on where FDI locate.<sup>13</sup> A debate is currently ongoing over whether fiscal incentives for FDI are beneficial or detrimental to host developing countries (Blomtröm and Kokko 2003; Morisset 2003). Among tax incentives, tax holidays have been favoured by policymakers. Cleeve (2008) reports that, in 2004, 70% of African countries use tax holidays to attract FDI compared to only 20 % of OECD countries. Tax holidays provide benefits as soon as companies begin earning income while the benefits of corporate tax rate accrue more slowly and over a longer period.

**<u>Table 1 - Types of Fiscal Incentives Used, by Geographical Region</u>**

|**Fiscal**<br>**Incentives**|**Africa**|**Asia**|**Latin**<br>**America &**<br>**Carib.**|**Central &**<br>**Eastern**<br>**Europe**|**Western**<br>**Europe**|**Other**<br>**Coun-**<br>**tries**|**Total**|**OECD**|**Devel**<br>**oping**|
|---|---|---|---|---|---|---|---|---|---|
|**(# of Countries)**|**(23)**|**(17)**|**(12)**|**(25)**|**(20)**|**(6)**|**(103)**|**%**|**%**|
|Tax Holidays|16|13|8|19|7|4|67|20|55|
|Accelerated<br>Depreciation|6|8|6|12|10|5|47|30|30|
|Investment<br>Allowances|4|5|9|3|5|-|26|30|49|
|Import duty<br>Exemption|15|13|11|13|7|4|63|5|56|
|DutyDrawback|10|8|10|12|6|3|49|5|24|

Sources: Bora 2002, UNCTAD, FDI/TNC database and Cleeve 2008 Supporters of fiscal incentives for FDI argue that they are needed to increase investment which, in turn, create jobs and generate economic and social benefits such as positive externalities or spillovers conveyed by foreign firms. Local firms may be able to improve their productivity as a result of forward and backward linkages with multinational firm affiliates. Several other arguments in favour of public support to FDI that have been identified by cases studies and econometric studies (see Boadway and Shah 1992; Blömstrom and Kokko 2003; Easson 2004). The point is however that the foreign firms differ from local firms and possess specific intangible assets (for instance knowledge and technology that can spill-over to local companies). The multinational firm will not include these spillovers in their private assessment of the cost and benefits of investing abroad and may consequently invest less than what would be socially optimal.<sup>14</sup> Therefore, the question is to check empirically whether spillovers and externalities associated with FDI are strong enough to justify fiscal incentives. The earliest discussions of spillovers in the FDI literature date back to the 1960s but surveying this ample empirical literature would lead us too far. Blömstrom and Kokko (2003) conclude that there is strong evidence pointing to the potential for significant spillovers benefits from FDI but also that spillovers do not occur automatically. The latter conclusion is mainly due to the fact that most developing countries do not have the capability in terms of technical skills and human capital to benefit from FDI. The most favorable tax treatment should therefore be focused on foreign investment generating ample spillovers. The problem is obviously that it is difficult for the host country to measure the social benefits derived from FDI location. An interesting point is that in the presence of FDI spillovers, not only should foreign investment be subsidized but also local firms should strengthen their capacity to absorb foreign technology.

> 13 For an analysis of the impact of tax incentives on the cost of capital, see Boadway and Shah (1992) and Shah (2003) for an application of the cost-of-capital methodology to fiscal incentives in Pakistan.

> 14 This argument is in line with the theoretical point by Besley and Seabright 1999 mentioned above.

14