Attracting private investment: Tax reduction, investment subsidy, or both?

a r t i c l e i n f o This paper uses a real-option model to examine the net benefit to a government from using tax cut and/or investment subsidy as incentives to induce immediate investment. Although earlier papers generally concluded that investment subsidy dominates tax cut, it is observed that many governments use a combination of subsidy and tax cut. We show that, when the government uses a different discount rate from private firms, and when it has to borrow money to provide an investment subsidy, it is possible to get an internal optimum; that is, it might be optimal for the government to provide an investment subsidy as well as charge a positive tax rate on the profits from the project. Thus, we provide an explanation for the puzzling fact that many governments provide an investment subsidy to a firm while simultaneously taxing its profits. It is widely accepted that private investment has a significant and positive effect on economic growth (Kim, 1998). Private corporate investment helps reduce unemployment, increases government revenues by way of tax collections, reduces imports and/or increases exports, helps with technology transfer, develops local entrepreneur-ship, etc. Not surprisingly, governments around the world have stepped up efforts to attract private investment. 1 The two methods most commonly used by governments to encourage private investment are tax rate reduction and investment grant/subsidy (This paper compares the efficacy of these two methods, in terms of their ability to attract investment as well as how they impact the net benefit to the government from the investment project. It also examines the optimal combination (from the government's perspective), if any, of these two investment incentives. Of course, tax reduction and investment subsidy should not be viewed as substitutes for strong economic fundamentals and basic " desirable " conditions for investment, such as solid infrastructure, reliable and transparent legal system, adequate property rights, macroeconomic and political stability, and an educated workforce. There has been some research on the relative effectiveness of tax cut versus investment subsidy as investment incentives (Pennings, 2000, 2005, Yu et al., 2007; Zee et al., 2002). Such analyses are useful for governments trying to decide whether to offer tax rate reduction or investment subsidy (or what combination of the two to offer) to spur corporate investment. Zee et al. (2002) stress the importance of cost-effectiveness: a tax reduction is costly because of the forgone …