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On Fiscal Policy in Competition for Foreign Direct Investment : When Does a Less Developed Country Win ?

This paper analyzes the competition for foreign direct investment among countries at different stages of development, and asks when less developed countries can win in this kind of competition. It is assumed that domestic companies in a more developed country use more capital in production, and that wages in a less developed country are lower. The paper explicitly models the empirical observation that countries tend to compete for foreign direct investment by providing public inputs, in addition to (or instead of) offering subsidies or tax reliefs to foreign investor. However, while only foreign company benefits from tax incentives, additional public inputs increase the output of domestic companies as well. The results reveal that if governments of competing countries are not allowed to discriminate between domestic and foreign firms, there may be situations in which a less developed economy will attract foreign direct investment depending on the labor cost differential and the responsiveness of foreign and domestic companies to changes in the supply of public inputs. In addition, including public inputs in the model may alter the result as compared to including another location determinant that cannot be affected by public policy. There are situations in which consideration of public inputs will increase a less developed country’s chances of winning the investment. If tax discrimination between domestic and foreign firms is permitted, both countries will optimally raise the supply of public inputs but the more developed country will always win the foreign investment.