Should Countries Promote Foreign Direct Investment?

This paper examines whether policies to promote foreign direct investment (FDI) make economic sense. The discussion focuses on whether existing academic research suggests that the benefits of FDI are sufficient to justify the kind of policy interventions seen in practice. For small open economies, efficient taxation of foreign and domestic capital depends on their relative mobility. If foreign and domestic capital are equally mobile internationally, it will be optimal for countries to subject both types of capital to equal tax treatment. If foreign capital is more mobile internationally, it will be optimal to have lower taxes on capital owned by foreign residents than on capital owned by domestic residents. Absent market failure, there is no justification for favouring FDI over foreign portfolio investment. In practice, countries appear to tax income from foreign capital at rates lower than those for domestic capital and to subject different forms of foreign investment to very different tax treatment. FDI appears to be sensitive to host-country characteristics. Higher taxes deter foreign investment, while a more educated work force and larger goods markets attract FDI. There is also some evidence that multinationals tend to agglomerate in a manner consistent with location-specific externalities. There is weak evidence that FDI generates positive spillovers for host economies. While multinationals are attracted to high-productivity countries, and to high-productivity industries within these countries, there is little evidence at the firm or plant level that FDI raises the productivity of domestic enterprises. Indeed, it appears that plants in industries with a larger multinational presence tend to enjoy lower rates of productivity growth over time. Empirical research thus provides little support for the idea that promoting FDI is warranted on welfare