Rethinking Investment Incentives

Trends and Policy Options

Ana Teresa Tavares-Lehmann, Perrine Toledano, Lise Johnson, Lisa Sachs

• Publisher: Columbia University Press
• Year: 2016
• ISBN:
  9780231541640
• Topic: Commerce
• Subtopic: Fiscalité

Governments often use direct subsidies or tax credits to encourage investment and promote economic growth and other development objectives. Properly designed and implemented, these incentives can advance a wide range of policy objectives (increasing employment, promoting sustainability, and reducing inequality). Yet since design and implementation are complicated, incentives have been associated with rent-seeking and wasteful public spending.

This collection illustrates the different types and uses of these initiatives worldwide and examines the institutional steps that extend their value. By combining economic analysis with development impacts, regulatory issues, and policy options, these essays show not only how to increase the mobility of capital so that cities, states, nations, and regions can better attract, direct, and retain investments but also how to craft policy and compromise to ensure incentives endure.

CHAPTER 1

Introduction

Ana Teresa Tavares-Lehmann, Lisa Sachs, Lise Johnson, and Perrine Toledano

In July 2015, the government of Ethiopia hosted the Third International Financing for Development Conference, bringing together world leaders from governments, businesses, and international organizations to chart a course for financing the post-2015 development agenda. That agenda includes the most critical challenges facing society—ending extreme poverty, eradicating preventable diseases, and halting global warming, among others. Achieving the resulting sustainable development goals (SDGs) by 2030 will require mobilizing and harnessing substantial resources from both the public and the private sectors. At the conference, the global leaders recognized that “private business activity, investment and innovation are major drivers of productivity, inclusive economic growth and job creation” and that “private international capital flows, particularly foreign direct investment, along with a stable international financial system, are vital complements to national development efforts” (UN 2015, para. 35).

Indeed, now more than ever, investment has an important role to play in sustainable development through the injection of capital, generation of employment, and transfer of technology and know-how. Many governments have increasingly recognized that role: recent decades have seen a dramatic increase in the array of government incentives offered to attract such investment—and, in particular, foreign direct investment (FDI)—and to increase its contribution to sustainable development. In fact, the Addis Ababa Action Agenda adopted at the conference recognized that “incentives can be an important policy tool” (UN 2015, para. 27) in financing sustainable development. Well-designed investment incentives can attract and channel resources so as to develop renewable energy technologies, enable wider access to energy and other infrastructure, train human resources, and strengthen health systems—all of which can support sustainable development (UNCTAD 2014).

Understanding how, when, where, and why governments use incentives to attract and guide investment is critically important if we are to assess whether and how society benefits from incentives. It is increasingly apparent, however, that the use and impact of incentives are not well understood—including by the policy makers who use them. Incentives are often quite costly for governments, and yet they are only rarely designed to strategically meet sustainability or development objectives. It is widely acknowledged that companies may seek—and governments may offer—incentives beyond those that may be needed to attract an investment, whereas other investments or more general policies that would be more effective at attaining SDGs are underutilized or poorly designed or implemented.

Although the use of incentives by both national and subnational governments around the world is ubiquitous, with few exceptions, little is known about their prevalence, distribution, effectiveness, and impacts. Due largely to a lack of transparency regarding these measures, the use of investment incentives has thus far largely escaped systematic monitoring, reporting, or analysis.

But this may be changing. Some government entities, including, most notably, the European Union (EU), are imposing broad transparency requirements and strengthening their monitoring and evaluation. Along with improvements in understanding the use of these measures, there have been developments in terms of hard or soft regulation. International organizations and experts are increasingly discouraging certain types of fiscal, financial, or regulatory incentives for a number of reasons, one of which is that they might be wasteful and inefficient. This concern is particularly pressing as subnational and national jurisdictions competing for capital engage in “bidding wars” that can drive those jurisdictions to increase the types and generosity of incentives they offer in order to attract new investments and even lure coveted existing investments away from other jurisdictions. In the latter case, such incentives are inefficient in a regional or global sense, as the result is simply to reallocate investment within or across regions rather than generating new investments. Other concerns are that locational or behavioral incentives might be unduly costly (with costs outweighing their benefits) and might have harmful distributional impacts, resulting in increased inequality rather than inclusive growth.

Investments and investment incentives have potentially large costs and benefits for national and subnational jurisdictions. This volume advances our understanding of the role that incentives have played in attracting and retaining investment from foreign and domestic sources, the policy rationales supporting or discouraging various types of incentives, the strategies that may be more effective at achieving the objectives of host governments, and the potential for future coordinated action on competition for capital and other issues.

The book is structured as follows: Part I sets the scene, providing a crucial introduction to the main concepts, definitions, and types of incentives. Part II gives a global overview of the use of investment incentives across geographic regions. Part III provides practical guidance for designing, administering, and monitoring the use of incentives in order to optimize their impacts on sustainable development. Part IV focuses on current and potential future governance of incentives from multilateral to subnational levels.

DEFINING INVESTMENT INCENTIVES

Before beginning an analysis of the use and effects of incentives, it is necessary to define what types of measures are included as investment incentives in this book. In fact, there are a number of different, well-accepted definitions of investment incentives. An often-cited definition of investment incentives is provided by the OECD (2003, 12): “measures designed to influence the size, location or industry of a foreign direct investment project by affecting its relative cost or by altering the risks attached to it through inducements that are not available to comparable domestic investors.” Another commonly used definition is that suggested by UNCTAD (1996, 11): “measurable advantages provided by government to particular companies or group of companies with a goal to force them to behave some way.” For Thomas (2007, 11), investment incentives represent “a subsidy given to affect the location of investment. The goal may be to attract new investment or to retain an existing facility.”¹ Wells et al. (2001, vii) refine this perspective of investment incentives as subsidies by stating that “incentives can be direct subsidies (including cash payments or payments in kind, such as free land or infrastructure) or indirect subsidies (tax breaks of various sorts or protection against competition from rival firms, including import protection, for example).” Using an illustration of a fiscal incentive, they further note that “to be considered an investment incentive, however, a tax break must not be available to all investors but, rather, must be tailored to specific investors or types of investors” (vii).

The definition of investment incentives is important not just from an academic perspective. When assessing the practical policy implications of investment incentives, it is crucial, in the first place, to be clear on what measures are being analyzed. Because different authors may use the term in different ways, they may come to varying conclusions about the appropriateness or effectiveness of particular incentives. For instance, the first definition is focused on FDI incentives, assuming that the entity that decides on the incentives can discriminate against domestic investors. Much of the literature and policy is expressly directed at FDI incentives because of the particular advantages FDI can bring in terms of capital, technology, and other transfers;² the distinct challenges countries may face in attracting that investment; and the issues that may arise when granting incentives to foreign or multinational companies. However, not all investment incentives are geared toward attraction of FDI; indeed, many investment incentives schemes do not distinguish between investors based on their nationality. Thus, the policy rationales and implications of incentives specific to FDI may not apply to general incentives that are available to domestic investors as well.

Some chapters of this book focus on strategies for using incentives to attract and benefit from FDI (e.g., chapter 8 by Brennan and Ruane), whereas other chapters discuss incentives given to domestic and foreign firms alike (e.g., chapter 6 by Krakoff and Steele). In general, most of the policy implications drawn from the chapters of this volume apply to incentives generally, whether targeted at foreign investments or at all investments.

A second important aspect of the definitions above is the notion of specificity—that is, as set out in the revised OECD Benchmark Definition of FDI (OECD 2008), investors (companies or individuals) are given such incentives or advantages when they carry out specific investment projects. Similarly, Wells et al. (2001) note that incentives—to qualify as such—must be tailored to specific investors or types of investors. Thus, under these definitions, incentives are not given to every project or investor. Rather, they are attached to certain priorities or characteristics of the investment project—for example, investment in a certain sector, in a certain territory (e.g., a low-density area or a poorer region), of a certain financial magnitude, or attached to a target such as employment or technological content.

A definition of investment incentives limited to such specific measures typically excludes general policies and host-state characteristics that are attractive for investors, such as the quality of a jurisdiction’s physical infrastructure and its general legal and regulatory climate. Nevertheless, as Gugler and Johnson discuss in chapters 5 and 12, respectively, the line between specific and general measures is not always easy to draw. And, as is illustrated by Bellak and Leibrecht (chapter 4), in the context of evaluating governments’ efforts to attract and keep FDI, more general policies and practices, such as those enshrined in international investment treaties, are often considered as part of the investment incentives mix.

A third element introduced in the definitions above is the notion that the advantages provided should be measurable. Although this is important, the value of incentives is not always easy to identify, much less to quantify, in practice.³ Of course, this presents substantial challenges when assessing the costs, benefits, and effectiveness of incentives policies, as discussed throughout the chapters in this volume.

A final issue raised by the definitions above and highlighted by Thomas in chapter 11 is the focus on incentives as subsidies geared toward altering the location of an investment. This is a somewhat narrow definition of incentives, as incentives may be aimed at inducing other outcomes, such as altering the amount of the investment, the value-added characteristics, the technological content, or even the sectoral focus (as the first definition by the OECD notes). However, by focusing more narrowly on (re)location incentives (and excluding, e.g., incentives to overcome market failures that result in underinvestment in public goods and incentives to induce more development-oriented outcomes), we may more readily isolate the especially problematic measures that drive wasteful interjurisdictional competition for capital and identify governance strategies aimed at addressing those issues.

For the purposes of this volume, we employ the following definition, merging the most important (in our perspective) aspects from the above definitions:

Investment incentives are targeted measures designed to influence the size, location, impact, behavior, or sector of an investment project—be it a new project or an expansion or relocation of an existing operation.

Investment incentives are most frequently financial, fiscal, and regulatory measures, but they can also include information and technical services (specifically provided to certain investors) as a particular type of incentive (see chapter 2 for a complete overview of incentive types).

THE EFFECTIVENESS AND EFFICIENCY OF INCENTIVES

Many of the incentives analyzed in this volume are those used by jurisdictions to influence the location decisions of investors, based on the belief that incentives may compensate for market failures⁴ or otherwise tip the balance in favor of a specific jurisdiction to which an investor would otherwise not come. Inward investment incentives have been around for over a century (Sbragia 1996; Thomas 2007). However, only in the late twentieth century can a generalized use of incentives by most countries in the world be observed, together with a considerable diversification in terms of types and subtypes of incentives (Thomas 2007). Jurisdictions compete in what have been called beauty contests (OECD 2001), bidding wars (Oman 2000), and locational tournaments (Mytelka 2000) in order to look more appealing to investors.

In the last two decades, “red carpets replaced red tape” (Sauvant 2012), and there has been a widespread use of investment incentives aimed at making regions and countries look more attractive to increasingly mobile and global businesses.⁵ In the global race for investment, incentives are used as “anabolic steroids” (Oxelheim and Ghauri 2004).

A major question underlying the chapters in this volume is whether incentives are in fact effective at attracting investment.⁶ There is little doubt that some incentives may contribute to luring some investors to some jurisdictions, but effectiveness depends on what is being offered, to what type of investment project, and by what location. Some investors, such as strategic asset–seeking investors and resource-seeking investors, do not seem to be readily swayed by incentives when making investment decisions; others, including more “footloose,” efficiency-seeking investors, may value them more (UNCTAD 2015; chapter 3 in this volume).

It is very difficult to empirically assess the redundancy of incentives—that is, whether investors would have come even without the incentives. Some of the chapters in this volume explore this question directly and others implicitly; nevertheless, there is evidence that the risk of redundancy is quite high. Surveys undertaken in many jurisdictions by the World Bank’s Facility for Investment Climate Advisory Services (FIAS) showed an average redundancy ratio (the share of investors that would have invested even without investment incentives) of 77 percent and a positive answer to the question of whether the fiscal incentive influenced the decision in only 16 percent of cases, on average. Those positive answers were generally observed (1) in the case of efficiency-seeking FDI whose strategy is only to minimize costs of exported products, (2) when the investor had to decide among similarly attractive jurisdictions, and (3) when the incentive matched the need of the investor in a particular phase of the project cycle. In all the other cases, it has been regularly shown that the role of fiscal incentives is rather marginal (CCSI 2015).

Even though incentives may tip the balance, or be “the cherry on top of the cake,” particularly when a short list of similar locations is being evaluated (CCSI 2015), incentives cannot fully compensate for the absence of certain fundamentals, such as the existence of a relevant market, the availability of adequate human resources, and political stability, among other factors. In particular, it has been argued that incentives often fail to make up for unattractive business climates and investment environments characterized by poor infrastructure, legal and economic instability, weak governance, and small markets (CCSI 2015). Many factors (or determinants) affect the investor location decision: the distance to major markets, the proximity of raw materials, the size of the l...