for the value of alternative uses for foregone tax revenues, the administrative costs of the R&D tax credit system and the various new distortions the tax scheme could itself introduce.

_Fiscal Incentives for FDI._ This section concludes with a look at policies to attract FDI and to enhance the benefits of FDI for the domestic economy, which are often rationalized on the basis of the technology transfers FDI is expected to bring. A general point that emerges from the large research literature on the determinants and consequences of FDI<sup>34</sup> is that the fundamentals that are important for encouraging and benefiting from capital investment as such - a friendly business climate, macroeconomic and political stability, good quality infrastructure, a relatively open trade policy regime and availability of relatively skilled labor – are also important for FDI.

Governments also use targeted policies to attract FDI, such as tax incentives, import duty exemptions, or land and power subsidies. If FDI creates positive spillovers for the economy, there is a theoretical rationale for some government intervention. However, as noted, the evidence for horizontal FDI spillovers is mixed, especially in developing economies. There is evidence that domestic firms with high human capital and R&D receive more spillovers, and also that foreign firms that do R&D in the host country generate more spillovers. But this provides a rationale for strengthening education, and perhaps for incentives to R&D done locally (whether by local or foreign firms) rather than for subsidizing FDI. Given stronger evidence for vertical technology transfer between MNCs and developing country suppliers (Blalock and Gertler, 2005), it is clear that policies that _discourage_ FDI carry a high price tag in forgone technology and, all else being equal, should be avoided. However this type of vertical technology transfer is internal to supply chain transactions and the benefits are realized by the supplier and the buyer. By itself such technology transfer does not provide a rationale for intervention.<sup>35</sup> Overall, empirical research provides little conclusive evidence to warrant substantial fiscal incentives to promote FDI on welfare grounds. Nevertheless, in the mid-1990s more than 100 countries offered such incentives, a trend that continues. A survey of 45 developing countries found that 85 percent offered some kind of tax holiday or reduction of corporate income tax for foreign investment. (World Bank, 2005). How effective are such measures? Most studies show that such incentives are only one among a set of relevant investment climate variables (of the sort outlined in the last paragraph). Indeed, the World Bank’s Investment Climate Surveys show that unreliable power supply, weak contract enforcement, corruption, and crime can impose costs several times greater than taxes. A MIGA survey of 191 companies with plans to expand operations found that only 18 percent in manufacturing and 9 percent in services considered grants and incentives to be influential in their choice of location. Of 75 Fortune 500 companies surveyed, only four identified them as influential.<sup>36</sup> This does not mean that fiscal incentives are unimportant. When other fundamentals are satisfied, they play a role in the choice of location. Incentives can influence the choice of

> 34 Recent surveys of this work include Balasubramanyam, et al (2001) and Hanson (2001).

> 35 Blalock and Gertler (2005) argue that there may nevertheless be an externality associated with vertical technology transfers that warrants some public intervention.  If a MNC transfers technology to only one supplier it could enhance the market power of and be “held-up” by that supplier.  Thus the MNC has an incentive to transfer technology to several competing suppliers, leading to a more productive supply base and lower prices.  However the MNC cannot prevent the new suppliers from also selling to the MNCs’ competitors, who will then be in a position to increase competition and lower prices in the downstream market.  The original MNC would not however take all these social welfare gains into account and may transfer a less than optimally amount of technology to suppliers.

> 36 See World Bank (2005); MIGA (2002); Morisset (2003); Farrell, Remes and Schulz (2005); and Oman (2000).

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