RESTRICTEDWORLD TRADE
ORGANIZATIONWT/WGTI/W/64
19 November 1998
(98-4651)
Working Group on the Relationship
between Trade and InvestmentOriginal:  Spanish
COMMUNICATION FROM MEXICO
The following communication, dated 10 November 1998, has been received from the
Permanent Mission of Mexico with the request that it be circulated to Members.
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Are Fiscal Incentives Efficient in Attracting Foreign Direct Investment?
Introduction
1. Foreign investment plays a decisive role in economic growth and in a country's adjustment to
globalization.  Capital growth – in both physical and financial terms - , job creation, and transfer of
better technology and of greater managerial abilities are some of the elements which make foreigninvestment attractive.  A growing number of firms in more and more countries are expanding to other
countries.  Within this globalization context, competition to attract capital flows is becoming
increasingly keen.
2. In some countries, competition for foreign investment has led to the use of fiscal policy -
especially tax incentives - as a way of artificially increasing the expected return on capital flows.  A
substantial amount of foreign investment goes to countries that offer fiscal incentives.  For example, it
is estimated that offshore investment funds in tax havens handle US$ 1 trillion.  Between 1985 and1994
1, foreign direct investment (FDI) by G7 countries in countries that offer particularly
advantageous tax regimes increased from US$40 billion to US$210 billion.
3. Most economic literature affirms that the impact of fiscal incentives on FDI, if any, tends to
be small in comparison with other factors such as market size, production costs, regulatory framework
and, in general, political and economic stability in the host country.2  Nevertheless, studies show that
investment incentives can be a marginally decisive variable in allocating FDI if two or more countries
or regions with similar political and economic structures are competing to attract it by using
incentives.  Governments are therefore increasingly tempted to make use of investment incentives.
4. This paper demonstrates that fiscal incentives to attract FDI are a "second best" solution
because they are not based on economic criteria of equity or efficiency;  it also shows that the costsassociated with harmful tax competition, greater lobbying and inefficient resource allocation can more
than offset the benefits derived from granting ince ntives;  and it underlines the need for the Working
                                                     
1 See OECD (1998):  "The economics of harmful tax competition" (DAFFE/CFA/WP2(97)18/REV2),
pp. 5-8.
2 For a summary of these studies, see for example OECD (1995):  "Taxation and FDI:  The Experience
of Economies in Transition" and WTO (1998):  "The Impact of Investment Incentives and Performance
Requirements on International Trade" (WT/WGTI/W/56).  See also UNCTAD (1996):  " Incentives and Foreign
Direct Investment" (UNCTAD/DTCI/28).WT/WGTI/W/64
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Group on the Relationship between Trade and Investment to examine this issue further and explore
options to eliminate its distorting effects.
Arguments in favour of fiscal incentives
5. The reasons usually put forward in favour of granting fiscal incentives to attract FDI are that
they are a way of increasing competitiveness, promoting regional development, remedying market
imperfections and absorbing the positive externalit ies associated with FDI.  All these arguments
assume that the incentives are incorporated into th e foreign investor's objective function so that they
have a favourable impact on his decision on where to locate the investment.
6. Increased competitiveness.   By enhancing the capital/labour ratio in the economy, foreign
investment induces an increase in labour productivity.  The host country's competitiveness also tends
to increase when FDI includes more advanced technology, introduces better management methods
and promotes greater competition at the domestic level.
7. Regional development.   Fiscal incentives at the sub-federal level can be directed towards
attracting FDI to less-developed regions which are consequently less well endowed with
infrastructure.  This drawback is reflected in higher production costs compared with other regions.
The objective of the incentives is therefore to co mpensate the foreign investor for the higher costs
incurred by investing in areas that are economically more backward.
8. Market imperfections and externalities.   In cases of imperfect information or positive
externalities where the social rate of return exceed s the private rate of return (for example, FDI in
research and development), fiscal incentives are a variable used to remedy both market imperfections
and the externality concerned.
Fiscal incentives do not constitute an "optimum" policy9. In the majority of cases described above, the use of fiscal incentives is not the "best" policy
but a "second best" solution.  In addition to the costs inherent in the incentives – as explained in the
following section - in each case there are more efficient alternatives.
10. For example, if FDI induces enhanced competitiveness, it is nevertheless questionable
whether incentives should be used for this purpose.  This is because of the negative secondary effectswhich can even have a counterproductive effect on competitiveness.
3
11. Where fiscal incentives are granted for FDI in order to achieve regional development
objectives, these could be met more efficiently by raising social spending to increase capital (in both
physical and human resource terms) in the region (i.e. infrastructure, education, health, etc.).
12. Because the location of FDI is the subject of prior analysis, imperfect information is not very
common.  To overcome this problem, it would be sufficient to promote properly the existing
advantages for FDI in the country.
13. Lastly, in view of the minimum impact on relative prices and the difficulty of internalizing
externalities, investment incentives would appear to  be justified if there is a positive externality
associated with FDI.  Nevertheless, since it is  extremely complicated to calculate exactly the
externalities associated with FDI and to determine the appropriate level of incentives, there is a risk
that the incentives might be too great and in the end generate costs that exceed the expected benefits
                                                     
3 For example, lower tax revenue which affects fiscal balance, pressure from investors to obtain similar
privileges, discrimination against domestic investors, etc.WT/WGTI/W/64
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of the FDI.  This risk is even greater when several countries compete for a particular investment
project.
14. To summarize, in most cases the allocation of subsidies or reduction of taxes in order to
attract FDI are justified neither by efficiency criteria nor by equity criteria.  To attract FDI it is
preferable to remedy, and not to compensate for, structural or economic policy imperfections.
Cost of fiscal incentives
15. The major costs associated with the use of fiscal incentives to attract foreign investment
include their ineffectiveness in achieving their obj ectives;  greater lobbying that may result in a
negative sum game;  and erosion of the tax base.
16. Lack of effectiveness.   A fiscal incentive meets its objective if it attracts additional FDI that
would not otherwise have gone to the host c ountry.  If, on the other hand, the FDI would have
occurred without the need for the incentive, the latter is redundant and will be reflected in a windfallcapital gain for the foreign investor.
17. Greater lobbying.  If the incentive was a decisive factor in deciding on the location of the FDI
and was of a temporary nature, there is a possibility that, once the incentive period has expired, the
foreign investor may lobby to obtain the benefits of lower taxes on a permanent basis.  Otherwise, and
if the installation cost is low, he will prefer to move to another country where he can benefit fromincentives.
18. Likewise, if an incentive targets only foreign investors, this discriminates against domestic
investors.  Logically, the latter will lobby to obtain the same incentive or equivalent compensation,
which will increase the planned cost of the initial incentive.
19. There is also a possibility that an incentive may increase the earnings of a multinational firm
so that it has to pay higher taxes in its country of origin.  In this case, the incentive amounts to a
transfer from the host country to the country of origin of the investment.
4
20. Erosion of the tax base.   A fiscal incentive can have negative secondary effects.  One of these
is the possible erosion of the tax base, which is particularly important if there is competition among
countries to attract FDI.  Owing to the greater openness of trade and investment today, the potentialeffects of tax changes in one country have a greater impact on other countries.  Competition among
countries to attract FDI through fiscal incentives ther efore tends to be harmful:  insofar as a country
reacts by increasing its incentives because another country increased them, the tax bases of both
countries will be eroded.
21. This non-cooperative game play also implies that, in order to maintain fiscal balance, other
taxes will have to be increased or spending reduced, with the attendant social consequences.  If fiscal
balance is not sought, the erosion of the tax base will create inflationary deficit financing pressure.
22. The problem of harmful tax competition may also occur at the sub-federal level, where states
or municipalities in the same country cut local taxe s with the aim of attracting investment and creating
jobs locally.  The consequences are similar to those of tax competition among countries.  However,
because local authorities are responsible for a smaller number of taxes, it is more likely that the
variable which offsets the incentive given at the local level will be a reduction in spending, with theresulting negative effects.
                                                     
4 This problem is minimized if the countries concerned have a double taxation agreement.WT/WGTI/W/64
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23. To summarize, this analysis shows that the costs of fiscal incentives (lack of effectiveness,
greater lobbying pressure resulting in a negative sum game, and erosion of the tax base) can exceed
the benefits yielded by FDI.
Impact of investment incentives on international trade
24. The impact of FDI on international trade is well known.  On the one hand, through access to
factors at lower cost, FDI can enjoy the comparative advantages of the host country and become an
important source of exports.5  On the other hand, by facilitating the development of production chains,
FDI is also a trigger for exports for the country of origin of the investment.6  Any incentive
encouraging FDI will therefore affect the trade structure and trade flows of the countries concerned.
Thus, if the incentive leads to inefficient allocation of capital, this indirectly implies inefficient
exploitation of comparative advantages.
25. Because of the close interaction between FDI and trade, if the use of fiscal incentives does not
properly reflect FDI externalities and leads to inefficient allocation of investment resources, the result
may be distortions in international trade patterns  similar to those caused by certain trade policy
measures.
26. Moreover, in a competition situation, the irrational use of incentives not only wastes resources
but may also have a negative impact on aggregate income distribution.  When all countries competingfor FDI offer incentives, these cancel each other out and the investment is allocated as would
originally have been the case without the incentives .  Ultimately, this leads to a transfer of income
from countries receiving the investment to investors in the country of origin of the investment.
27. In addition, since not all countries have the resources to compete for FDI, the use of
incentives and the resulting diversion of investment and trade flows will benefit those countries withdeeper pockets to finance incentives, to the detrimen t of countries that have fewer resources for doing
so.
28. Investment incentives can also have a direct impact on international trade when they affect
the activities of enterprises by inducing them to adopt certain practices (for example, fiscal incentives
which enhance the profitability of production for export will lead to an increase in exports and also ofimports of inputs associated with these exports).
7  In such cases, the effects on trade are similar to
those caused by performance requirements.  In fact, both types of measure are often applied together.
Conclusion
29. To summarize, the use of fiscal incentives to attract FDI is not justified by either efficiency or
equity criteria.  Conversely, it can imply higher costs for the beneficiaries and lead to distortions in
international investment and trade flows.  Mexico therefore considers that this is an area in which
international cooperation has a useful role to play in order to deal with the harmful competition thatresults from the use of such incentives.
                                                     
5 For example, exports by subsidiaries of the Un ited States, Japan and the European Union in some
Latin American and South-East Asian countries account for up to 50 percent of the total exports of these
countries.  See OECD (1997):  " The role of FDI in economic development".
6 Fontagné estimates that, for a sample of 14 OECD countries, each FDI dollar generates $2 of exports
and a trade surplus of $1.7.  (Fontagné, "How foreign investment affects international trade andcompetitiveness:  an international assessment", submitted to the OECD Committee on Industry inOctober 1997).
7 See WTO (1998), op cit , pp.13-14.WT/WGTI/W/64
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30. Without prejudice to the WTO provisions, especially those in the Agreements on Subsidies
and Countervailing Measures (SCM) and on Trad e-Related Investment Measures (TRIMs), which
could apply to investment incentives, Mexico suggests that the Working Group on the Relationship
between Trade and Investment should study this question in greater detail with the aim of reaching a
better understanding and assessment of the implications of such incentives, and should explorevarious options in order to eliminate their distorting effects.
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