under a newly elected, more populst gover-

27 20 G-24 Dscusson Paper Seres, No. 9 nor, threatened to renege on the promsed subsdes to GM. Sharply hgher nterest rates n the aftermath of Brazl s currency crss had rased borrowng and debt-servce costs n the country, and forced state and federal governments to rase taxes and cut back on spendng. Ro Grande do Sul s governor clamed that hs state could no longer afford the subsdes. GM felt t was too close to completon of the project to pull out. Instead, the frm lobbed the state government and the presdent s offce to have the subsdes mantaned. GM and the governor reached an accommodaton, whose detals were not publshed but appeared to nvolve a partal (but far from complete) reducton n the subsdy. As part of ths deal, GM agreed to an early pay back a $150 mllon loan from the state government whch had been part of the subsdy package. 2. Ford Motor Co. n Brazl 38 Though Ford was ntally cautous n ts approach to the Brazlan market, the company ultmately moved to expand ts automoble producton capacty n the country n a manner smlar to GM. Throughout the 1990s Ford s Brazllan operatons lost money. To reverse the stuaton, Ford decded to speed the ntroducton of new models, reduce fnancng costs and reorganze ts dealer network. A key part of ths strategy was Project Amazon, the constructon of a $700 mllon automoble assembly plant n Ro Grande do Sul to produce subcompact cars for the southern cone market. The plant, whch would be Ford s fourth n Brazl, was to employ 1,500 workers and was ntally scheduled for completon n The project would allow Ford to ncorporate Brazl nto ts global producton strategy of reducng the number of vehcle platforms and engne/transmsson famles on whch ts cars are based, whle smultaneously ncreasng the number of models avalable and the speed wth whch new models are ntroduced. At the global level, Ford ams to desgn and develop vehcles for worldwde markets n fve vehcle centres: four n the Unted States and one n Europe. Smlar to GM, Ford negotated a package of subsdes from the Ro Grande do Sul government n return for locatng n the state. The value of the subsdes appeared to be qute smlar to the package GM receved, consstng of $250 mllon n straght subsdes for the constructon of nfrastructure related to the plant and temporary exemptons from value-added taxes and mport dutes for plant machnery, whose total value was expected to reach $1.5 bllon over the lfe of the project (also set at 15 years). In contrast to GM, Ford had barely ntated constructon of ts project when Brazl s currency crss ht n early Consequently, t had receved lttle n the way of subsdes from the Ro Grande do Sul government, and n fact clamed to be owed $40 mllon n promsed payments. Brazl s crash ht Ford hard, causng the company s sales n the country to fall by 27 per cent n the frst half of 1999 relatve to the same perod n the prevous year. Ford s market share fell to 9 per cent (from 14 per cent two years earler). When the new governor of Ro Grande do Sul announced n May 1999 that he was takng away Ford s subsdes, just as he was threatenng to do to GM, Ford decded to termnate constructon n the state and move the Amazon project to a new locaton n Brazl. Later n 1999, Ford chose the north-east state of Baha, n a relatvely poor regon of Brazl, as the new ste for ts plant, after consderng several other states (Parana and Santa Catarna). Although few detals are known, the package of ncentves the Bahan state government promsed Ford appears to be even more generous than what Ro Grande do Sul had ntally offered. The relocaton of the plant ste has delayed completon of the faclty untl The Baha plant wll be larger than the one orgnally planned for Ro Grande do Sul, requrng a $1.2 bllon ntal nvestment, and wll produce fve dfferent models of the Ford Focus, a subcompact car, wth an annual producton capacty of 250,000 unts. The plant wll have a smlar desgn to GM s Blue Macaw plant, wth supplers of 17 parts housed under the same roof as the automoble assembly faclty. Also lke GM, Ford s supplers wll be prmarly foregn frms, whch work wth Ford n other regons. 3. Intel n Costa Rca 39 In 1996, Intel decded to buld a $300 mllon sem-conductor assembly and testng plant n Costa Rca. Intel, whch at the tme had slcon-wafer fabrcaton plants n Israel and Ireland and sem-conductor assembly and testng plants n Chna, Malaysa and the Phlppnes, chose Costa Rca over alternatve stes n Brazl, Chle, Indonesa and Mexco. What makes the Intel decson notable s that Costa Rca, a low-ncome country wth a populaton of 3.5 mllon, offered lttle n the way of specal nducements to Intel. The frm, wth a few exceptons, receved the standard package of ncentves aval-

28 Should Countres Promote Foregn Drect Investment? 21 able to other foregn frms that set up operatons n the country s EPZs. In contrast to Brazl s aggressve lurng of automoble producton plants, Costa Rca dd not enter nto a bddng war wth other potental locatons. Producton of sem-conductors nvolves three stages: the fabrcaton of slcon wafers and of semconductor chps, and fnal assembly and testng. The frst two stages are the most skll- and captal-ntensve, wth the fxed costs of constructng a fabrcaton plant exceedng $1 bllon by the md-1990s. The assembly and testng stages, n whch wafers are thnned and then cut nto ndvdual chps or ntegrated crcuts, s more labour-ntensve than fabrcaton, but s stll skll- and captal-ntensve relatve to many other manufacturng actvtes. Whle chp fabrcaton plants are concentrated n Japan, the Republc of Korea, Tawan Provnce of Chna and the Unted States, assembly and testng plants are ncreasngly located n developng countres. Durng the 1990s, Intel on average bult a new plant every nne months to meet the steadly ncreasng demand for chps. Gven short product lfe cycles and rapd mtaton by rvals, what Intel needs n ts global producton stes s speed n rampng up producton and access to a dependable, well-educated labour pool. In Costa Rca s EPZs, frms enjoy a seres of tax breaks as long as they engage n export producton. 40 All frms are exempt from () mport dutes on raw materals, components and captal goods; () export, sales, excse and muncpal taxes; and () taxes on corporate ncome durng the frst eght years followng an nvestment, wth a 50 per cent exempton applyng for the next four years. Foregn nvestors face no restrctons on repatratng profts or foregn currency management. Certan EPZs offer addtonal ncentves, ncludng longer-term exemptons from corporate ncome taxes and subsdes for employment or employee tranng. As of 1997, there were 190 companes n eght ndustral parks operatng under Costa Rca s EPZ system. Wth ts rapd expanson of producton capacty, Intel s constantly lookng for new producton facltes. In early 1996 t decded to buld a 400,000 square feet plant, whch would employ 2,000 workers to assemble and test the latest Pentum mcroprocessors. At the tme, Intel antcpated that by 1999 the plant would process one quarter to one thrd of the chps that t manufactured. For Intel, the requred features of a producton ste (gven moderately large fxed costs and the need to begn producton quckly) nclude poltcal and economc stablty, a suffcent supply of professonal and techncal operators (preferably n a non-unon envronment), ease of mportng components and exportng fnal products and mnmal lags n obtanng necessary permts and lcenses. Costa Rca showered Intel wth attenton and nformaton, but dd not employ extraordnary measures to attract the frm. Costa Rca dd offer a few concessons to Intel, all of whch were extended to other frms as well. These ncluded wavng a 1 per cent tax on assets (extended to all frms n EPZs), ncreasng the number of foregn ar carrers allowed to fly nto Costa Rca, lowerng energy prces for large buyers of electrcty, and expandng tranng n electroncs and Englsh n several of Costa Rca s techncal hgh schools. Intel executves stated that they chose Costa Rca based on the country s long hstory of stablty, open trade and nvestment regme, relatvely hgh-qualty prmary and secondary educatonal systems, and recent success n attractng other multnatonal frms n electroncs. C. Evaluaton of FDI promoton cases In ths subsecton we use the nsghts from the theoretcal model developed earler to examne whether on welfare grounds () Brazl was justfed n offerng subsdes to GM and Ford, and (b) Costa Rca would have been justfed n subsdzng Intel. We focus on the ssue of subsdes and not tax breaks, as tax breaks on ncome to foregn captal tend to move a country towards to the resdence prncple and therefore more effcent taxaton (Costa Rca, n partcular, appears to have been close to havng zero taxes on drect foregn captal). Snce state governments are the enttes offerng subsdes n Brazl, we consder whether subsdes to FDI would be lkely to rase state welfare. A full treatment of ths ssue requres a much more complete analyss than we offer here. Our goals are smply to dentfy the key questons behnd whether subsdzng FDI was lkely to rase welfare and, based on casual evdence, to dentfy some possble answers to these questons. The model we developed earler appears to be applcable to both the Brazlan and the Costa Rcan contexts. In each, foregn frms are technologcally advanced relatve to domestc ones; they operate n markets whch appear to be mperfectly compettve at a regonal, natonal, or global level; and they produce prmarly for export (Intel to the world market, and GM and Ford to the broader Mercosur market).

29 22 G-24 Dscusson Paper Seres, No. 9 () Is FDI lkely to rase producton costs for domestc frms (.e. s the multnatonal frm relatvely ntensve n the use of nelastcally suppled factors)? To the extent that the scale of new producton by a multnatonal frm s large, the prces of nelastcally suppled factors used n producton may rse. As we showed earler, a subsdy to FDI n ths context, all else equal, would lower natonal welfare. Hgher ncomes (resultng from the subsdy) to factors employed n domestc frms would smply offset hgher producton costs to domestc frms, and hgher ncomes to factors employed n the multnatonal would be nsuffcent to cover the drect cost of the subsdy. Producton of both automobles and sem-conductors appears to use relatvely ntensvely sklled labour: Intel prefers workers wth at least a hgh-school educaton, and a level of schoolng well above the average n Costa Rca; GM s (and presumably Ford s, also) hourly wage of $9 s well above the Brazlan average. We would expect sklled labour to be relatvely scarce n both Costa Rca, Ro Grande do Sul and Baha, such that the arrval of a multnatonal frm would put upward pressure on the local relatve factor prce. () Are there domestc frms whch compete drectly wth the multnatonal frm? To the extent that a foregn frm faces no domestc rvals, then any ncrease n ts producton n the host economy s unlkely to drectly lower the proftablty of domestc frms. In ths case, a subsdy to FDI would have no drect consequences for competton n the ndustry of relevance to host-economy welfare. (The absence of domestc rvals, however, also means the potental absence of frms whch could beneft from productvty spllovers.) In Brazl, foregn frms overwhelmngly domnate producton of automobles and also appear to domnate producton of automoble parts. In Costa Rca Intel faces no domestc compettors and would appear to have few domestc supplers. () Are there domestc frms whch are lkely to beneft from productvty spllovers, or forward or backward lnkage effects from FDI? If no domestc agents beneft from productvty spllovers from FDI, then a subsdy to FDI wll lower natonal welfare (assumng the absence of other dstortons n the economy). Ths ssue s obvously dffcult to evaluate n full. However, that GM, Ford and Intel face no domestc rvals of any sgnfcance and rely prmarly on foregn frms for parts and components suggests that there are few canddate domestc frms to beneft from productvty spllovers n ether Brazl or Costa Rca (to the extent that such spllovers even exst). Of course, domestc frms n dsparate ndustres may learn basc management sklls smply from observng how multnatonals lke GM, Ford and Intel structure ther supply chans, ntroduce new products, treat ther workers, etc. But such learnng effects would have to be substantal to justfy the subsdes Brazl granted to GM and Ford. Emprcal lterature to date shows lttle evdence of such effects. (v) Is the multnatonal lkely to repatrate most profts to ts home country? To the extent that a foregn frm does not share rents wth host-country supplers or employees, all returns to FDI accrue to shareholders of the multnatonal, who are lkely to be located abroad. Ths ssue s also dffcult to evaluate, but gven the global reach of frms lkely GM, Ford and Intel (and ther clear preference for a non-unon envronment), there s no obvous reason to expect these frms to share profts wth ther host-country workers. Agan, the magntude of such proft-sharng would have to be large to justfy the Brazlan subsdes gven to Ford and GM. A prelmnary evaluaton of the three cases of FDI promoton suggests that the case for subsdes to GM and Ford n Brazl was weak, and that subsdes to Intel n Costa Rca would have been dffcult to justfy. In both Brazl and Costa Rca, subsdynduced ncreases n producton would appear to have been lkely to lay upward pressure on the relatve wage of sklled workers, thus reducng the proftablty of domestc frms. Whle the foregn frms n queston would appear to face few domestc rvals, lmtng the drect consequences of FDI for domestc proftablty, there would also appear to be a few frms n the same lnes of busness whch would beneft from spllovers. A partcularly troublng feature of FDI subsdes n Brazl s that they appeared to result from competton between Brazlan states for the rght to

30 Should Countres Promote Foregn Drect Investment? 23 host foregn plants. Both GM and Ford appeared to have already concluded that they needed to ncrease producton capacty n Brazl. The subsdes, then, may have had lttle effect on whether the automoble companes nvested n the country and only have had an mpact on where they located ther facltes wthn Brazl. The end result of ths nter-state fscal competton for FDI may be lmted to extra burdens for Brazlan taxpayers and excess capacty n the regonal automoble ndustry. V. Concludng remarks In ths paper we have examned whether t makes sense for countres to promote FDI. Our work falls short of an n-depth analyss. The goal has been, nstead, to dentfy the key ssues whch determne whether FDI promoton polces are justfed, and then to examne relevant academc lterature to see whether there s evdence that such condtons appear to hold n practce. Our focus has been, n partcular, on whether spllovers related to multnatonal producton justfy FDI promoton. For small open economes, effcent taxaton may or may not requre lower taxes on captal ncome to foregn resdents than on captal ncome to domestc resdents. Absent market falure, there s no reason to favour FDI over foregn portfolo nvestment. In practce, countres appear to tax ncome from foregn captal at postve rates (f rates that are lower than those for domestc captal) and to subject dfferent forms of foregn nvestment to unequal tax treatment. FDI appears to be qute senstve to hostcountry characterstcs. Hgher taxes deter foregn nvestment, whle a more educated work force and larger consumer and ndustral markets attract FDI. There s also some evdence that multnatonals tend to agglomerate n a manner consstent wth locatonspecfc externaltes. There s weak evdence that FDI generates postve spllovers for host economes. An oft-mentoned possblty s that FDI rases the productvty of domestc agents. Whle multnatonals are attracted to hgh-productvty countres, and to hgh-productvty ndustres wthn these countres, there s lttle evdence at the plant level that FDI rases the productvty of domestc enterprses. Indeed, t appears that plants n ndustres wth a larger multnatonal presence enjoy lower rates of productvty growth. Emprcal research thus provdes lttle support for the dea that promotng FDI s warranted on welfare grounds. Usng a smple theoretcal model, we derved condtons under whch subsdes to FDI would be more lkely to rase host-country welfare. Subsdes to FDI are lkely to be warranted where multnatonals are ntensve n the use of elastcally suppled factors, the arrval of multnatonals to a market does not lower the market share of domestc frms, and FDI generates strong postve productvty spllovers for domestc agents. Emprcal research suggests the frst and thrd condtons are unlkely to hold. In the three cases we examned Ford and GM n Brazl and Intel n Costa Rca t appeared that the second condton held but not the frst or thrd condtons. It thus appears lkely that Brazl s subsdes to foregn automoble manufacturers may have lowered natonal welfare. Costa Rca appears to have been prudent n not offerng subsdes to Intel. There clearly s a need for much more research on the consequences of FDI, but the mpresson from the lterature s that countres should be sceptcal about clams that promotng FDI wll rase ther welfare. A sensble approach for host countres s to presume that subsdes to FDI are not warranted, and so avod preferental treatment of FDI relatve to foregn portfolo nvestment or domestc nvestment. Devatons from such a polcy would be justfed only where there s clear and drect evdence of substantal postve spllovers assocated wth multnatonal producton and where multnatonals are unlkely to choose the optmal level of producton (from the host country s perspectve) wthout a subsdy or other nducement. If t s true that the benefts of FDI for host countres are nsuffcent to justfy FDI promoton polces, then why do host-country governments contnue to offer multnatonals specal treatment? One answer s that governments feel compelled to offer concessons gven that multnatonals subject ther locaton decsons to bddng by potental host-country governments. The approprate response s not to valdate auctons of ths type but nstead to seek nternatonal cooperaton among governments to prevent multnatonals from extractng all gans assocated wth ther presence n host economes. A second answer s that promotng FDI serves the nterests of host-country poltcans. Attractng multnatonals may beneft specfc consttuences, from whom poltcans derve support, or may ft nto poltcal strateges of empre-buldng. Whatever the ex-

31 24 G-24 Dscusson Paper Seres, No. 9 planaton, countres are lkely to be better served by beng cautous about promotng FDI, untl we see strong emprcal evdence that the socal rate of return on FDI exceeds the prvate rate of return. Notes 1 Throughout the paper foregn nvestment refers to nward foregn nvestment. 2 A recent UN study shows that durng the perod over 135 countres reduced regulatory restrctons on FDI (UNCTAD, 1999c). 3 The Group of 24 conssts of: Algera, Côte d Ivore, Egypt, Ethopa, Gabon, Ghana, Ngera and the Democratc Republc of Congo; Argentna, Brazl, Colomba, Guatemala, Mexco, Peru, Trndad and Tobago and Venezuela; Inda, Iran, Lebanon, Pakstan, the Phlppnes, Sr Lanka and the Syran Arab Republc. 4 That small open economes do tax corporate ncome at rates comparable to or hgher than large economes s somethng of a puzzle. See Gordon (1992) and Gordon and MacKe-Mason (1995) for a dscusson. Relatedly, Rodrk (1997) dscusses how globalzaton contrbutes to conflcts between an electorate demandng more socal nsurance and a government able to tax fewer factors of producton. 5 From the perspectve of global welfare, the resdence prncple provdes the bass for effcent nternatonal taxaton. The ncome of all resdents, whether orgnatng from domestc or foregn sources, s taxed at equal rates, whle non-resdent ncome s untaxed. However, f all governments were to grant foregn tax credts (and many do), a small open economy would lose lttle by taxng non-resdent ncome up to the rates at whch ncome s taxed n the home countres of non-resdents (see Av-Yonah, 1999, for a dscusson). 6 One potental source of market falure we do not consder s that related to mperfectons n fnancal markets, whch some suggest may make FDI preferable to foregn portfolo nvestment n that t may be less volatle (see Rodrk and Velasco, 1999, on short-term captal flows). Hausmann and Fernandez-Aras (2000) and Fernandez-Aras and Hausmann (2000) cast doubt on ths hypothess, and also dscuss recent lterature on currency crses and foregn captal nflows. 7 Another argument for promotng FDI s that multnatonal frms oblge governments to bd for the rght to host ther new facltes. If governments fal to offer suffcently generous tax breaks, they may not attract FDI. A multnatonal enterprse consderng a large nvestment project may be able to extract tax concessons because countres have n effect granted t market power by allowng the frm to hold a one-sded aucton. The aucton allows the multnatonal to extract all benefts assocated wth ts presence n a country. A preferred soluton for host countres n ths case s multlateral cooperaton to avod one-sded bddng for FDI. See Bond and Samuelson (1986), Black and Hoyt (1989), and Janeba (1998) for alternatve vews on the subject. 8 That multnatonal enterprses may be technologcally advanced relatve to local frms (Daves, 1977; Teece, 1977) s not n tself a justfcaton for promotng FDI. If multnatonals do possess superor technology, then we expect the rate of return on ther nvestments to be hgher than that for local frms, n whch case multnatonals requre no artfcal nducement to choose the optmal level of FDI. 9 Yet another possblty s that FDI reduces nformatonal barrers to trade and nvestment between the host economy and the rest of the world (Rhee, 1990). Agents elsewhere may lack complete nformaton about factor productvty, government polcy, or the general busness clmate n the host economy. By attractng FDI, the host economy may sgnal to the rest of the world that t has a postve envronment n whch to do busness. In ths case, there are lkely to be dmnshng returns to promotng FDI. After the frst several multnatonal frms have establshed themselves n a country, any sgnal from addtonal FDI s lkely to be unnformatve. 10 Other research suggests FDI may be detrmental to the host economy. Recent varants of ths argument nclude the dea that, once establshed n a country, multnatonals favour hgh trade barrers and wll lobby the host-country government to rase tarffs (Bhagwat et al., 1987; Blongen and Ohno, 1998). There s some emprcal support for ths vew (Blongen and Fglo, 1998). The dffculty of evaluatng the economc mpact of potental polcy changes resultng from FDI leaves these ssues beyond the scope of ths paper. 11 We nclude all countres for whch data are avalable. 12 The non-g-24 countres were chosen to represent regonal dversty, mportant FDI sources (Japan), and countres wth polces that are relatvely frendly towards FDI (Costa Rca, Ireland, Thaland). 13 See Madan (1999) for more detals on EPZs. 14 Ths statement s based on the presumpton that foregn captal s more moble than domestc captal. 15 A comparson s further complcated by the prolferaton of blateral nvestment treates and the ndrect effects of trade polces on FDI. See UNCTAD (1999a and 1999b). 16 However, gven wdespread evason of captal gans taxes by non-resdent foregners n emergng economes, the effectve captal gans tax may be zero n many cases. 17 See Markusen (1995, 1998) for surveys of the lterature. 18 Formal theores of multnatonal enterprses address the orgns of ownershp and locaton advantages n multnatonal producton, but not nternalzaton advantages. Whle there s extensve nformal lterature on transacton costs and the organzaton of multnatonal producton (Caves, 1995), there s as of yet lttle formal modellng of why multnatonal frms choose to own foregn subsdares versus lcensng technology or contractng out producton. 19 Although, FDI may lower ncomes for some factors of producton n some countres. 20 To gve an example: for US sales to Germany, the rato would be sales by afflates of US multnatonals n Germany dvded by the sum of these afflate sales plus US exports to Germany. 21 See Hanson (2000a and 2000b) for surveys of the lterature and dscusson of these ssues. 22 Atken et al. (1997) take a smlar approach. 23 Many Japanese frms whch nvest n the Unted States are part of ndustral groups, whch may nfluence ther response to host-regon economc condtons (Belderbos and Sleuwaegen, 1996). 24 For a detaled dscusson of manufacturng plants n developng countres see Tybout (2000). In the Unted States, Fglo and Blongen (1999) fnd that countes n South Carolna wth more employment n multnatonal frms experence hgher wage growth, lower growth n publc

32 Should Countres Promote Foregn Drect Investment? 25 expendture, and shfts n the composton of publc spendng away from educaton towards transportaton and publc safety. 25 For a survey of the lterature see Blomstrom and Kokko (1998). 26 Caves also fnds that for Canadan manufacturng ( ) ndustry average proftablty of domestc plants s postvely correlated wth ndustry average proftablty of foregn plants and negatvely correlated wth the average share of foregn plants n ndustry sales (whch he nterprets as a pro-compettve effect of FDI). 27 See Veugelers and Cassman (1999) for evdence that the propensty to transfer technology abroad s not lnked to multnatonalty per se but rather to access to nternatonal markets. 28 Other works cte less drect evdence of spllovers related to FDI. In many contexts, multnatonal frms develop backward lnkages wth local ndustry (Behrman and Wallender, 1976; Lall, 1980) or provde tranng to local workers (Chen, 1983; Gehrschenberg, 1987). These actvtes may create channels through whch spllovers could flow from multnatonals to host economes, but ther occurrence n no way establshes that such spllovers actually exst. Anecdotal evdence of FDI demonstraton effects, n whch local frms learn about modern technology or management technques by watchng multnatonals (Blomstrom and Kokko, 1998), are plausble but pure conjecture n the absence of formal statstcal analyss. 29 In a related work, Gorg and Strobl (2000) fnd that n Ireland the larger the presence of multnatonal frms n the sector, the smaller s the sze of domestc startup frms. 30 It s mportant to note that these results are for the drect mpact of FDI on domestc enterprses n the same lnes of actvty. It s possble that FDI rases the productvty of domestc agents through ndrect, general-equlbrum effects, such as backward-forward lnkages or productvty spllovers common to all ndustres. 31 There are other potental spllovers from multnatonals, whch n the nterest of space are not dscussed here. See Blomstrom and Kokko (1998) for a dscusson of emprcal research on the mpact of multnatonals on worker tranng, ndustry lnkages, ndustry competton, and source-country economes. 32 Though subsdes for FDI are typcally negotated before MNEs begn producton, makng them appear lump-sum n nature, the fact that subsdes are often proportonal to plant capacty and delvered n portons as a project moves towards completon makes them smlar n effect to perunt producton subsdes (e.g. magne capacty subsdes n a world n whch frms choose capactes and then engage n Bertrand prce competton). 33 These are that b 0, B 0, and b >1/B. By the secondorder condtons to proft maxmzaton, Cournot stablty condtons requre that r 11 + r 12 B 0 and R 11 + R 12 B Industry 1 may, for nstance, produce an nput that s consumed by domestc frms and then exported n the form of a fnal good (e.g. hard dsk drves whch are assembled nto personal computers). 35 We assume that foregn frm 1 repatrates to ts home country any profts t earns n the host economy. 36 That s, the market falure n ths case s due to mperfect competton, not to multnatonal producton. 37 Ths subsecton s based on materal from the followng sources: Intervew wth Mustafa Mohaterem, Chef Economst for General Motors, 31 May 2000; Frtsch (1999: A11); Kerwn and Muller (1999: 114); Frtsch and Whte (1999: A1); Smonan (1997: 5). GM pcks supplers for Blue Macaw, Automotve News Europe (1997: 8); Crag (1999: 1); Kolodzejsk et al. (1999: 66). 38 Ths subsecton s based on materal from the followng sources (n addton to those lsted n the prevous footnote): Jac s turnaround team, Automotve News Internatonal (1 February 2000: 16); Ford plans to spend $1 bllon on ts Brazlan operatons, The Detrot News (22 September 1999: B3); Connelly (2000: 1); Mullgan (2000: 5). 39 Ths subsecton s based on materal from Spar (1998) and Renhardt (2000: 110). 40 As n many countres, frms n Costa Rca s EPZs are allowed to sell a fracton of ther output on the domestc market (though few actually do). References AITKEN B, HANSON G and HARRISON A (1997). Spllovers, foregn nvestment and export behavour. Journal of Internatonal Economcs, 43: AITKEN B and HARRISON A (1999). Do domestc frms beneft from foregn nvestment? Evdence from Venezuela. Amercan Economc Revew, 89: AITKEN B, HARRISON A and LIPSEY R (1996). Wages and foregn ownershp: A comparatve study of Mexco, Venezuela and the Unted States. 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33 26 G-24 Dscusson Paper Seres, No. 9 BORENSZTEIN E, DE GREGORIO J and LEE J-W (1998). How does foregn drect nvestment affect economc growth? Journal of Internatonal Economcs, 45: BRAINARD L (1997). An emprcal assessment of the proxmty-concentraton tradeoff between multnatonal sales and trade. Amercan Economc Revew, 87: CAVES RE (1974). Multnatonal frms, competton and productvty n host-country markets. Economca, 41: CAVES RE (1995). Multnatonal Enterprse and Economc Analyss (second edton). Cambrdge, Cambrdge Unversty Press. CHEN EKY (1983). Multnatonal Corporatons, Technology and Employment. London, Macmllan. CONNELLY M (2000). Ford whttles platforms. Automotve News, 19 June. CRAIG C (1999). Ford, General Motors may lose ther Brazlan ncentves. Detrot Free Press, 23 March. DAVIES H (1977). Technologcal transfer through commercal transactons. Journal of Industral Economcs, 26: DIXIT A and GROSSMAN G (1986). Targeted export promoton wth several olgopolstc ndustres. 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34 Should Countres Promote Foregn Drect Investment? 27 MARKUSEN J and VENABLES A (1999b). Foregn drect nvestment as a catalyst for ndustral development. European Economc Revew, 43: MATOUSCHEK N (1999). Foregn drect nvestment and spllovers through backward lnkages. CEPR Dscusson Paper No London, Centre for Economc Polcy Research. MOTTA M, FOSFURI A and RONDE T (1999). Foregn drect nvestment and spllovers through workers moblty. CEPR Dscusson Paper No London, Centre for Economc Polcy Research. MULLIGAN M (2000). Survey FT Auto. Fnancal Tmes, 29 February. PRICE WATERHOUSE (varous years). Corporate Taxes: A Worldwde Summary. New York. RAZIN A and SADKA E (1991). Internatonal tax competton and gans from tax harmonzaton. Economcs Letters, 37: RAZIN A, SADKA E and YUEN CW (1998). A peckng order of captal flows and nternatonal tax prncples. Journal of Internatonal Economcs, 44: REINHARDT A (2000). The new Intel. Busness Week, 13 March. RHEE YW (1990). The catalyst model of development: Lessons from Bangladesh s success wth garment exports. World Development, 18: RHEE YW and BELOT T (1990). Export catalysts n low-ncome countres. World Bank Dscusson Paper No. 72, Washngton, DC, World Bank. RODRIGUEZ-CLARE A (1996). Multnatonals, lnkages and economc development. Amercan Economc Revew, 86: RODRIK D (1997). Has Globalzaton Gone Too Far? Washngton, DC: Insttute for Internatonal Economcs. RODRIK D and VELASCO A (1999). Short-term captal flows. NBER Workng Paper, no SIMONIAN H (1997).GM plans to develop car n Brazl. Fnancal Tmes, 3 June. SPAR D (1998). Attractng hgh technology nvestment: Intel s Costa Rca plant. World Bank Occasonal Paper No. 11, Washngton, DC, World Bank. TEECE DJ (1977). Technology transfer by multnatonal frms: The resource cost of transferrng technologcal knowhow. Economc Journal, 87: TYBOUT J (2000). Manufacturng frms n developng countres: How well do they do, and why? Journal of Economc Lterature, 37: UNCTAD (1999a). Investment-Related Trade Measures. New York: Unted Natons. UNCTAD (1999b). Trends n Internatonal Investment Agreements: An Overvew. New York: Unted Natons. UNCTAD (1999c). World Investment Report 1999: Foregn Drect Investment and the Challenge of Development. New York and Geneva, Unted Natons. VEUGELERS R and CASSIMAN B (1999). Importance of nternatonal lnkages for local know-how flows. CEPR Dscusson Paper No London, Centre for Economc Polcy Research. WHEELER D and MODY A (1992). Internatonal nvestment locaton decsons. Journal of Internatonal Economcs, 33: YEAPLE SR (1999). The determnants of US outward foregn drect nvestment: Market access versus comparatve advantage (mmeo). Madson, Unversty of Wsconsn.

35 28 G-24 Dscusson Paper Seres, No. 9 Appendx DERIVATION OF THE WELFARE EFFECTS FOR THE HOST ECONOMY In ths appendx, we derve a more complete expresson for the change n host-economy welfare, as stated n equaton (9). We begn by dervng equlbrum expressons for the change n output of domestc frms and foregn frm 1. Totally dfferentatng the frst-order condtons to proft maxmzaton for foregn frm 1, we obtan: 1 1 R 1 11 dy1 + R12b1'dY1 D dz + ds = 0 (A1) Cournot stablty condtons (see note 34) mply that 1 1 1/(R11 + R12b1') 0 1 (A2) whch defnes the curvature of the revenue functon for foregn frm 1. A larger value for 1 mples that margnal addtons to revenue change relatvely lttle as output expands (whch we expect to be the case where demand s more nelastc). Usng (A2), we derve the change n output for foregn frm 1 as, dy1 = 1(ds D1dz) (A3) Ths shows that output for foregn frm 1 rses only f the unt producton subsdy exceeds the ncrease n margnal costs from expandng output (as dscussed n the text). Smlarly, totally dfferentatng the frstorder condtons for domestc frm 1, we obtan, r 1 11 dy1 + r12b1'dy1 + r13λ1' B1'dy dz = 0 (A4) Cournot stablty condtons mply that 1 1 γ1 1/(r11 + r12b1' + r13λ1' B1') 0 1 (A5) whch allows us to wrte: dy1 = γ1dz (A6) For domestc frm 1, then, output unambguously falls (the ndrect strategc productvty effect s mplctly emboded n the Cournot stablty condton, snce foregn frm 1, the source of the spllovers, s a drect compettor of domestc frm 1). For domestc frms =2,,N, the dervaton s somewhat dfferent, snce these frms by assumpton do not nteract strategcally wth foregn frm 1. Totally dfferentatng the frst-order condtons for these frms, we obtan: r 1 11 dy + r12b 'dy + r13λ 'dy dz = 0 (A7)

36 Should Countres Promote Foregn Drect Investment? 29 Usng the Cournot stablty condtons for these frms, whch are analogous to (A2), we fnd: dy = γ (dz r13λ 'dy 1) (A8) Defnng ρ r λ, whch s the effect of the productvty spllover on the margnal productvty of output 13 (whch we expect to be postve f the spllover s postve) and usng equaton (A3), we fnd that dy = γdz + ρ 1(ds D1dz) (A9) For domestc frms that do not compete aganst foregn frm 1 n product markets, the FDI subsdy has two effects, whch work n opposte drectons (as dscussed n the text). The frst, emboded n the frst term on the rght n (A9), s that rsng factor costs lead to a reducton n output, and the second, emboded n the second term on the rght n (A9), s that the productvty spllover, to the extent t s postve, leads to an expanson of output. Output for a gven frm rses f the productvty boost from the spllover more than offsets the rse n margnal cost from the ncrease n factor prces. Combnng equaton (8) n the text wth (A3), (A6) and (A9), we obtan the followng expresson for the change n the wage of sklled labour: dz = ds γ 1 γ ρ D ( + D γ ρ 1 + D ) 1 (A10) The sklled wage rses unambguously f productvty spllovers from multnatonal producton are postve. In ths event, (A3), (A6), (A9) and (A10) together mply that dy 1 s postve, dy 1 s negatve, and dy for 1 s of ambguous sgn (though we know from equaton (8) n the text that the aggregate change n domestc frm output must be negatve). Fnally, combnng equaton (9) n the text wth (A3), (A6), (A9) and (A10), we obtan a more complete expresson for the change n host-economy welfare from a small ncrease n a unt producton subsdy to foregn frm 1 (startng from s=0): 1 γ dw = ds β + φγρ γ + D1( γρ + D1) 1 1 φ γ 1 Y1 ( γρ + D1) 1 1 γ 1 (A11) If productvty spllovers are non-negatve, then all ndvdual parameters are non-negatve n equaton (A11), n whch case, dw sgn = ds sgn φ γ 1 Y1 β + φγρ ( γρ + D1) γ 1 (A12)

37 30 G-24 Dscusson Paper Seres, No. 9 To nterpret equaton (A12), consder each term nsde the brackets on the rght. The frst term s the drect effect of spllovers on domestc profts. Postve spllovers ncrease revenues and profts drectly, as captured by ß (see man text and precedng appendx for defntons). The second term s the strategc effect of domestc spllovers on profts. Even f hgher factor costs make a domestc frm lower ts output, postve spllovers make the frm more aggressve relatve to ts foregn rval. The frm lowers ts output by less than t would have n the absence of spllovers. Spllovers thus moderate the loss n market share a frm experences from an ncrease n factor costs (but only for frms that do not compete drectly aganst foregn frm 1). (Of course, the mpact of the spllover may be so large that the frm rases ts output, even n the face of rsng factor costs. Some domestc frms, however, must lower ther output (see equaton (8).) Ths effect s the product of three terms: φ, the mpact of the foregn rval frm s output response to a change n the domestc frm s output on the domestc frm s profts; γ, the margnal responsveness of domestc frm profts to changes n domestc frm output; and ρ, the responsveness of domestc frm s output to productvty spllovers from FDI. The thrd term on the rght n (A12) captures the loss n domestc profts due to rsng factor costs. Ths term depends on the nteracton between two effects: the ncrease n demand for labour at unchanged factor prces, whch s the sum of labour demand from foregn frm 1 (D 1 ) and the extra labour demand from domestc frms nduced by productvty spllovers (γ ρ, whch s the output response of a domestc frm to the spllover); and the strategc effect of hgher factor costs on domestc frm profts (the rato term), whch results n domestc frms lowerng output and cedng market share to the foregn rval frm. The fourth term on the rght captures the cost of the subsdy, whch ntutvely s proportonal to the level of producton by the multnatonal frm.

38 Should Countres Promote Foregn Drect Investment? 31 G-24 Dscusson Paper Seres* Research papers for the Intergovernmental Group of Twenty-Four on Internatonal Monetary Affars No. 1 March 2000 Arvnd PANAGARIYA The Mllennum Round and Developng Countres: Negotatng Strateges and Areas of Benefts No. 2 May 2000 T. Ademola OYEJIDE Interests and Optons of Developng and Least-developed Countres n a New Round of Multlateral Trade Negotatons No. 3 May 2000 Andrew CORNFORD The Basle Commttee s Proposals for Revsed Captal Standards: Ratonale, Desgn and Possble Incdence No. 4 June 2000 Katharna PISTOR The Standardzaton of Law and Its Effect on Developng Economes No. 5 June 2000 Andrés VELASCO Exchange-rate Polces for Developng Countres: What Have We Learned? What Do We Stll Not Know? No. 6 August 2000 Devesh KAPUR and Governance-related Condtonaltes of the Internatonal Rchard WEBB Fnancal Insttutons No. 7 December 2000 Andrew CORNFORD Commentary on the Fnancal Stablty Forum s Report of the Workng Group on Captal Flows No. 8 January 2001 Ilan GOLDFAJN and Can Flexble Exchange Rates Stll Work n Fnancally Gno OLIVARES Open Economes? * G-24 Dscusson Paper Seres are avalable on the webste at: Copes of G-24 Dscusson Paper Seres may be obtaned from c/o Edtoral Assstant, Macroeconomc and Development Polces Branch, Dvson on Globalzaton and Development Strateges, Unted Natons Conference on Trade and Development (UNCTAD), Palas des Natons, CH-1211 Geneva 10, Swtzerland; Tel. (+41-22) ; Fax (+41-22) ; E-mal: [email protected]