Powers of attraction: How to make the most of tax holidays as a foreign direct investment incentive

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In a global economy where countries compete fiercely for foreign direct investment, Prof. José Mata offers some insights for policymakers wishing to extract maximum value from specific tax related investment incentives—notably tax holidays.

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José Mata was a professor of International Strategy at HEC Lausanne until 2021. His interests center on the dynamics of markets and firms’ strategies.

The development of a truly global economy has created an economic landscape where nations are pitted against each other in an effort to attract foreign businesses to their shores. This type of inward investment offers many benefits for host countries, especially for developing economies. Investing firms can provide employment and often have higher productivity, bringing new know-how that can spillover to local domestic firms.

One popular method for attracting foreign direct investment is to provide tax incentives, such as tax holidays, for inward investing firms. However, in a highly mobile global economy, the challenge for host nations is persuading firms to stay after tax incentives are reduced or withdrawn, as it is relatively easy for firms to close and move to take advantage of tax breaks offered elsewhere.

This is an issue that José Mata a professor at HEC Lausanne, University of Lausanne, has been investigating, together with colleague Paulo Guimarães, an Economist at the Bank of Portugal and Professor at the University of Porto. Using data from Puerto Rico, where tax holidays—tax exemptions that are subsequently eliminated—were used to attract foreign firms, the research identifies three factors that affect an investing firm’s sensitivity to reductions in tax benefits. In doing so Mata, who believes the research findings can be generalized to other countries, is able to offer some important pointers for host countries that want to obtain the optimum value from similar tax incentives.

One factor, described in the research as ‘information asymmetry’, relates to the degree of knowledge and information a firm has about doing business in a potential host country. The less knowledge a firm has about the environment for doing business in a particular country, the infrastructure, labor force skill levels, costs of doing business, governance and so on, the more likely it is to make investment assumptions that require a higher threshold for profits. By providing tax incentives the host country government lowers that threshold and attracts firms that would otherwise refrain from investing.

A firm that already knows a lot about the country is more likely to enter the country solely to benefit from the tax break, rather than to gain knowledge about doing business in that country. Thus if the tax break is subsequently reduced or removed there are fewer reasons to prevent that firm relocating to a country with a more favorable tax regime. Contrast that with firms with less knowledge, which may well discover that they are able to benefit from additional efficiencies, besides the tax incentives. They have the opportunity to discover what it is like doing business in the host country, and if that experience is favorable, may remain even if the tax incentives are reduced or removed.

Mata and Guimarães also discovered that if companies invested in a country where there was a large migrant population from the investing firm’s home nation, that migrant population acted as conduit for knowledge back to the home nation. Consequently the investing firms behaved like firms with greater knowledge about the host country and were more sensitive to reductions in tax incentives.

A second factor is the degree of friction in terms of the ease of relocating. A firm that makes investments that are not easily recoverable should it leave, such as the costs of training local employees, is more likely to stay in a country.

While a third factor revealed by the research is that industry clusters exert a gravitational pull on investing firms. A firm locating in an area that is developing economically is more likely to stay if tax incentives are reduced than a firm locating to an area with little growth. However, this is only true where the economic growth focuses on a particular activity, rather than an area experiencing economic growth generally. The attraction of the cluster is partly due to the availability of specialized labor.

The findings allow Mata to offer a number of pointers that policymakers, trade associations and other stakeholders should focus on, if they want to get the maximum value from foreign investment incentives.

Countries that want to attract firms using tax holiday incentives should target foreign firms that know less about the business environment in the country being invested in. They should also promote the arrival of firms in a concerted effort, for a limited time period, rather than having a less significant but steady influx. The aim is to create some momentum, so that the presence of one firm benefits from the presence of others.

Companies that are more skills intensive, and willing to invest in training people locally, should also be targeted. While it also helps to develop and promote specialized sector clusters, both new and existing, to potential investors. Although it is worth noting that if a cluster is sufficiently strong, additional tax incentives may not be needed to persuade firms to locate there.

And, as Mata points out, given the UK’s impending exit from the EU and heightened need to attract investment independently of its EU membership, policymakers would do well to note these pointers. As any natural inclination to offer tax incentives to countries already very familiar with the UK’s business environment, may not be the optimal use of UK tax payers’ money.

Related research paper: Temporary investment incentives and divestment by foreign firms, José Mata and Paulo Guimarães, Oxford Economic Papers, Volume 71, Issue 1, 1 January 2019, Pages 166–186

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