Review of Investment Incentives: Best Practice Application

In today’s globalised economy, few countries can remain competitive without foreign direct investment (FDI). With the potential benefits including technology transfer, employment gains, skills upgrading, and growth, it is not surprising that many governments offer investment incentives (e.g. targeted tax breaks, as opposed to improvements in the general investment/ business climate that benefit all firms). Governments may see such incentives as a necessary measure to compete with other host countries, and to signal government commitment to an open investment environment. Support for incentives could also arise from agency problems and the comparative ease with which incentives can be enacted. In most instances however, the efficacy of these measures are overestimated while the costs remain hidden.

Overestimation of benefits is understandable. Numerous factors are behind a firm’s decision to invest abroad with investment incentives playing a nuanced role. As noted by James (2009), countries typically pursue growth-related reforms using a combination of approaches, including macroeconomic policies, investment climate improvements, and industrial policy changes. It is therefore difficult to pinpoint the specific effect of incentives. Academic research in the area of investment determination reflects this. Some recent studies attribute an important role to investment promotion agencies (IPAs), especially in relation to targeted information provision and services. Evidence supporting targeted tax and financial incentives has been harder to find. In particular, redundancy ratios (the number of firms who would have invested without an investment) are high. For example, FIAS studies on Vietnam, Thailand, Mozambique and Jordan found rates of 85 percent, 81 percent, 78 percent and 70 percent respectively. Despite this, many administrations feel that not offering incentives could put them at a disadvantage and continue to offer programmes. If this is the case, it is important that any associated distortions and costs related to these tools are minimised.

The paper by Krista Tuomi will assist in this goal through an analysis of best practice in the area of investment incentives. It focuses on developing countries in particular, as their circumstances may be very different to those of developed. The paper begins with an overview of what investment incentives are, giving an idea of the breadth and diversity across countries. It also looks at some of the trends in incentives schemes, and the benefits and costs related to them. It then analyses some African and other developing country case studies of ‘best practice’ tracking how the countries have implemented these programs. The paper ends with practical recommendations for a way forward.

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