WORLD TRADE
ORGANIZATIONWT/WGTI/W/62
28 October 1998
(98-4195)
Working Group on the Relationship
between Trade and InvestmentOriginal:  English
COMMUNICATION FROM KOREA
The following communication, dated 16 October 1998, has been received from the Permanent
Mission of the Republic of Korea with the request that it be circulated to Members.
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Investment Incentives for Foreign Invested Enterprises:
Issues arising from Korea’s Experience
Investment Incentives
1.  Governments provide various types of incentives to induce foreign direct investment ("FDI").  The
most common incentives are tax incentives, which are offered by developed as well as developing
countries.  Another often-used type of incentive is financial assistance to potential investors, for
example, in leasing or acquiring lands.  In the case of developing countries, incentives are frequently
provided to FDI that accompanies advanced technology.  The problem with this type of incentive isthat it is difficult to define which FDI brings advanced technology and whether the host country has
the infrastructure to accommodate the high-technology investment.
2.  When these incentives are provided only to foreign firms, they may raise competition concerns.
Therefore, in sectors where domestic firms are potential entrants, incentives to domestic firms shouldbe provided as well.  Of course, the provision of incentives should not amount to granting monopoly
rights to these firms.
3.  When governments give incentives to induce firms to locate production facilities in their territories,
there can be negative effects in terms of economic efficiency.  Incentives can cause firms to transfer
production facilities from a relatively economic to a relatively uneconomic site, where incentives are
used to compensate from differences in production costs to the firm.  If different regions in a countryprovide various incentives and compete to attract FDI, it could unnecessarily increase the cost to
society of producing the relevant goods and services.
4.  However, in countries where the business environment for FDI is unfavourable to foreign firms,
incentives will play an important rôle in compensating for the country-specific barriers.  As a result,incentives can help build a "level playing field" for FDI.  It should be noted that if the initial barriers
to FDI do not exist, the distortive effects of incentives could potentially outweigh the benefit in
inducing FDI.WT/WGTI/W/62
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Korea’s experience with tax incentives
5.  Korea has provided tax incentives to foreign invested enterprises (FIEs) since the 1960s.  The
evolution of Korea’s tax incentive system for FIEs can be divided into three stages.
From the 1960s to 1984, tax deductions and exemptions were given to all foreign invested
enterprises.
From 1984 to 1989, only those FIEs, which fall under the following categories, were given tax
benefits:
- FIEs which bring in advanced technology;
- FIEs established in free export zones;
- FIEs which have an import substituting effect;
- FIEs which induce large amounts of capital;
- FIEs established in industries open only to small- and medium-sized enterprises; and
- some others.
Since 1990, tax incentives have been provided only to those FIEs that bring in advanced
technology and FIEs established in free export zones.
6. Two factors explain the gradual scaling down of Korea’s incentive system for FIEs. First, benefits
resulting from the incentive system have fallen short of expectation, for reasons explained below.
Secondly, as restrictions on FDI have been diminished in recent years, so has the need to
compensate foreign investors.  Increasing concern has been expressed that, against the
background of FDI liberalization, tax incentives give disproportionate advantage to FIEs against
domestic firms.  In response to this legitimate concern, the Korean Government started to linkFDI liberalization to the reduction of tax incentives for FIEs.
7. However, tax incentives for FIEs bringing in advanced technology have actually increased during
the last ten years.  The tax exemption period for such FIEs was also extended from five years to
seven years recently.  The aim of this policy is to close the gap between the private and social
rates of return.  Korea is undergoing rapid economic structural reform and is actively seeking to
attract advanced technologies as the social rates of returns of advanced technology investmenthave increased.
8. While it is difficult to precisely estimate the extent to which tax incentives have contributed to the
growth of FDI, it is agreed that they have generally failed to achieve their desired effects.  There
are a few reasons for this failure.
First, as is well evidenced in the literature on FDI, tax levels are only a minor consideration when
firms decide where to invest.
Second, tax incentives were insufficient compensation for Korea’s relatively high factor costs
such as wage and interest rates.
Third, the effects of tax incentives were partially nullified, as “tax sparing” was not granted to
Korea by some of the major investor countries.  As a result, during the period from 1982 to 1988,
it is estimated that about 39 per cent of the amount of tax exemptions and reductions to FIEs inKorea were collected by their home governments when the FIEs repatriated their profits.WT/WGTI/W/62
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Issues
Korea’s experience with tax incentives for FIEs as described above suggests a few important
issues that warrant close examination.
Linkage between FDI liberalization and incentives
9. Incentives for FIEs are sometimes justified as compensation for discriminatory treatment against
foreign firms. As discriminations against foreign firms diminish, such an argument has less merit.
If the current trend of lowering the barriers, external and internal, to foreign firms continues and is
not matched by commensurate reductions in incentives, governments of host countries will
increasingly find that they are discriminating against domestic firms.
Market structure vs. harmful competition
10. Another argument for incentives for FIEs is that they correct market failures by bridging the gap
between private and social rates of return.  This positive contribution cannot be denied.  However,it is also likely that competition among countries  to attract foreign investment will become so
fierce that they may end up offering incentives whose costs outweigh benefits.  This situation is
equivalent to the prisoners’ dilemma where only cooperation among participants provides a
mutually beneficial solution.
Relationship with bilateral taxation agreements
11. Bilateral taxation agreements also need to be examined in connection with tax incentives.  In
particular, “tax sparing” provisions merit further review.  The absence of “tax sparing” provisions
in the home country would largely nullify the potential benefits of tax incentives in the hostcountry when profits are repatriated.
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