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Are Fiscal Incentives an Effective Way to Attract Foreign Investment?

Fiscal policy is a very powerful government instrument, which influences the national economy of the country.

It determines the business climate and can give incentives to do business with both national and international companies. Fiscal policy has also a significant influence on the national economy on the global scale, as some countries use low taxes as their competitive advantage. According to Azemar (2008, p. 88), low taxation is an “opportunity to compensate for weak economic fundamentals”. Taxation policy can be used to attract multinational corporations’ investment, suggesting relatively low tax rates and a simplified tax climate. However, the effectiveness of fiscal incentives depends on the entire economic and business environment of a certain country, including its economic development, political stability, and international relations with other countries. Also, there is a significant difference between the impact of national fiscal policy on the economies of developed and developing countries on a global scale.

Fiscal incentives are measures, conducted by governments, and aimed to decrease the tax burden on the economic entities.

According to Rajan (2004, p.13), these measures include “reduced corporate income taxes; tax holidays; investment allowances and tax credits; accelerated depreciation; exemptions from selected indirect taxes; and export processing zones (EPZs) – and their relative merits”, and some others. Most of such incentives increase the expected profit of the companies and stimulate them to conduct their business exactly in the countries where such measures are carried out.

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Fiscal incentives can attract a foreign company in two ways.

  • First, the latter may be attracted by the country’s taxation system in terms of high perspectives of doing business there. In this case, companies invest in countries because they realize that their after-taxation profit will be relatively high in such countries.
  • Second, international companies may use such taxation systems to optimize their corporate finances and avoid high taxation without real investment in the economy.

Indeed, many countries have attracted huge inflows of money and capital, decreasing their taxes and eliminating all borders for capital inflows. According to Morisset (2003, p.1) “in 1985-94, foreign direct investment grew more than fivefold in tax havens in the Caribbean and South Pacific”. Such countries are known as offshore zones. They usually suffer from the lack of their natural resources, and underdevelopment of their industries, so a nice taxation climate is their only competitive advantage to fill their budgets, create new working places, and develop their entire economies. However, such capital inflows are usually artificial, and they ate usually associated with reverse outflows of capital out of the country in the future. In addition, the second type of capital inflows depends on the financial sectors of the economies, which do not shine in most countries. Consequently, governments are more interested in attracting FDI from other countries.

This issue is very topical, especially in developing countries, which suffer from poverty and lack of money. FDI in these countries can change the situation to be better because FDI has many positive effects on the national economies. They stimulate GDP growth, create new working places, and develop the entire economy. Significant sums of foreign direct investment can turn a country from dust to being productive. However, governments must find a way to attract FDI. Furthermore, sometimes FDI can do much harm to national security when strategically important companies are tried to be privatized.

When investing in developing countries, investors usually face high risks, which can not compensate for possible benefits from investing in such countries, such as “commercial and regulatory policies, the characteristics of their labor markets, the nature of competition in product markets, the cost and local availability of intermediate supplies, proximity to final markets, and a host of other attributes that influence the desirability of an investment location” (Hines 1999, p. 308).

Azemar (2008) defined the most important factors of the country’s attractiveness to investors. These include main macroeconomic indicators (GDP, GDP per capita), trade openness, exchange rate, distance, and others. According to Unctad (1996), the attractiveness of certain countries also depends on the “quality of infrastructure, the ease of doing business and the availability of skills”. Therefore, there are many controversies concerning the impact of fiscal incentives on the attraction of FDI. There are both positive and negative thoughts about this issue.

Vernon (1977) and Markusen (1995) claim that the effects of lower taxes on FDI are dramatically small, if not unnoticeable. However, the majority of scientists have proved that there is a negative association between tax rates and the volume of FDI. Yes, studies of this type, including the research of Hines (1999, p. 309), reported “a positive correlation between levels of FDI and after-tax rates of return at industry and country levels”… Furthermore, Azemar, Desbordes & Mucchielli (2007) went further and made a research into the influence of sparing agreements on the Japanese FDI. They concluded that sparing agreements enhance the attractiveness of developing countries, increasing the volume of FDI inflows.

However, it is also necessary to mention that the factors that have an impact on the location of FDI vary systematically between developing and developed countries (Blonigen and Wang 2004). Hines (1999, p. 312) carried out research, where he has used the statistical data of Japanese companies, and calculated the elasticity between tax rates and the number of locations of Japanese firms. For developed countries this figure is equal to -1,9; for developing it is -1,1.

However, the researches of such type have many problems. One of the difficulties facing all crossectional studies on this issue is “the inevitable omission of many important determinants of FDI that may be correlated with tax rates and therefore bias the estimation of tax elasticities” (Hines 1999, p. 311). As a result, the conclusion is that recently there is no methodology to research the issue of tax incentives and FDI accurately and correctly.

The researches above show that the effectiveness of financial incentives significantly depends on the state of the county’s economy.

Developed countries usually use this statement, and invest in developing countries, giving more advantages to themselves than to developing countries. They use national resources, cheap working force, and other resources using transnational corporations and increasing their profit and revenues. According to Nathan-MSI Group (2004), there are at least eight arguments against investment tax incentives. These include revenue loss, revenue leakage through avoidance and evasion, impact on tax administration, the economic cost of fiscal incentives, economic distortions, equity issues, lack of transparency, and political dynamics. Also, this company reports, that “experience shows that tax incentives usually don’t work”. Taking to account all the above, it is possible to conclude that fiscal incentives are not the most influential and effective way the developing countries may use to attract FDI.

Nowadays national economies become incrementally closer to each other because of globalization. This increases the efficiency of capital and labor force, as they move to countries and areas with better conditions and perspectives. Investors usually investigate the conditions of conducting business in different countries, paying attention to the systems of taxation, political stability, etc. Thus, taxation seems to be one of the most important issues that define the attractiveness of certain countries. However, different researches have concluded that the effect of fiscal incentives is not the most important instrument to boost the investors’ incentives to invest in a country. There are many other factors, which can either inflate or slash the willingness of investors to invest in the country. All these factors can be implicated by governments while the formation of their domestic tax policy. Furthermore, global society must consider these incentives and make some restrictions for developed countries to avoid exploitation and other negative impacts of the cross-border foreign direct investment, attracted by the governments of developing countries.

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