DPRIETI Discussion Paper Series 23-E-059

Backfired Deregulation of Foreign Ownership Restrictions
under Fiscal Competition for Foreign Direct Investment

OKOSHI, Hirofumi
Okayama University

Kyikyi Thar

Okayama University

The Research Institute of Economy, Trade and Industry

https://www.rieti.go.jp/en/

RIETI Discussion Paper Series 23-E-059
August 2023

Backfired Deregulation of Foreign Ownership Restrictions
under Fiscal Competition for Foreign Direct Investment 1
Hirofumi OKOSHI
Okayama University
Kyikyi Thar
Okayama University
Abstract
Parallel to tax/subsidy competition for foreign direct investment (FDI), we have recently observed therelaxation of FDI restrictions, especially in developing countries, and mixed outcomes of inward FDI.
This study examines how foreign-ownership regulation affects a multinational enterprise's (MNE's)
location choice under fiscal competition. Consistent with the literature, our model shows that the larger
country tends to host the MNE without FDI regulation due to the market-size advantage. With FDI
regulation, however, irrespective of the market-size gap, the smaller country can attract the MNE
under certain circumstances. Interestingly, our result indicates that looser FDI regulation in the larger
country can induce the MNE to choose the smaller country as the production location because thisreduces the local (potential) partner firm's profits and directs the local firm to decline the joint ventureoffer.
Keywords: Fiscal competition, Location choice, Foreign direct investment, Foreign ownership regulation, Joint
ventureJEL classification: F15, F13, H23, L13, L23
The RIETI Discussion Paper Series aims at widely disseminating research results in the form of professional
papers, with the goal of stimulating lively discussion. The views expressed in the papers are solely those of
the author(s), and neither represent those of the organization(s) to which the author(s) belong(s) nor the
Research Institute of Economy, Trade and Industry.

This study is conducted as a part of the Project “Economic Policy Issues in the Global Economy”' undertaken at the
Research Institute of Economy, Trade and Industry (RIETI). The draft of this paper was presented at JSIE Kansai andthe DP seminar of the Research Institute of Economy, Trade and Industry (RIETI). We thank Tomohiro Ara, Jota
Ishikawa, Toshitaka Kawagoshi, Masayuki Morikawa, Eiichi Tomiura and participants of JSIE Kansai and RIETI
seminar for their helpful comments. Hirofumi Okoshi acknowledges financial support from the JSPS KAKENHI(Grant Numbers JP22H00855 and JP22K13390).
1

1

Introduction

Given increasing globalization, governments’ competition, especially among developing countries,
for foreign direct investments (FDIs) has intensified. Among several policy determinants of FDI,
providing tax incentives or subsidies for FDI has been extensively recognized as a significant driver.
Several studies, including Hebous et al. (2011), have shown that lower corporate taxes induce more
inward FDI both for greenfield FDI and cross-border mergers and acquisitions. Moreover, Azémar
et al. (2007) and Azémar and Dharmapala (2019) showed the significant impact of a tax incentive,
specifically a tax-sparing provision, on inward FDI into developing countries from developed
countries. Although attracting inward FDI is expected to benefit a host country in several ways, theworldwide trend of lowering taxes to attract multinational enterprises (MNEs) has been criticizedas “harmful tax competition” in OECD (1998) because less tax revenue leads to lower public-good
provision.1 Therefore, analyzing tax competition is critical for a proper policy discussion in thecontext of international taxation.2
Despite the growing literature on fiscal competition for FDI, one important but overlooked aspect
is “joint ventures (JVs)” as an entry mode into foreign countries. According to Raff et al. (2012),
38.6% of the Japanese MNEs in their data sample were in the form of JVs. In addition, we can see
many examples of JVs in ASEAN (2021). As the JV is established only when all firms in the JV
contract reach an agreement, tax incentives can affect local firms’ incentives to accept JV offers fromforeign MNEs. This indicates that cumulative knowledge cannot apply to non-negligible cases of
FDIs, and whether the mechanisms in the literature hold even when we consider JVs is unclear.
Indeed, the fact that we observe many JVs in reality can be due to FDI regulation. For example,
some developing countries set an upper limit on foreign ownership when MNEs invest in them.
China limited the foreign-capital investment ratio to up to 50% of total investment. Thus, with FDI
regulation such as foreign-ownership regulation, foreign firms must establish JVs with local firms
as subsidiaries.
Recently, however, such a requirement has been relaxed or eliminated and its impact on inward
FDI has been mixed. It was announced that China would eliminate the equity-ratio requirement in
the country’s automobile industry in 2022, and a German car manufacturer, Volkswagen, raised its
equity ratio from 50% to 75%.3 Following the announcement of the removal of foreign-ownership
1 In addition to an increase in supplies, numerous other benefits from hosting an MNE have been pointed out. See

Chapter 7 of Navaretti and Venables (2020) for a summary of the effects on host countries.
2 The worldwide trend of lowering taxes for FDI has been discussed since the late 1990s, when the Organisation for
Economic Co-operation and Development (OECD) summarized a report titled “Harmful Tax Competition”.
3 See https://www.globaltimes.cn/page/202202/1252070.shtml.

1

OECD
Countries
Australia
Belgium
CanadaFinland
GreeceHungary
Iceland
Korea
LatviaMexicoNew Zealand
PolandSwitzerland
TurkeyUnited Kingdom
OECD Average

1997

2003

2010

2020

0.200
0.135
0.110
0.150
0.015
0.050
0.112
0.280
N.A
0.140
0.200
0.050
0.075
0.200
0.023
0.052

0.175
0.023
0.110
0.150
0.015
0.000
0.112
0.005
0.020
0.103
0.200
0.000
0.075
0.200
0.000
0.035

0.075
0.023
0.110
0.009
0.000
0.000
0.112
0.000
0.005
0.103
0.200
0.000
0.000
0.000
0.000
0.018

0.080
0.023
0.095
0.009
0.000
0.000
0.112
0.000
0.005
0.103
0.190
0.000
0.000
0.000
0.000
0.017

Non-OECDCountries
Argentina
Brazil
China
Egypt
India
Indonesia
Malaysia
Philippines
RussiaSouth Africa
Thailand
Viet Nam

1997

2003

2010

2020

0.000
0.025
0.379
0.015
0.237
0.160
0.360
0.128
0.233
0.060
0.175
0.620

0.000
0.025
0.360
0.015
0.082
0.143
0.126
0.078
0.233
0.060
0.091
0.250

0.000
0.025
0.247
0.005
0.048
0.085
0.007
0.068
0.092
0.010
0.091
0.107

0.100
0.025
0.071
0.005
0.035
0.147
0.007
0.068
0.163
0.010
0.066
0.025

Table 1: Indices of FDI regulation

restriction in 2018, a United States (US) electronic vehicle manufacturer, Tesla, was the firstwholly-owned foreign automaker in China.4 However, a car manufacture headquartered in the
Netherlands, Stellantis, ended its JV with a Chinese automobile group, Guangzhou, and determined
to supply Jeep into the Chinese market by imports.5 Thus, the effects of FDI deregulation on firms’
location choice is not obvious.
As the trend of relaxing FDI regulation is observed globally, understanding its impacts on MNEs’
location choice and its welfare effects is essential for proper policy discussions. Table.1 shows avariation in the FDI regulatory restrictiveness index for the manufacturing sector in some countries.6
The index value ranges from zero to unity, with a higher value representing tighter FDI regulation.
The declining trend in the index values over the years indicates that these countries have relaxed
their FDI restrictions to some degree. Despite the coexistence of changes in policies on inward
FDIs, this study investigates how FDI regulation affects an MNE’s location choice and whether FDI
regulation is desirable.
4 See https://www.globaltimes.cn/content/1176038.shtml.
5 See

https://www.reuters.com/business/autos-transportation/stellantis-announces-termination-jeepventure-with-chinas-gac-2022-07-18/.
6 The indices are computed by OECD and are accessible from https://www.oecd.org/investment/fdiindex.htm.
The index considers four main types of restrictions: foreign-equity limitations, screening or approval mechanisms,
restrictions on the employment of foreigners as key personnel, and operational restrictions such as restrictions on
branching and on capital repatriation or on land ownership. We drop some OECD countries such as the US and Japanbecause their indices have either remained unchanged or have equaled to zero over the years.

2

1.1

Preview of the model and results

Given the importance and drawbacks described above, this study revisits fiscal competition for FDI
by incorporating FDI regulation, that is, foreign-ownership regulation. Based on Bjorvatn and Eckel(2006), we construct an international duopoly model in which two countries in the same region
compete over a productive foreign MNE outside the region through a lump-sum tax/subsidy. The
two countries differ in market size. Furthermore, an incumbent local firm exists in the larger country
and supplies its goods only to the local market, whereas the MNE supplies its goods to the hostcountry and others via exports. Moreover, and as the focus of the study, the government in the larger
country may impose FDI restrictions on the share of foreign capital for some political reasons, suchas security purposes or the protection of local firms.
Without FDI restrictions, we find that the larger country wins the fiscal competition when themarket size is larger than a certain threshold, whereas, otherwise, the smaller country attracts
the MNE. The result is consistent with the literature and is widely known as the trade-off
between market-size and market-competition effects. Because having a subsidiary in the larger
country benefits the MNE in terms of zero transportation costs for the larger market, whereas
the establishment of its subsidiary in the smaller country without any local firms results inmonopoly profits without transportation costs, the MNE’s location choice depends on the tripletof technological gap, market-size differentials, and the amount of the transportation costs.
Especially, irrespective of the market-size gap, the MNE always chooses the larger country when
the technological gap between it and the local firm is wide and the transportation costs within theregion are low. Under a wide technological gap, the government in the larger country has a stronger
incentive to attract the MNE to increase consumer surplus, and thus its most generous fiscal policy
is a subsidy.
With FDI regulation, our model shows other location patterns in which the smaller country
attracts the MNE irrespective of the market-size gap in the other two situations. First, with strict
FDI regulation, the smaller country wins the fiscal competition when technological differences andtransportation costs are sufficiently small. In the presence of FDI regulation, the MNE needs to form
a JV to enter the larger country, and the new entity operates as a monopolist in the country. Thus, if
the local firm has high technology and its supplies to the market are potentially large, attracting the
MNE in the form of a JV hurts its consumers and thus the government’s fiscal policy is likely to be a
tax rather than a subsidy. From the viewpoint of the smaller country without local firms, attracting
the MNE simply increases consumer surplus and its government is ready to offer a subsidy. Thus,3the set of fiscal policies induces the MNE to locate in the smaller country.
Second and interestingly, the smaller country attracts the MNE if the level of FDI regulation
is sufficiently loose. This is because the local firm declines the JV offer by the MNE in such a case.
Under loose FDI regulation, the MNE’s ownership ratio is larger, and more of the JV’s profits accrue
to the MNE and less profits to the local firm. Thus, the local firm can earn more profits by declining
the JV offer and keeping its rival firm away from the larger country. At first glance, this result iscounterintuitive because one can expect looser FDI regulation to encourage the MNE to locate in
the country that is consistent with the anecdotes above. However, our result indicates that such alooser FDI regulation may keep the MNE away from the country, which is in line with the storyof Stellantis and Guangzhou. Therefore, although attracting an MNE benefits the host country andthe government has an incentive for inward FDI, deregulation of foreign ownership restrictions canbackfire.
Furthermore, we also explore the welfare effect of FDI regulation. It will be shown that, given
the MNE’s location in the larger country, the mitigation of FDI regulation decreases its welfare when
the degree of FDI regulation is at an intermediate level. This is because mitigated FDI regulationfrom an intermediate level lowers the local firm’s profits and thus fiscal policy should be moregenerous, which lowers welfare in the larger country because some of the generous subsidy accrues
to the MNE. Therefore, strict FDI regulation maximizes welfare in the larger country.
It is notable that whether FDI regulation benefits the larger country given the MNE’s location
there depends on the technological gap. When the technological gap is narrow, having the MNE in
the form of a JV increases the JV’s market power and thus FDI regulation decreases the country’s
welfare. However, when the technological difference is large, FDI regulation is desirable for thelarger country because the local firm has inferior technology and a JV using the MNE’s superior
technology reduces production-efficiency losses. These results could provide one rationale for thetrend that more developing countries mitigate their FDI regulation. As a wider technological gap
changes the optimal FDI regulation from very strict to no FDI regulation, technological improvement
in a technologically inferior country, i.e. technological transfer, can induce the larger country’s
government to eliminate FDI regulation.

1.2

Related literature

Our paper contributes to several strands of the literature. First, our paper is related to fiscal
competition for FDI. Since Haufler and Wooton (1999) examined an international fiscal-competition

4

model for a monopoly foreign firm, several studies have been conducted. Based on Haufler andWooton (1999), Ferrett and Wooton (2010) asked how a foreign firm’s international ownershipaffects the outcomes of fiscal competition and concluded that the firm’s location choice andtax/subsidy offer were independent of the distribution of the ownership. However, with local
firms, a firm’s ownership structure influences its strategies; thus, our paper provides new insights
into the relationship between fiscal competition and a change in a firms’ strategy due to a change
in ownership distribution.
Moreover, recent developments in the literature have introduced interactions between firms
since Bjorvatn and Eckel (2006) constructed an international duopoly model and showed that themarket-size difference and transportation costs are critical determinants of which country wins the
fiscal competition. Some papers have considered different market-competition structures, such as
differentiated products (Ma and Wooton, 2020), the existence of a public local incumbent (Amerighi
and De Feo, 2017), and network goods (Mukunoki and Okoshi, 2023), while others have introduced
different environments of the country relationship, such as more than three countries (Haufler andWooton, 2006, 2010) and hub-and-spokes countries (Darby et al., 2014). In contrast to these papers,
we incorporate another policy-related variable, FDI regulation, which has been overlooked.
Second, this paper contributes to FDI policies with regulation. Fatica (2010) introduced partial
foreign ownership when a foreign firm enters a host country and showed its incentive for a JV
rather than greenfield FDI if the fixed costs of greenfield FDI were high. Qiu and Wang (2011)
investigated a host country’s optimal policy that limits the share of profits accruing to a foreign
firm, and concluded that the optimal policy is to impose FDI regulation under certain market
conditions such as market-competition intensity and the gap between firms’ technologies. Cai
and Karasawa-Ohtashiro (2021) explored the optimal local-equity requirement by incorporating astate-owned enterprise that maximizes domestic welfare instead of its own profits. However, these
papers consider the optimal FDI regulation in a two-country model with one host country, and it
is impossible to consider fiscal competition between two host countries, whereas ours constructs athree-country model with two (potential) host countries.
The rest of the paper is organized as follows: Section 2 introduces our model and derives theequilibrium without FDI regulation, while section 3 derives the equilibrium in the presence of FDI
regulation. Section 4 investigates the welfare effect of FDI regulation. We discuss some extensions
in section 5. Section 6 concludes the paper.

5Figure 1: Model

2

Model

We consider a three-country model, as illustrated in Fig.1. There are two countries, A and B, inthe same region. We assume that the two countries are developing countries and seek to attracta productive foreign firm headquartered in an industrial country outside the region. We refer tothe foreign firm as a multinational firm, firm M, and transportation costs between the country andthe region are assumed to be prohibitively high and supplying its goods to the region requires a
production plant in the region.7
The two countries differ in two respects. First, the population in country A is n times larger
than that in country B. Let ni be the number of the population in country i ∈ { A, B}. Thus, wenormalize the size of country B to unity for simplicity, so that n A = n > 1 = n B holds. Second,
following Bjorvatn and Eckel (2006), there is a local firm, firm L, only in the larger country A.
Consumers in the region share the same utility function, and a representative consumer has thefollowing utility function:ui = qi −

q2i
+ zi
2

∀i ∈ { A, B},(1)

where qi and zi are its consumption of goods in imperfect and perfect industries in country i,
respectively. This quadratic utility function yields the representative consumer’s inverse demand
7 This is a standard assumption in the literature on fiscal competition for one foreign firm. It is possible to consider
the case in which the MNE supplies its goods via exports if transportation costs between the foreign country and theregion are sufficiently small or having one subsidiary in each country if fixed costs of FDI is small enough. However, we
do not consider such cases because only few new insights can be obtained while the analysis becomes complex.

6

function pi = 1 − qi and consequently the following aggregate inverse demand function:
Q i ≡ n i q i = n i (1 − p i )→pi = 1 −Qi,
ni

where Qi is the aggregate consumption of the good in the imperfect sector in country i.
The consumers have (potentially) three sources of income. First, each consumer owns an initial
income I which is assumed to be sufficient for the positive consumption of both imperfect andperfect industries. Second, we assume, following the literature, that the local firm is owned byresidents in the country and firm L’s profits (Π L ) are equally distributed to the local residents incountry A. Finally, if a country successfully hosts the MNE with a tax on FDI, the government
uniformly distributes the tax revenue to the consumers in the country. By contrast, if a country
needs to offer a subsidy to attract the MNE, the government collects tax from its consumers tofinance the fiscal policy. Overall, the budget constraint for the representative consumer in eachcountry is expressed by the following:ΠLt+ λ A ≤ zA + pAqA
n
n

(2)

I + (1 − λ ) t B ≤ z B + p B q B ,

(3)

I+

where λ takes unity if country A is the host country and zero if country B hosts the MNE.
Thus, by using eqs.(1) to (3), the utility-maximization problem yields the following welfare
functions:n
WA = nu A =
2



QA
n

2

+ Π L + λt A + nI, and WB = u B =( Q B )2
+ (1 − λ)t B + I.
2

(4)

Governments design their fiscal policy to maximize their own social welfare defined by eq.(4).
Each government designs a lump-sum fiscal policy, which we denote by ti . ti can be either positiveor negative: a positive ti is a tax while a negative one represents a subsidy.8 As explained above,
the investment tax revenue is uniformly distributed to the consumers in the country, whereas theinvestment subsidy is financed by a tax on the consumers.
In addition to the fiscal policy, firm M’s entry mode depends on FDI regulation in country A,
which is the main focus of the paper and is analyzed in the next section. Government A may impose
some degree of FDI restriction on foreign capital for some purposes, such as security reasons, and
8 The assumption of the lump-sum fiscal policy is standard in the literature and realistic because fiscal policies toattract FDI are often in the form of a one-shot or short-term tax/subsidy incentive scheme.

7firm M must form a JV, firm J, as its subsidiary in country A. Following Ishikawa et al. (2009), we
introduce an exogenous foreign-ownership regulation parameter α ∈ (0, 1), which means that firm
M owns α(> 0) percent of firm J at most, and firm L owns 1 − α percent of firm J. In other words,
firm M’s equity ratio is α percent and α percent of firm J’s profits accrue to firm M, whereas firm
L obtains the remaining profits. Thus, α rises as government A loosens it ownership restrictions. In
this paper, we assume that this parameter is exogenously given and government A cannot control it
for welfare maximization due to some political and/or security reasons.9 Note that, firm M always
establishes a wholly-owned subsidiary when it chooses to locate in country B because no local firm
exists in country B.
Our model considers two types of industries.
competition.

One industry is characterized by perfect

In this industry, perfectly competitive firms produce goods and we use it as anuméraire industry.

The other type of industry is the focus of our study and is imperfectlycompetitive in the region, which is described in detail below.
Firms M and L produce homogeneous goods with different levels of technology. Firm M
produces a homogeneous good with superior technology at the zero marginal cost (c M = 0),
whereas firm L produces goods with inferior technology and must incur a marginal cost c L =c > 0.10 For simplicity, intra-regional trade is assumed to be conducted only by firm M because
firm L has inferior technology and cannot earn sufficient profits to cover the relatively high fixed
cost of exports. Furthermore, exports between countries A and B entail a transportation cost, τ, perunit.11 The existence of transportation costs in our model creates a trade-off for firm M on location
choice: earning higher profits in a larger market versus earning higher profits from a monopolized
market in country B.
Before solving the model, we argue for two important assumptions about the formation of a JV.
First, a JV uses firm M’s superior technology and produces goods at a zero marginal cost c J = 0.
As firm M’s superior technology is available with firm-specific intangible assets such as patents,
production without patents is impossible and firm M’s negotiation power is quite strong. Thus, we
assume that firm M holds a maximum level of equity α and we do not incorporate the negotiation
process for the optimal ownership level α. Similarly, and for the purpose of comparing our analysis
with that in the literature, firm M prefers a wholly owned enterprise to a partially owned one.
A possible reason is the weak intellectual property protection in developing countries. As firm J
9 We argue the optimal α in section 4.
10 Ferrett and Gravino (2021) also introduces asymmetry in the marginal costs of production between the local firm

and multinational firm and shows that technological spillover can be a factor in where the multinational firm locates.
11 Throughout the analysis, we focus on the case in which both firm M and firm L operate in equilibrium. This pinscmax ), respectively.
down the ranges of c and τ as c ∈ [0, 12 ) and τ ∈ [0, 1+
2 ≡τ

8uses firm M’s superior technology and produces its goods at zero marginal cost c J = 0, the JV’s
profitability crucially depends on the quality of contractual enforcement.12 Thus, the MNE fears atechnology leak via the JV because a leakage of superior technology may induce more entrants andreduce firm J’s profits.
We solve the following three-stage game: In the first stage, governments determine the levelof tax/subsidy. Second, firm M chooses a country for the location of its production. Finally, firms
simultaneously determine the amount of production. We solve the game by backward induction. To
clarify the importance of FDI regulation, our analysis first examines the case without FDI regulationin the reminder of this section by considering cases (i) and (ii) in Fig.1. The next section focuses on
the case with FDI regulation by focusing on the cases (iii) and (ii) of the figure.

2.1

Without FDI regulation

As a benchmark analysis, we begin our analysis with no FDI regulation.
At the third stage, given the aggregate demand function and firm M’s location in i, firms M andL maximize the following profits:
ΠiM = pii QiMi + ( pij − τ ) QiMj − ti ,and

ΠiL = ( piA − c) QiL ,j 6= i(5)where QiMi and QiMj represent the amounts of supplies by firm M locating in country i to themarkets in countries i and j, respectively, and QiL denotes the amount of supplies by firm L whenfirm M invests in country i. Note that, hereafter, we use a superscript for the location of firm M
and a subscript for the country where firms supply their goods. Thus, for the profit-maximization
problem, we derive the following set of equilibrium outputs:n (1 + c ),3n(1 + c − 2τ )Q BMA =
,
3
A
Q MA
=

n(1 − 2c),3n(1 − 2c + τ )Q BL =,
3

Q LA =1−τ,2
1
Q BMB = ,
2
A
Q MB
=

(when firm M in A)(when firm M in B)

12 Property Right Alliance provides evidence that developing countries have weak protection for intellectual property

rights. See https://www.internationalpropertyrightsindex.org/.

9

and the profits of firms M and L are respectively as follows:(Firm M)

(Firm L)




Π A

M

2

2

c)
+ (1−4τ ) − t A ,= n (1+
9

(6)


2

Π BM = n(1+c−2τ ) + 1 − t B .
9
4


2

Π LA = n(1−2c) ,
9


Π BL

(7)

+ τ )2= n(1−2c,9

At the second stage, firm M chooses the production location to maximize its profits. Given theoperating profits shown in eqs.(6), we can compute the condition under which firm M invests incountry A as follows:4nτ (1 + c − τ )A−ΠM− Π BM ≥ 0 ⇔ t A ≤ bt FDI≡ tB +
A
9|{z}
Gains from A’s market

τ (2 − τ )
4 }
| {z

,

Losses from B’s market

whereas firm M invests in country B ifAΠM− Π BM < 0 ⇔ t B < bt BFDI ≡ t A +τ (2 − τ )
4 }
| {z

Gains from B’s market−

4nτ (1 + c − τ )
9
|
{z
}

Losses from A’s market

holds. The conditions clearly mean that the MNE prefers locating in country i if government i offers
ti less than or at most equal to the threshold btiFDI .
The upper bound of ti for firm M to locate in country i is determined by three elements. The firstelement is the level of the rival government’s fiscal policy, which is captured by the first term of btiFDI .
In addition, as locating in country i increases the profits from the host market due to the absence oftransportation costs, firm M’s incentive to locate in the country is stronger, which is reflected by thesecond term. However, locating in country i generates transportation costs for supplying goods tothe market in country j and thus decreases the profits from the exporting market, which is capturedby the third term.
Given the location of firm M, both governments determine their policy at the first stage.
Countries A and B aim to attract firm M to maximize their welfare. Country A’s welfare is givenby the following:WAA =n(1 − 2c)2n (2 − c − τ )2n(1 − 2c + τ )2n (2 − c )2+
+ t A + nI and WAB =
+
+ nI,
18
9
18
9

10

(8)

whereas country B’s welfare is,WBA =(1 − τ )2
+I
8

and

WBB =

1
+ t B + I.
8

(9)Thus, eqs.(8) to (9) provide us with the following most generous fiscal policies that each government
can offer to attract firm M,nτ (τ − 2c),6(2 − τ ) τ
WBB ≥ WBA ⇔ t B ≥ t B ≡ −<08

WAA ≥ WAB ⇔ t A ≥ t FDI≡
A

Note that the sign of t B is always negative, whereas that of t FDI
is ambiguous. GovernmentA
B offers a subsidy because having firm M is always beneficial to country B due to the absence oftransportation costs and an increase in consumer surplus. However, regarding t FDI
A , two conflicting
mechanisms arise. On the one hand, attracting firm M increases consumer surplus in country A
because transportation costs do not exist. On the other hand, the absence of transportation costs
decreases firm L’s profits. As firm L earns higher profits when firm M locates in country B andtransportation costs are large, government A is not eager to attract firm M and thus the mostis positive and a tax when transportation costs
generous fiscal policy is likely to be a tax. Thus, t FDIAc
FDI is negative otherwise. Note that 2c < 1+c holds only
are large and 2c < τ < 1+
2 holds, and t A
2c
FDI is always negative and awhen c < 13 holds. Thus, if c > 13 holds, (τ <) 1+
2 < 2c holds and t A

subsidy. Intuitively, the most generous policy in country A is a tax if the local firm’s technology is
sufficiently low and transportation costs are large because the benefits from protecting firm L arelarge only in such a situation.
From now on, let us identify which country wins the fiscal competition for firm M. As the setof the most generous policies (t FDI
A , t B ) maximizes firm M’s profits, firm M chooses country A forA ( t FDI ) ≥ Π B ( t ) holds; otherwise, it chooses country B. Using eq.(6), t FDI ,its production when Π M
M B
AA

and t B , we have the following:
A FDI
ΠM(t A ) R Π BM (t B ) ⇔ n R n FDI ≡27(2 − τ ).
4(8 + 14c − 11τ )Hence, which country wins the fiscal competition depends on the market-size and technology
gaps as well as the level of transportation costs. More specifically, firm M tends to locate in thelarger country A when the market gap is large (n ≥ n FDI ), firm L’s technology is sufficiently low

11∂n FDI∂c < 0, or the transportation costs are low∂n FDI∂τ > 0

because of the market advantage andsubsidization under a large c and/or a small τ.
Note that firm M’s equilibrium location in A irrespective of market advantages is possible if cis large and τ is small. This situation corresponds to the case in which the most generous fiscal
policy in country A is providing large subsidies. Specifically, as n FDI R 1 holds if and only ifτR

2(28c−11)1, country A wins the fiscal competition irrespective of the market-size gap if 11
17
28 < c < 2and τ <

2(28c−11)
hold.
17

The result is summarized as the following lemma:
Lemma 1. (Location of firm M): Without FDI regulation, country A can attract firm M when (i)2(28c−11)111
hold or (ii) n ≥ n FDI holds. Otherwise, country B attracts firm M.
28 < c < 2 and τ <173

FDI regulation (0 < α < 1)

In this section, we turn to the case with FDI regulation, α ∈ (0, 1). In this case, firm M must form
a JV with firm L when it invests in country A whereas investment in country B is not regulated as
there are no incumbent firms. Therefore, we can carry over the equilibrium outputs and profits inthe previous section, when firm M chooses country B for its production location. Thus, our focus,
for now, is on the situation in which firm M establishes a subsidiary in country A.
Note that when firm M forms a JV with firm L, joint profit maximization is most profitable.
This means that firm J uses technology at zero marginal cost and produces monopoly output levelto maximize the joint profits, Π J = p J A Q J A + ( p JB − τ ) Q JB − t A .13 Thus, firm J produces Q J A = n2
and Q JB = 1−2 τ . As firms’ allocation of profits is based on equity levels, firm M and firm L receive,
respectively,
n + (1 − τ )2
− tA
4


n + (1 − τ )2
JV
Π L = (1 − α )
− tA
4
JV
ΠM
=α



as their profits.14
13 In our model, the firms produce homogeneous goods and thus the monopoly output arises. Once we consider
differentiated products, a strategic interaction via joint profit maximization appears and the proportions of ownershipfor firms M and L are a crucial element for decisions on outputs. Although we we do not incorporate this feature in thecurrent analysis to keep our analysis comparable with the literature, we argue substitutability of goods in Section 5.2.
14 This specification signifies that the fiscal policy, t , is paid by not only firm M but also by firm L. This is naturalA
setting because some tax reductions or subsidies last for several years after firms’ entry, and an MNE and a local firm
jointly receive the fiscal policy.

12

JV
Similar to the analysis in the previous section, with Π BM of eq.(6) and Π M, firm M prefers toform a JV and to invest in country A if
n + (1 − τ )JVΠM− Π BM ≥ 0 ⇔ t A ≤ bt AJV ≡
4

2



1 n(1 + c − 2τ )2 1−
+ − tB ,α
94holds and firm M invests in country B if,n(1 + c − 2τ )JV
ΠM− Π BM < 0 ⇔ t B < bt BJV ≡
9

2



n + (1 − τ )2
1
+ −α
− tA
4
4

holds. Intuitively, a higher α increases firm M’s profits and magnifies firm M’s incentive to locate
JV
JV
in country A. Thus, an increase in α leads to a higher bt A
and a lower bt BJV . In addition, note that bt A

as α approaches unity because the market structure in A is different.
is not equal to bt FDI
A
Note that with FDI regulation, firm L declines the offer of forming a JV with firm M if the gains
from forming the JV are negative. As firm L’s outside option if it declines the JV offer is Π BL ofeq.(7), firm L accepts the JV offer if
2n + (1 − τ )n(1 − 2c + τ )Π LJV ≥ Π BL ⇔ t A ≤ bt LA ≡−49(1 − α )2holds. As firm L also needs to incur 1 − α percent of the lump-sum fiscal policy in country A,
the above condition simply means that a low t A is essential for firm L to accept the JV offer andthe threshold depends on the degree of FDI regulation. Therefore, a JV can be formed only when
n
o
JV bL
t A ≤ min bt A
, t A holds.
Given the above policy constraints, government A determines the fiscal policy in the first stage,
whereas the policy decision by government B is the same as in the previous section because of theassumptions that firm L cannot export to country B and that there are no incumbent firms. In thecase of FDI regulation, welfare in country A is computed as follows:
WAJV =n (1 − α){n + (1 − τ )2 }++ αt A + nI.
8
4

(10)

By using WAB and WAJV , we can derive country A’s most generous offer to attract firm M asn + (1 − τ )JVWAJV ≥ WAB ⇔ t A ≥ t A
≡
4

2



1 n(1 + 16c − 12c2 + 8cτ − 4τ 2 ) + 6(1 − τ )2
−
.
α
24

JV
Similar to t FDI
A , the sign of t A is ambiguous. When a JV is established, two conflicting effects

13

exist. On the one hand, consumer surplus decreases because firm J is the only operating firm and amonopoly outcome is obtained. On the other hand, firm L’s profits can increase because firm J uses
technology than is superior to that of firm L and 1 − α percent of profits from country B accrue toJVfirm L. Thus, the sign of t A
depends on the sizes of the two effects.
JV
Before we identify which country wins the fiscal competition, we must check whether t A
≤
o
n
JV bL
min bt A, t A holds, because the inequality is essential for country A to induce firm M to form a JV.

We confirm

JV
∂bt A
∂bt LAbJVbL∂α < 0 and ∂α > 0, and thus we have a unique threshold of α such that t A ( t B ) = t A

holds at α = αt . Specifically, we have
bt JV (t B ) R bt LA ⇔ α R αt ≡A

8n(1 + c − 2τ )2 + 9(2 + 2τ − τ 2 ).
8n(2 − 2c + 5c2 − 2τ − 8cτ + 5τ 2 ) + 9(2 + 2τ − τ 2 )JVWhen α < αt holds, as shown in appendix A, in equilibrium, t A≤ bt AJV (< bt LA ) always holds. In
JV
addition, t A≤ bt LA (< bt AJV ) holds when αt < α < α J (< 1) holds. Therefore, country A loses the fiscal

competition when α J < α < 1 holds because sufficiently large α decreases firm L’s profits and firm
L declines the JV offer.
From now on, we examine the condition under which country A wins the fiscal competition byconsidering firm M’s profits under the set of the most generous fiscal policies. Suppose 0 < α < α J .
JV JVAs shown in appendix B, irrespective of the country-size difference, Π M(t A ) < Π BM (t B ) holds andcountry B can attract firm M when τ < τ B ≡√2(4+7c)−3 1+64c−32c2
225
under c < 22holds. This isbecause the most generous fiscal policy for government A is likely to impose a tax because joint
profit maximization generates a monopoly outcome and the technological gain is small under asmall τ and c.
However, we also derive results similar to those in the case without FDI regulation. First, country
JV JV
A wins the fiscal competition irrespective of the market-size differential, namely, Π M(t A ) >
5Π BM (t B ), when τ < 22c17−5 holds under 22< c. Moreover, if max τ B , 22c17−5 < τ holds, whichcountry wins the fiscal competition depends also on the market-size differential as well as thetransportation costs and technological difference, namely,
JV JV
ΠM(t A ) R Π BM (t B ) ⇔ n R n JV ≡27(2 − τ )τ,ξ

where ξ ≡ −5 + 32c − 44c2 + 56cτ + 32τ − 44τ 2 . Similarly, in the case without FDI regulation
summarized in lemma 1, country A has a larger market or technological advantage with lowtransportation costs and thus it tends to win the fiscal competition.

14

Figure 2: Location for the multinational enterprise

The above results are summarized as the following lemma:
Lemma 2. (Location of firm M): With FDI regulation, country A attracts firm M when 0 < α < α J ,max τ B , 22c17−5 < τ, and n ≥ n JV hold. Otherwise, country B attracts firm M.
The results are illustrated in Fig.2 in the (c, τ ) plane. As we focus on the case in which both
firms operate in equilibrium, we consider the area below τ ≤ τ max . The left figure shows the casewithout FDI regulation. Lemma 1 shows that a larger country tends to attract FDI when n ≥ n FDI
holds. Therefore, country A always wins the fiscal competition for FDI when n FDI ≤ 1(< n) holds,
which corresponds to the area labeled “Region 1-FDI.” In the area above the line, n FDI = 1, n FDI > 1
holds and country A (B) wins the fiscal competition when n ≥ n FDI (n < n FDI ) holds.
With FDI regulation, as is depicted in the right figure, additional cases are possible. First, similar
to the threshold, n FDI = 1, another threshold, n JV = 1, is drawn with a dashed line above the solidline showing n FDI = 1. The areas below the line represent the case in which the larger country
always attracts the MNE, labeled “Region 1-JV,” whereas the area above the dashed line corresponds
to the case in which the equilibrium location depends on the market size. The expansion of thearea in which country A successfully attracts FDI irrespective of the market-size gap is because
government A’s offer is likely to subsidize the JV. If firm L’s technology is sufficiently low and c islarge, 1 − α percent of firm J’s profits tends to be greater than firm L’s profits when firm M enters
country B and thus the benefits from the most generous equilibrium policy decrease.
In addition to “Region 1-JV,” another dot-dashed curve represents τ = τ B , and thus the area
below the threshold is the case in which the smaller country can attract the MNE irrespective of15

5
the market-size differential, which is labeled “Region 2.” If c < 22holds and firm L is relatively

productive, government A tends to tax the JV and reduces consumer surplus due to an increase inmarket power. Thus, a less generous policy discourages firm M from entering country A.
Above the thresholds, τ = τ B and n JV = 1, the fiscal competition relies on the market-size gap
and firm M’s location is in country A if n ≥ n JV holds; the corresponding areas are labeled “Region
3-A” and “Region 3-B.” The difference between “Region 3-A” and “Region 3-B” is the order of n JV
and n FDI : “Region 3-A” is the case in which n JV < n FDI holds and “Region 3-B” is the case in whichn FDI < n JV .15 The intuition is the same as above: a small c (large c) leads to the most generous fiscal
policy of government A as an investment tax (subsidy). Thus, with a small (large) technology gap,
the likelihood of firm M’s location in the larger (smaller) country increases.
Lemmas 1 and 2 immediately prove the following proposition:
Proposition 1. (Impact of FDI regulation on firm M’s location): FDI regulation can induce a smaller
country to host firm M irrespective of market size gap. Specifically, country B always wins the fiscal
5competition if (i) 0 < α < α J , τ < τ B , and c < 22hold or (ii) α J < α < 1 holds.

This proposition has two notable results of the fiscal competition. First, although it is wellknown that a larger country is more likely to host MNEs, we showed that the smaller country
always wins the fiscal competition when 0 < α < α J and τ < τ B or α J < α < 1 hold. In the former
case, FDI regulation weakens country A’s incentive to attract firm M due to an increase in market
power. Thus, this result indicates that considering a change in market structure is important when
discussing fiscal competition.
More importantly, our model predicts that the deregulation of foreign ownership in country
A can trigger a relocation of firm M from country A to B. This happens when weakening FDI
regulation from α ∈ (0, α J ) to α ∈ (α J , 1) under n JV < n. As briefly explained in the Introduction,
this is somewhat surprising because less strict FDI regulation seems to increase firm M’s gains fromlocation in country A and the likelihood of country A hosting the MNE is expected to increase.
However, as a larger α decreases firm L’s profits, firm L does not accept the JV offer by firm M,
which can lead to the result that the smaller country hosts the MNE. This may be a rationale for the
anecdotal evidence that Stellantis and Guangzhou Automobile Group ended their JV in 2022. As
attracting an MNE is beneficial for social welfare, our model shows a backfiring of the deregulationof foreign-ownership restriction.
15 Specifically, we have n JV − n FDI = 27(2−τ )τ (1−2c)(5−22c) R 0
4ξ (8+14c−11τ )

16

5
⇐⇒ 22
R c.

4

Welfare effect of FDI regulation

Thus far, we have assumed that the level of FDI regulation is exogenously given and fixed due
to reasons such as security purposes. However, as shown in proposition 1, the degree of FDI
regulation is a critical element for the fiscal competition and it is interesting to see how changes in α
affect welfare in country A and to consider the optimal level of FDI regulation from the viewpointof social welfare. For this aim, we introduce stage zero where government A determines the levelof α to maximize its welfare.

4.1

Optimal regulation

JV
Note that, although we used the most generous fiscal policies (t FDI
A , t A , t B ) to identify the MNE’s

location choice, the host country does not need to offer the most generous fiscal policy. This issimply because the MNE benefits from gains from locating in the host country, either in the formof a larger market or a lack of competitors, and thus the host government must provide a slightly
more generous fiscal policy than the sum of the other government’s fiscal-policy benefits and gains.
Specifically, in the absence of FDI regulation, the equilibrium fiscal policies for the host country are
∗ =b
t FDI
t FDI
A
A ( t B ) and are computed as follows:

∗
t FDI
=
A

τ {32n(1 + c − τ ) − 27(2 − τ )}72

Similarly, in the presence of FDI regulation, we can derive the equilibrium fiscal policies as follows:




2
2

bt JV (t B ) = n+(1−τ ) − 1 n(1+c−2τ ) + 2+2τ −τ2

A
JV ∗
tA
=
 L

bt
A

4

9

α

8

if 0 < α < αt
if αt < α < α J

To see the welfare effect of α, we can confirm the following lemma: See appendix C for the proof.
Lemma 3. (Effect of change in α): Suppose a mitigation of FDI regulation that keeps firm M’s
location in country A. Then, we have
WAJV (bt LA ) < WAJV (bt LA )

α=αt

JV
∂WAJV (bt A(t B ))∂WAA (bt LA )+ τ )2=0and= − n(91(−12c< 0. Moreover, as∂α∂α− α )2= WAJV (bt AJV (t B )) holds, welfare in country A is maximized at α ∈ (0, αt ) in

the presence of FDI regulation.
Intuitively,∂WAA (bt LA )< 0 holds because a mitigated FDI regulation decreases the local firm’s profits∂αand thus fiscal policy should be more generous, which lowers welfare in the larger country becausesome of the generous subsidy accrues to the MNE. Thus, as lemma 3 states, welfare in country A
17under FDI regulation is maximized when α ∈ [0, αt ) is set.
By comparing welfare in country A without and with FDI regulation, we can identify whether
FDI regulation is desirable. Thus,
JV∗
WAJV (bt A(t B )) − WAA (t FDI)=A

5n(1 − 2c)(22c − 5)R0⇔cR .
72
22

(11)

Therefore, having firm M in the form of a JV is more beneficial than in the form of FDI when5c > 22holds. Otherwise, country A’s welfare under no FDI regulation is greater than that under

FDI regulation. The intuition behind the result is a trade-off between higher profits for firm L andan increase in monopoly power. With a wide technology gap, firm L benefits from forming a JV byusing superior technology and the opportunity for exports is substantial. However, with a narrow
technology gap, consumers’ losses from an increase in market power are large. Thus, FDI regulation
benefits the large host country only when the local firm owns low technology and the former benefit
is a dominant effect.
To summarize the above argument, we have the following proposition:
Proposition 2. (Welfare effect of α on a large country): Suppose a mitigation of FDI regulation thatkeeps firm M’s location in country A. Then, the elimination of FDI regulation benefits country A
55holds, whereas the optimal regulation is α ∈ [0, αt ] when c > 22
holds.
when c < 22

Proposition 2 implies that the marginal cost c is critical for the optimal FDI regulation, andthus it is important to discuss the impacts of technological improvement on the optimal level of
FDI regulation. Note that we normalized the marginal cost of firm M to zero and thus we caninterchangeably interpret c as the technology gap between firms M and L. Therefore, we can regard
an increase in c as technological improvement in the industrial country and a decrease in c as
technological improvement in the developing country A.
As in proposition 2, the optimal α lies in the range of 0 < α ≤ αt when the gap is large,
whereas deregulation is the optimal policy when the technological gap is small. Thus, technologicalimprovement in country A can trigger the elimination of FDI regulation. This can provide a new
rationale why some developing countries such as China recently relaxed or eliminated their FDI
regulation. Such technological improvement can be driven by, for example, technology transfer andtechnological spillovers.

18

4.2

Effects when the smaller country is the hostFinally, although country B cannot determine α, it is also important to analyze the effects of FDI
regulation on country B because FDI regulation affects the most generous policy and consequently
country B’s welfare. As previous studies have ignored the existence of FDI regulation, we know
little about whether location in a smaller country due to FDI regulation is desirable.
Similar to the previous subsection, given firm M’s location in country B, we can derive theequilibrium fiscal policies as follows:τ {9(2 − τ ) − 2n(8 + 14c − 11τ )},36(2 − τ )τ nξJV)=t BJV ∗ = bt BJV (t A
− .
4
72

t BFDI ∗ = bt B (t FDIA ) =Note that when country B hosts the MNE, the market structure in the region is the same without
and with FDI regulation, and no impact on consumer surplus is observed. Thus, a change in welfare
in country B is equivalent to a change in the equilibrium fiscal policy, namely,
WBJV (t BJV ∗ ) − WBB (t BFDI ∗ ) = t BJV ∗ − t BFDI ∗ =5n(1 − 2c)(5 − 22c)
R0⇔cQ .
72
22

(12)

The above equation immediately shows that FDI regulation has positive impacts on a host country
5
when the technological gap between an MNE and a local firm is narrow, c < 22
. This is because,due to an increase in monopoly power in the case of a JV, fiscal competition is mitigated when firm
L is productive and thus country B can attract firm M with a less generous fiscal policy in suchcases.
The impact of FDI regulation on a small host country is the opposite to that on a large hostcountry. In other words, whether FDI regulation is beneficial for a host economy depends on
a combination of the host country and cost gap between the MNE and the local firm in the large
country. On the one hand, a large technological gap means that firm L’s production is inefficient andthus FDI regulation is beneficial for the larger economy. On the other hand, a small technological
gap indicates that forming a JV enhances the MNE’s market power and discourages the government
in country A from competing against country B, which is beneficial for the smaller country B.

19

5

Discussion

5.1

Trade liberalization

Due to increasing globalization, it is important to explore the effect of a reduction in transportation
costs.

5.1.1

Location choiceFirst, let us consider the effect of trade liberalization on the location choice. In the absence of FDI
FDI

189(1−c)regulation, we have ∂n∂τ = 2(8+14c−11τ )2 > 0, which means that a reduction in τ lowers n FDI and it
is more likely that firm M will choose the larger country A as the production location. The reason
is that lower trade costs reduce the benefits of locating in country A to obtain larger profits fromthe monopolized market and thus firm M is likely to choose the larger country A.
JV

In the presence of FDI regulation, the opposite sign could be obtained. We easily obtain ∂n∂τ =54{28(1−c)τ 2 +(1−2c)(5−22c)τ −(1−2c)(5−22c)}.
ξ2

As shown in appendix D, the sign of the first derivative is√(1−2c)(5−22c)(3−2c)(39−22c)−(1−2c)(5−22c)55positive either if (i) c > 22
holds or (ii) c < 22and< τ < τ max
56(1−c)JV

hold. Otherwise, the sign of ∂n∂τ is negative.
5
holds, firm L is highly
Intuitively, we can understand the above results as follows. When c > 22

more inefficient than firm M. Thus, government A has a stronger incentive to attract firm M and toincrease firm L’s profits via forming a JV and thus provides a generous fiscal policy for firm M tolocate in country A. As trade liberalization also increases the profits from country B, government
5
A’s incentive to attract firm M becomes stronger. In the case of (ii), namely, when c < 22and√
(1−2c)(5−22c)(3−2c)(39−22c)−(1−2c)(5−22c)< τ < τ max hold, firm M’s incentive to form a JV is strong
56(1−c)because firm L is productive and firm M’s profits from the larger market in country A is small whena JV is not formed.
However, trade liberalization increases n JV and induces firm M to locate in country B. Thisis the case in which firm L’s marginal cost is low and trade costs are small. In such a case,government A’s incentive to attract firm M is weak because of an increase in firm J’s market power,
and consumer surplus declines. Because this loss rises as trade costs become smaller, government
A’s most generous policy becomes less attractive for firm M. Thus, a reduction in trade costs makes
locating in country B more beneficial.

205.1.2Equilibrium policy and welfare

As one of the central concerns about international taxation in the current economy is the possibilityof a “race to the bottom,” here, we explore the effect of a reduction in trade costs on the equilibrium
fiscal policy. Hereafter, our analysis focuses on the case in which trade liberalization does notaffect firm M’s location and thus the difference between welfare without and with FDI regulation ischaracterized by the difference in fiscal policies. In the rest of the subsection, we consider the casein which country A hosts firm M, which is the most interesting case.16
First, without FDI regulation, we have17∗∂t FDI
16n(1 + c) − 27 − (32n − 27)τ16n(1 + c) − 27A=
R 0 ⇐⇒R τ.
∂τ
72
32n − 27

This implies that a reduction in trade costs tightens the equilibrium fiscal policy when trade costs
are sufficiently high but relaxes it when trade costs are low. Thus, if we ignore the possibility of FDI
regulation, the “race to the bottom” story occurs when trade costs are sufficiently low.
In the presence of FDI regulation, the analysis is somewhat complex due to two equilibrium
JV bL
fiscal policies. Recall that the equilibrium fiscal policy is min{bt A, t A } with FDI regulation. By
JVdifferentiating bt A
and bt LA , we have

∂bt LA{9(1 − τ )(1 − α) + 4n(1 − 2c + τ )}=−<0∂τ18(1 − α)JV∂bt A{16n(1 + c − 2τ ) − 9(1 − τ )(1 + 2α)}
=
R0
∂τ
36α
16n(1 + c) − 9(1 + 2α)9(1 − τ )(1 + 2α)
⇔nR
⇔τQ
.
16(1 + c − 2τ )32n − 9(1 + 2α)JVThus, a reduction in τ always enhances bt LA ; however it can increase bt A
only when the population

gap is small or the transportation cost is large.
The equilibrium fiscal policy in country A is drawn in Fig.3 at different levels of the population
gap in the (τ, t A ) plane.18 The thick curves represent the case with a wider population gap (n = 2)
whereas the thin ones correspond to the case with a narrow gap (n = 1.7). Given a fixed level of α,tJJV
we can derive unique thresholds, τ α and τ α , such that bt A
(t B ) = bt LA and bt LA = t AJV hold. Both curves
t
t
t
JV bL
are kinked at τ α and the optimal fiscal policy is bt A
(t A ) when τ < τ α (τ α < τ) holds. In the range

16 When country B hosts firm M, we can easily confirm that t JV ∗ = t FDI ∗ + (5−22c)(1−2c) .
B
72
BThis means that changes

in the equilibrium fiscal policies are always the same between the two cases. Moreover, we can derive(22n−9)τ −(14cn+8n−9)+8n−9
R 0 ⇐⇒ τ R 14cn
22n−9 .
18
16n
(
1
+
c
)−27
(1− c )
17 We can confirm that τ max −= 2(2732n> 0 holds.
32n−27−27)
18 We use the following parameters: c = 0.3 and α = 0.7.

21

∂t BFDI ∗∂τ=∂t BFDI ∗∂τ=Figure 3: Fiscal policy in A over τtJVτ ∈ [0, τ α ), the thick curve shows that the effect of a reduction in τ on bt A
is monotonic in the casewith a larger population gap; however, with a narrow population gap, a hump-shaped relationshipbetween transportation costs and fiscal policy is observed, as depicted by the thin curve. Under
JV ∗a large τ (> τ α ), a monotonic and negative relationship between τ and t A
is shown. Therefore,t

trade liberalization mitigates the fiscal competition if transportation costs are high, which is a similar
pattern to that in the case without FDI regulation.
In addition, Fig.4 shows welfare in country A in equilibrium.19 The left figure depicts welfare55while the right one uses c = 0.3 > 22
. In each figure, the dashed curvewith c = 0.2 < 22represents the case with FDI regulation, whereas the solid curves show that without FDI regulation.
B

J

In the ranges of τ ∈ [0, τcα=0.2 ] and τ ∈ [τcα , τcmax ], country A cannot attract the MNE and WAB (<J∗ )) holds. At τ ∈ [max{ τ B , 0}, τ α ], the MNE locates in country A in equilibrium.
WAA (t FDIcA

As shown in proposition 2, welfare in country A without FDI regulation is always higher when5
. However, in the right figure, welfare incountry A is the host country in the left figure c < 22tcountry A with FDI regulation is greater when τ ∈ [0, τ α ) holds. Thus, when τ is sufficiently
small, trade liberalization decreases welfare in country A but such a welfare loss is mitigated if thetechnological gap is large.
19 The figures use n = 2 and α = 0.7 and different sets of c. The left figure uses c = 0.2 whereas the right one uses

c = 0.3.

22

Figure 4: Welfare in A over τ

5.2

Substitutability of goods

In this paper, we assumed that both firms produced homogeneous goods, which most clearly shows
the mechanism behind the results. Here, we briefly argue for the importance of the assumption byconsidering the case with a firm in an independent industry.
Suppose that there are two independent industries, X and Z, and firm M operates in industry X,
whereas firm L operates in industry Z. In this case, firm M’s entry into country A has no impacts
on industry Z and therefore we can simply ignore the outcomes in the industry. This means thatfirm L always accepts a JV offer because of additional profits from industry X, that is, (1 − α)π JV ,and the equilibrium in the benchmark analysis in which firm M enters country B under α ∈ (α J , 1)
no longer exists. Moreover, consistent with Haufler and Wooton (1999), we can confirm that firm
M’s location in equilibrium under fiscal competition is in country A. The reason is that government
A has stronger gains from attracting firm M via consumer surplus and the local firm’s additional
profits and can provide sufficiently large subsidies to cover firm M’s losses via forming a JV withthe local firm.20 The above discussion indicates that our results in the main analysis require a
sufficiently strong similarity of goods, which creates firm L’s incentive to decline a JV offer andthe government’s weaker willingness to attract firm M under FDI regulation due to an increase inmarket power.
20 Specifically, the most generous fiscal policy in country A is t

A = −

A
A
CS A
−CS BA +(1−α)π M
A represents firm
, where π M
αM’s operating profits when it establishes its subsidiary in A, whereas that in country B is the same as in the benchmark
analysis. Then, we have Π M (t A ) − Π BM (t B ) =3(n−1)(2−τ )τ
> 0.
8

23

6

Conclusion

With globalization, harmful tax/subsidy competition has been among the central policy discussions
in the context of international taxation. In parallel, we also have observed a relaxation of FDI
regulation such as the mitigation of foreign-ownership restrictions; however, the interrelation
between the two policies has been overlooked in the literature. To explore the interlink, this paper
extended Bjorvatn and Eckel (2006) by introducing foreign-ownership regulation.
Among the main findings in the paper is that FDI regulation influences the equilibrium location
choice of an MNE headquartered in a third country outside the region with two competing
countries. In the absence of FDI regulation, as is well known in the literature, the larger country
with a local firm is likely to be the host country for an MNE headquartered in a third country
outside the region. The smaller country can host the MNE only when the gap between the market
sizes of the larger and smaller countries is narrow as monopoly profits in the smaller country are
relatively more important than a duopoly market in the larger country.
In the presence of FDI regulation, however, the smaller country can win the competition for the
MNE irrespective of the market-size gap. This outcome is realized when (i) the technological gap
between the MNE and the local firm is narrow and transportation costs between the competing
countries are low, or (ii) the foreign-ownership regulation is loose. In the first case, the larger
country’s government has less of an incentive to attract the MNE because the FDI regulation induces
the MNE and local firm to establish a JV and thus a monopoly output level of supplies is realized.
With a smaller technological gap, large amounts of goods are supplied even if the MNE locates inthe smaller country due to the local firm’s supplies, and thus the larger country’s most generous
fiscal policy is not as attractive.
Second and more interestingly, the smaller country can host the MNE when the larger country’s
FDI regulation is loose. This is because the local firm declines the JV offer by the MNE because thelocal firm’s profits based on the equity ratio are small. At a glance, looser FDI regulation enhances
the MNE’s position in the JV and it is expected that looser regulation makes it more likely that the
MNE’s equilibrium location is in the larger country. However, this ignores the local partner firm’s
viewpoint, and our result shows that looser regulation decreases the local firm’s gains from the JV,
leading to the result that the smaller country attracts the MNE.
We also investigated the welfare effect of FDI regulation assuming the MNE’s location was
fixed. On the one hand, when the larger country is the host, FDI regulation is beneficial if thetechnological gap is wide. This is because the local firm’s production is less efficient and the local

24

firm can increase its profits from a JV in the case of FDI regulation. On the other hand, when thesmaller country is the host, FDI regulation is beneficial if the technological gap is narrow. In sucha case, the incentive of the larger country’sgovernment to attract the MNE is weaker because theestablishment of a JV increases its market power and hurts consumers. Such a disincentive mitigates
the fiscal competition and thus welfare in the smaller country increases.
Despite the new findings obtained, there remains room for further research. In the current
model, we assumed away other motivations for governments to attract the MNE than more supplies
due to the absence of transportation costs. However, governments in developing countries expect
job-creation effects and/or technological spillovers in reality. Thus, it would be interesting to
introduce unemployment and research and development activities into the model. Furthermore,
the current model ignores the possibility of forming a JV without FDI regulation to focus on acomparison between traditional models without FDI regulation and the model with FDI regulation.
Thus, considering a JV without FDI regulation could also be considered in future studies. Finally, as
FDI regulation varies across industries in reality, an empirical investigation about the link between
inward FDI and FDI regulation is essential.21 We leave these directions for extensions for future
research.

Appendixes
n
o
JV
JV bL
under 0 < α < α J
A. Derivation of min bt A
, tA ≥ tA
JVRecall that bt A
< bt LA holds when 0 < α < αt holds and bt AJV > bt LA holds when αt < α holds.

First, suppose that 0 < α < αt holds. We can computebt JV (t B ) − t JV = nξ − 27(2 − τ )τ .
A
A
72α
JV JV
As this condition is equivalent to the condition Π A(t A , t B ) R Π B (t B ), whenever country A can
JVattract firm M, bt A
(t B ) > t AJV holds.
21 See https://stats.oecd.org/Index.aspx?datasetcode=FDIINDEX for the variation of the FDI index acrossindustries.

25

Next, consider the case of αt < α < 1. Then, we havebt LA − t JV =AΞ
72α(1 − α)where Ξ ≡ 3n(1 + 16c − 12c2 + 8cτ − 4τ 2 ) + 18(1 − τ )2
− α n{11 + 16c − 4c2 + 8(2 − c)τ − 4τ 2 } + 18(1 − τ )23n(1+16c−12c2 +8cτ −4τ 2 )+18(1−τ )2

JV
Hence, bt LA > t A⇔ Ξ > 0 ⇔ α < α J ≡ n{11+16c−4c2 +8(2−c)τ −4τ2 }+18(1−τ )2 holds.
o
n
JV bL
JV
Therefore, in the range of 0 < α < α J , min bt A
, tA ≥ tA
holds.

B. Derivation of n JVJVWe derive n JV , which is defined by Π M= Π BM (t B ). We can calculate the difference,

JV JV
ΠM
(t A ) − Π BM (t B ) =nξ − 27(2 − τ )τ72

where ξ ≡ −5 + 32c − 44c2 + 32τ + 56cτ − 44τ 2 .
JV JVAs ξ < 0 holds when τ < τ B holds, Π M(t A ) − Π BM (t B ) < 0 holds and country A always loses the

fiscal competition in such a case.
JV JVIn contrast, when τ B < τ holds, ξ is positive and Π M(t A ) R Π BM (t B ) holds if and only ifnR

27(2−τ )τ
= n JV .
ξ

C. Proof of lemma 3
JV ∗Suppose, first, the case in which 0 < α < αt holds and t A= bt AJV (t B ). By substituting bt AJV (t B ) into

eq.(10), we have
WAJV

JVt A =bt A(t B )=

n n + (1 − τ )2n(1 + 16c − 12c2 + 8cτ − 4τ 2 ) + 6(1 − τ )2
+
−
+ nI,
8
4
24

which is independent from α and thus

∂ WAJV |JVt A =bt (t B )A∂α= 0 holds.

JV ∗Next, under the range of α ∈ (αt , α J ), the equilibrium fiscal policy is t A= bt LA . Similarly, byusing t A = bt LA ,n n + (1 − τ )
WAJV
= +
L
8
4
t =bt
A

2



−

A

26

α
1−α



n(1 − 2c + τ )2
9



+ nI

is obtained. Taking the first derivative of the above equation yields∂ WAJV |t =bt L
A

2

+τ )
< 0.
= − n(91(−12c− α )2A∂αFinally, we can computeαn(1 − 2c + τ )2
1−α
9
A
2
n(1 + 16c − 12c + 8cτ − 4τ 2 ) + 6(1 − τ )2
+
24



2
n + (1 − τ )n(1 − 2c + τ )2−=α49(1 − α )n + (1 − τ )2n(1 + 16c − 12c2 + 8cτ − 4τ 2 ) + 6(1 − τ )2
−
−
4
24α


= α bt LA − bt AJV ,=−− WAJVWAJVLbt A =bt JV
t A =tAJVand bt LA = bt A
holds at α = αt , by definition. Thus, at α = αt , WAJV

JV

D. Derivation of the signs of ∂n∂τ =t A =bt LA= WAJVJVt A =bt A

also holds.

54{28(1−c)τ 2 +(1−2c)(5−22c)τ −(1−2c)(5−22c)}
ξ2
JV

By differentiating n JV with respect to τ, we have ∂n∂τ =54ξ n JV
, where ξ n JV
ξ2

≡ 28(1 − c)τ 2 + (1 −JV

2c)(5 − 22c)τ − (1 − 2c)(5 − 22c), and hence ξ n JV determines the sign of ∂n∂τ .
5holds. Note that ξ n JV takes the minimum value when τ =First, suppose c > 22−(1−2c)(5−22c)
56(1−c)holds, and the minimum value is given by(ξ n JV ≥) ξ n JV |τ = −(1−2c)(5−22c) = −56(1−c)(1 − 2c)(5 − 22c)(3 − 2c)(39 − 22c).
112(1 − c)5Hence, c > 22
yields ξ n JV |τ = −(1−2c)(5−22c) > 0, and thus consequently ξ n JV > 0 holds.
56(1−c)5
Next, suppose c < 22
. As the minimum value is negative and ξ n JV is a convex function, there

exist a unique threshold such that ξ n JV =≥ 0 holds in the range of τ > 0. Specifically,ξ n JV ≥ 0 ⇐⇒ τ >JVHence, ∂n∂τ−(1 − 2c)(5 − 22c) +p(1 − 2c)(5 − 22c)(3 − 2c)(39 − 22c)(> τ B )56(1 − c)−(1−2c)(5−22c)+√(1−2c)(5−22c)(3−2c)(39−22c)> 0 holds if τ >56(1−c)√JV−(1−2c)(5−22c)+ (1−2c)(5−22c)(3−2c)(39−22c)∂nB.
∂τ < 0 holds if τ < τ <56(1−c)is obtained.

27

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