Use and misuse of investment incentives
Investment incentives are pervasively used, often misused, and occasionally unaccounted for. Their effectiveness has been hotly debated in public and academic circles for many years, but the complexity of assessing their impact means that evidence of their effectiveness has been largely inconclusive.
The rationale for offering incentives is Pigou’s classic argument that there may be benefits from investment externalities that accrue to a country’s citizens that are non-appropriable by the investing firm. For example, the setting up of an advanced manufacturing facility may create new skills and knowledge within a region that would not have been possible without that particular investment. Since such externalities (or spillovers) create benefits that cannot be captured by the investing firm, governments may offer some form of incentive to induce the firm to invest in the region if it believes that that investment would not happen without such support. In theory, incentives should amount to no more than the estimated additional benefit to society.
Over the years, incentives have taken many forms, such as tax breaks, corporate income tax credits, subsidised rates of financing, and free land to mention a few; and they’re offered by almost all countries worldwide. In fact, an UNCTAD survey amongst investment promotion agencies in over 100 countries from all regions of the world showed that by the mid-1990s nearly all countries used some form of investment incentives, and many more have been introduced since then.[1]
Those sceptical about their effectiveness argue that other investment and location determinants – such as natural resources, wages, political stability, skills and market size – are far more important than incentives, and that at best they are only marginally effective.
It has also been argued that in many cases the competition between regions or countries to attract foreign direct investment (FDI) has led to what is known as the ‘race to the bottom’, such that most of the benefits from incentives accrue to the investing firm rather than the tax-paying public at large.
The infamous bidding war between Vietnam and the Philippines for the setting up of a new production plant by New York based Cannon Inc. in 2001 is just one example. The corporation was set to create some 300 new jobs in the Philippines until Vietnam offered a substantially bigger incentive package that would not have been allowed under Philippine law.[2] As a result of a more generous fiscal package, Vietnam won the bidding war, edging out the Philippines with an additional two-year tax holiday.[3]
With the exception of European Union State Aid regulations (which impose some restrictions on the use of discretionary subsidies to firms), attempts to regulate this sort of competition have been feeble and largely absent.
Thus, in spite of their huge cost and somewhat uncertain returns, there is no doubt that state and local governments will continue to make extensive use of incentives in their attempt to spur investment for economic development. Effectively, no government would want to miss out on encouraging domestic investment or to lose out on potential investment to other countries/regions. Incentives remain one of the few, “easy-to-use” policy instruments which influence firms’ behaviour in the short run.
They will not only continue to be used extensively, but they are also bound to become more important in both multinationals’ and domestic firms’ investment decisions. It has long been argued that in an increasingly globalised world, firms are becoming more footloose and hence more sensitive to incentives.[4] This effect is likely to be reinforced by the ongoing coordination between governments that seek to tackle concerns over aggressive tax avoidance by multinational firms.[5] In addition, because such incentives tend to be more effective when competing countries’ characteristics are broadly similar, we should also expect increased sensitivity as emerging economies continue to make inroads in the race for FDI.
Such developments need not necessarily be a bad thing. Focusing first on FDI, recent research by Oxford economist Beata Javorcik on developing countries shows that FDI does not only increase productivity, but also creates jobs that pay higher wages and offer more training.[6] If incentive awarding agencies are able to make educated guesses about the additional benefits that investment would bring to their region, then cross-country competition may lead multinationals to locate where they are valued most.
Similarly, there exists evidence of the positive impact of incentives awarded to domestic firms. For example, a study on subsidies awarded to Italian firms finds that incentives have a positive impact on employment (although not on productivity).[7]
This is not to say that incentives are always beneficial. Rather, I am suggesting that incentives may have negative but also positive impacts. The net effect will depend on factors that are specific to the region, the project and the incentive design.
[1] UNCTAD (1995) World Investment Report: Transnational Corporations and Competitiveness, New York: United Nations publications.
[2] Charlton, A. (2003) ‘Incentive Bidding for Mobile Investment: Economic Consequences and Potential Responses’, OECD Working Paper No. 203.
[3] SOMO (2011) ‘Revisiting the Rationale Behind Fiscal Incentives for Investments’, article published by the Centre for research on Multinational Corporations.
[4] Bartik, T.J. (2007) ‘Solving the Problems of Economic Development Incentives’, in Reining in the Competition for Capital, Markusen A., ed. W.E. Upjohn Institute of Employment Research, pp. 103-140.
[5] OECD (2015) Explanatory Statement: OECD/G20 Base Erosion and Profit Shifting Project, OECD.
[6] Javorcik, B. (2014) ‘Does FDI Bring Good Jobs to Host Countries?’ World Bank Policy Research Paper 6936
[7] Bernini, C. and Pellegrini, G. (2011) ‘How are growth and productivity in private firms affected by public subsidy? Evidence from a regional policy’, Regional Science and Urban Economics 41, pp. 253-265.
