How Tax Policy and Incentives Affect Foreign Direct Investment

How Tax Policy and Incentives Affect Foreign Direct Investment

A Review

By Jacques Morisset1 And Neda Pirnia

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Foreign Investment Advisory Service (FIAS), a joint service of the International Finance Corporation and the World Bank. The opinions and arguments expressed are the sole responsibility of the authors and do not necessarily reflect those of the above institutions. We would like to thank Bijit Bora, Gokhan Alkinci and Carl Aaron for their comments. To be published in “New Directions for Research in FDI”, B. Bora (ed), Rutledge, forthcoming

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Introduction

In a world where an increasing number of governments compete hard to attract multinational companies, fiscal incentives have become a global phenomenon. Poor African countries rely on tax holidays and import duty exemptions, while industrial Western European countries allow investment allowances or accelerated depreciation (Table 1). This trend seems to have grown considerably since the early 1990s as evidenced by the number of high profile foreign investments, such as Toyota in Northern France or Mercedes-Benz A.G. in the U.S. State of Alabama. These have generated considerable debate about whether governments have offered unreasonably large incentives to entice those firms to invest in their area. Still, this debate about the effectiveness of tax incentives is hardly new and has accumulated a long history.2

The objective of the paper is to review the existing literature on tax policy and Foreign Direct Investment (FDI) as well as to explore possibilities for future research. Taxes affect the net return on capital and should, at least in the mind of numerous policymakers, influence the capital movements between countries. For this reason, the early literature attempted to evaluate if a generous tax policy could compensate for other obstacles in the business environment and, thus, attract multinational companies. In the mid-1980s, the literature went one step further by

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