Questions: Are fiscal incentives an effective way to attract foreign direct investment?
Foreign direct investments are widely regarded as a beneficial way for host countries to accumulate capital, raise employment and tax revenue, and obtain organizational practice, and transfer knowledge (UNCTAD-DTCI, 2000: 3). Therefore, most governments are striving to create an enabling environment by providing investment incentives to attract foreign direct investment (Blomstrom and Kokko, 2003: 2). Fiscal incentives such as tax holidays, reduction of corporate income tax rate and investment tax credits are globally applied to attract foreign direct investment. However, the effectiveness of fiscal incentives is questioned and ambiguous. This essay will base on interaction effects between tax system of home and host countries, tax sparing used, different types of fiscal incentives used, and characteristics of the multinational corporations to identify whether fiscal incentives are effective to attract FDI. Finally, this essay will argue that fiscal incentives will attract more or less FDI basing on the former four factors, while host countries’ internal conditions such as the market size, agglomeration, infrastructures, political and economic stability are essential in determining FDI even reduce or eliminate effects of fiscal incentives.
Firstly, the home country’s tax regimes largely determine whether host countries’ fiscal incentives are effective. Basically, two general taxation systems will be illustrated to identify impacts of fiscal incentives on the FDI. To begin with the tax exempt system, most or all incomes earned abroad are exempted from home-taxation. However, in the tax credit system, residents of the country are taxed on their worldwide incomes (Hines, 1999:310). Comparably, multinationals from territorial tax system (France, Canada, and Germany) are more responsive to fiscal incentives in host countries than do investors from worldwide tax system (U.S., Japan, and Mexico) (Morisset and Pirnia 2000: 17). For example, fiscal grants on corporate income taxes are more effective for investors from territorial tax system (Azemar and Delios, 2007:2). This asymmetrical sensitivity relative to fiscal incentives is due to its different influence on tax cost between exempt and credit investors. However, the existence of tax deferral in worldwide tax system offers an opportunity for investors to receive the benefit from fiscal incentives. For example, Americans investors are allowed to defer any U.S. tax liabilities on certain repatriated overseas profits until they receive such profits in the form of dividends. (Hines, 1999:306). Then during the period of fiscal incentives (the foreign tax rate is lower than the domestic tax rate), profits can be retained in order to shelter them from domestic taxation. Therefore, with the existence of tax deferral, the fiscal incentives are effective to investors from tax credit system. Nevertheless, this deferral is available only on the active business profits of incorporated foreign Subsidiary company (Ibid: 306). Overall, fiscal incentives are more effective for investors from tax exempt countries while investors from tax credit countries also attracted by fiscal incentives because of tax deferral.

However, the existence of tax sparing insures the effectiveness of fiscal incentives on FDI. Specifically, tax sparing included in bilateral tax treaties between OECD members (except the United State) and developing countries, modifies the influence of home country tax system (Azémar, Desbordes and Mucchielli, 2007: 543). According to the table 1(Azemar and Delios, 2007:6), in the presence of fiscal incentives but absence of tax sparing, after tax profit for investors from tax credit system is unchanged with or without tax holidays and the spared amount is transferred to the treasury of home countries. However, in the presence of tax sparing, after tax profit increased from 60 to 100. With