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Dr Gift Mugano
The attitude towards inward foreign direct investment (FDI) has changed considerably over the last decades, as most countries have liberalised their policies to attract all kinds of investment from multinational corporations (MNCs).

On the expectation that MNCs will raise employment, exports, or tax revenue, or that some of the knowledge brought by the foreign companies may spill over to the host country private sector, many governments have also introduced various forms of investment incentives, to encourage foreign owned companies to invest in their jurisdiction.

These include Organisation for Economic Cooperation and Development (OECD) country governments, which, from a developing country viewpoint, have sometimes been considered as discouraging FDI flows toward less developed economies.

The most powerful arguments in favour of such incentives are based on the prospect for knowledge spill overs.

Since technology to some extent is a public good, foreign investment can result in benefits for host countries even if the MNCs carry out their foreign operations in wholly-owned affiliates. These benefits take the form of various types of externalities or “spill overs”.

For instance, local firms may be able to improve their productivity as a result of forward or backward linkages with MNC affiliates, they may imitate MNC technologies, or hire workers trained by MNCs.

The increase in competition that occurs as a result of foreign entry may also be considered a benefit, in particular if it forces local firms to introduce new technology and work harder.

However, the foreign MNCs will not include these spillovers in their private assessment of the costs and benefits of investing abroad, and may therefore invest less than what would be socially optimal.

If, on the other hand, the benefits of FDI are adequately reflected in the private return accruing to an investment, market incentives ensure that this investment effectively takes place and no special government incentives should be necessary.

The motive for public subsidies to foreign investors is to bridge the gap between the private and social returns, thus promoting larger inflows of FDI.

Today’s discussion examines whether international investment incentives can be justified on the basis of academic research on the host country effects of FDI.

Special attention is paid to “financial incentives” given to multinationals to compensate them for being unable to reap all the benefits of their activities.

Some alternative policy measures available for governments to benefit from inward foreign investment are also discussed.

Investment incentives and FDI

There is a strong consensus in the literature about why multinationals invest in specific locations.

MNCs are mainly attracted by strong economic fundamentals in the host economies. The most important ones are market size and real income levels, skill levels in the host economy, the availability of infrastructure and other resource that facilitates efficient specialisation of production, trade policies, and political and macroeconomic stability.

The relative importance of the different fundamentals varies depending on the type of investment.

For instance, evidence has shown that foreigners investing in the United States and China have mainly been attracted by the large market size, while multinationals investing in Singapore focus on the availability of skilled labour, good infrastructure and political and macroeconomic stability.

The location of FDI may also be influenced by various incentives offered by governments to attract multinationals.

These incentives take a variety of forms. They include fiscal incentives such as lower taxes for foreign investors, financial incentives such as grants and preferential loans to MNCs, as well as other incentives like market preferences and monopoly rights.

Although no reliable statistics of the size of these incentives are available, a detailed study by United Nations Conference for Trade and Development (UNCTAD) shows that international investment incentives play only a limited role in determining the international pattern of foreign direct investment.

According to UNCTAD, factors like market characteristics, relative production costs and resource availability explain most of the cross-country variation in FDI inflows. Nevertheless, UNCTAD study also reviewed in some instances international investment incentives plays a role for MNC decisions on the margin.

For instance, if a firm has two or less similar location alternatives for its investment, incentives can tilt the investment decision.

This is particularly the case for financial incentives like grants and other types of subsidies, since they reduce the initial costs of the investment and lower the risk of the FDI project.

The question is whether the host country’s costs for providing the incentives – in terms of grants, subsidies, and other expenses – are justified. Are investment incentives likely to yield benefits that are at least as large as the costs?

To answer this question, it is convenient to begin by considering a hypothetical case where foreign MNCs do not differ in any fundamental way from local firms (although we know that the reality is that MNCs typically possess firm-specific intangible assets that are not generally available in the host countries).

Even in this extreme case, it may be possible to construct theoretical arguments in favour of investment incentives that are based on expected employment gains or faster economic growth resulting from FDI inflows.

The costs of the initial investment incentive could arguably be recouped over time as the economy (and thereby the tax base) grows thanks to the FDI inflows. However, there are several strong arguments against this type of incentives.

Firstly, there are obvious problems in identifying those marginal cases that would not enter the host economy without the incentives.

Secondly, it is difficult make reliable calculations about the expected future benefits in terms of growth, employment, or tax revenue.

This is particularly complex in cases where FDI projects that are driven by investment incentives rather than economic fundamentals of the host country.

The reason is that these investors are likely to be relatively footloose, and could easily decide to move on to other locations offering even more generous incentives before the expected benefits in the first location have been realised.

Thirdly – and most importantly – if foreign investors do not differ in any fundamental way from local investors, subsidising FDI will distort competition and may generate significant losses among local firms.

Thus, it is hardly possible to justify investment incentives focusing on foreign MNCs that do not differ fundamentally from local companies. At the same time, it should be noted that this conclusion does not rule out public policy intervention in situations where unemployment, insufficient investment, and weak growth are central policy problems.

Instead, the policy prescription is that the problems should be addressed with policies that do not differentiate between foreign and local investors.

Are foreign direct investment incentives then justified?

Based on the argument that foreign firms can promote economic development and growth, many countries have introduced various investment incentives to encourage foreign MNCs to invest in their market.

Incentives can only be justified if the foreign firms differ from local companies in that they possess some firm specific intangible asset that can spill over to local firms.

In that case, the foreign investor’s private benefits are lower than the social benefits (including the spill overs) and total foreign investment will fall short of the optimal amount unless various investment incentives compensate the foreign investor.

Given the empirical evidence on spill overs, there are therefore reasonable arguments in favour of investment incentives.

At the same time, there are good reasons to remain cautious in granting incentives focusing exclusively on foreign investors.

This is rightly so because FDI incentives in many cases prepares the ground for rent seekers.

It is well known from the trade literature that selectivity, in combination with lack of transparency, increases the risk for rent seeking and corruption.

Policy measures that focus on broad and general forms of support that are available to all firms, irrespective of nationality, tend to reduce rent-seeking and corruption.

Moreover, competition among governments (national or local) to attract FDI may create problems.

When governments compete to attract FDI there is a tendency to overbid and the subsidies may very well surpass the level of the spill over benefits, with welfare losses as a result.

These problems may be particularly severe if the incentives discriminate against local firms and cause losses of local market shares and employment.

However, the most important argument against investment incentives focusing exclusively on foreign firms is based on the evidence that spill overs are not automatic, but depend crucially on the conditions for local firms.

The potential for spill overs is not likely to be realised unless local firms have the ability and motivation to learn from foreign MNCs and to invest in new technology.

This implies that investment incentives aiming to increase the potential for spill overs may be inefficient unless they are complemented with measures to improve the local learning capability and to maintain a competitive local business environment.

Taking these arguments into account, it is possible to propose some conclusions for the design of investment incentives.

First and foremost, the incentives should be available on equal terms to all investors irrespective of industry and nationality of investor, rather than based on discretionary decisions.

The motive for supporting foreign investors – including existing investors that may consider expanding their activities – is to equalise social and private returns to investment.

The reason for subsidising local firms is to strengthen their capacity to absorb foreign technology and skills.

The incentives should not be of an ex ante type that is granted prior to the investment, but they should instead promote those activities that create a potential for spill overs.

In particular, these include education, training, and research and development activities, as well as linkages between foreign and local firms.

An advantage of performance based incentives is that they may affect the entire stock of investments, rather than just the flow of new investment.

Given their broad scope, the investment incentives in question should be considered part of the economy’s innovation and growth policies rather than a policy area that is only of relevance for foreign investors.

In addition to investment incentives of the type discussed above, governments should also consider their efforts to modernise infrastructure, raise the level of education and labour skills, and improve the overall business climate as parts of their investment promotion policy.

As noted repeatedly above, these are important component of the economic fundamentals that determine the location of FDI.

In addition to attracting FDI and facilitating the realisation of spillovers, these policies will also promote growth and development of local industry.

This, after all, is one of the ultimate goals of government intervention in general. Ireland seems to be an excellent example of the advantages of such policies.

There is no doubt that the Irish success in attracting FDI and benefiting from such investments, to a large extent stems from having the right “fundamentals”.

Ireland has for a long time been considered a preferred location for FDI, but it should be noted that the various incentives attracting foreign investors, including low taxes, good infrastructure, access to the EU market, and continuously increasing labour skills, have also been available to local companies. This is a likely reason for the positive effects of inward FDI on local industry.

A similar example is provided by Sweden, which was the world 7th largest recipient of foreign investment during the second half of the 1990s. While Sweden provides an attractive business environment, industrial policies do not distinguish between foreign and domestic investors.

Concluding remarks

Foreign direct investment can play an important role in raising a country’s technological level, creating new employment, and promoting economic growth. Many countries are therefore actively trying to attract foreign investors in order to promote their economic development.

However, there are different ways to attract FDI. International experience has shown that the use of investment incentives focusing exclusively on foreign firms, although motivated in some cases from a theoretical point of view, is not a recommended strategy.

The main reason is that the strongest theoretical motive for financial subsidies to inward FDI – spill overs of foreign technology and skills to local industry – is not an automatic consequence of foreign investment.

The potential spill over benefits are realised only if local firms have the ability and motivation to invest in absorbing foreign technologies and skills. To motivate subsidisation of foreign investment, it is therefore necessary, at the same time, to support learning and investment in local firms as well.

Hence, rather than proposing narrowly defined FDI policies, it is argued that effective investment incentive packages should be seen as part of the country’s overall industrial policy, and be available on equal terms to all investors, foreign as well as local.

The incentives should focus in particular on those activities that create the strongest potential for spill overs, including linkages between foreign and local firms, education, training, and research and development.

It should also be noted that the country’s industrial policies in general are important determinants of FDI inflows and effects of FDI.

By enhancing the local supply of human capital and modern infrastructure and by improving other fundamentals for economic growth, a country does not only become a more attractive site for multinational firms, but there is increased likelihood that its private sector benefits from the foreign participation through spill over benefits.

As the Government of Zimbabwe is coming up with orthodox policies measures aimed at attracting FDI, lessons from this discussion should be taken into account.

Together we make Zimbabwe great.

Dr Mugano is an Author and Expert in Trade and Competitiveness. He is a Research Associate at Nelson Mandela Metropolitan University and a Senior Lecturer at the Zimbabwe Ezekiel Guti University.

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