Benefits of FDI Subsidies: The Role of Funding Sources
41 Pages Posted: 9 Nov 2020
Date Written: August 15, 2020
Using a two-country model with heterogeneous firms, we show that the optimal level and welfare gains of foreign direct investment (FDI) subsidies critically depend on how they are funded. In a setting that resembles common tax distortions in emerging markets, we compare the effects of distortionary taxes that are imposed to fund FDI subsidies and examine their cross-country spillovers. Our model predicts that the optimal level of FDI subsidies and the associated welfare gains are much lower than those for non-distortionary taxes. FDI subsidies funded by distortionary taxes are also found to be beggar-thy-neighbor, although they generate positive cross-country welfare spillovers if funded by non-distortionary labor income taxes.
Keywords: Foreign direct investment, FDI subsidies, tax distortions, emerging markets
JEL Classification: F13, F23, F42, E62
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