Use of incentives in attracting foreign direct investment

Mar 18, 2019

It is clear that FDI incentives might play a role for investor decisions on the margin.


By Michael Mugisha

Foreign direct investment (FDI) is an integral part of an open and effective international economic system and a major catalyst to development. Yet, the benefits of FDI do not accrue automatically and evenly across countries, sectors and local communities.

Developing countries, emerging economies and countries in transition including Uganda have come increasingly to see FDI as a source of economic development and modernisation, income growth and employment.

Thus, countries have liberalised their FDI regimes and pursued policies and offered various incentives to attract quality FDI which promotes economic development, creates employment opportunities, provides technological transfer and financing. Majority of such countries have also established investment promotion agencies and enacted policies to incentivise FDI.

These normally include incentives of a fiscal or financial nature. The former are designed to reduce tax burden and include tax concessions in the form of a reduced corporate income tax rate, tax holidays, exemption from import duties and duty drawbacks on exports.

The latter consist of direct contributions to an investor's firm from the government and includes grants, subsidised loans, loan guarantees, the participation of publicly funded venture capital in investments involving high commercial risks and government insurance at preferential rates.

Note that empirical research shows that international FDI incentives play only a limited role in determining the international pattern of foreign direct investment. Factors like market characteristics, relative production costs and resource availability explain most of the cross-country variation in FDI inflows.

Nevertheless, it is clear that FDI incentives might play a role for investor decisions on the margin. For instance, if an investor has two more or less similar location alternatives for an investment, incentives can tilt the investment decision. This is particularly the case for financial incentives like tax holidays and other subsidies, since they reduce the initial costs of the investment and lower the risk of the FDI project.

However, the question is whether the host country's costs for providing the incentives in terms of tax holidays, subsidies and other expenses is the best practice.

To answer this, a hypothetical situation would be whether incentives offered for FDI are likely to yield benefits that are at least as large as the costs. Keep in mind that incentives offered for FDI can only be justified, if the foreign investors firms differ from local firms such that they possess some firm specific tangible assets with spill overs to local firms/ economies.

Whereas it is understandable that incentives are a global reality offered to compete and attract quality FDI, the best practice should be creating an attractive and enabling environment that takes into account; country efforts to modernize its infrastructure, research and development, raise the level of education and labour skills and improve the overall business climate as part of the investment promotion policy.

In any case, incentives are still a good strategy but this should be followed with strict performance measurements for investors while also that ensuring that they are provided on equal terms to all investors irrespective of industry or nationality. Furthermore, although incentives are good, they are not sufficient determinants/factors an investor will base on to make his/her investment decision.

Therefore, incentives, especially tax holidays or exemption should be given to facilitate business continuity not at commencement of operations. This implies that they should be awarded to investors up to at least five years. This would determine the investment's eligibility for a given incentive.

However, the provision for incentives should also include a consultative process involving relevant stakeholders.

This should also include a criteria for granting incentives which is realigned to minimise revenue loss the country continues incurring through offering incentives.

The writer is a Research Fellow



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