Foreign direct investment subsidy in a dynamic stochastic general equilibrium model with heterogeneous firms

• DOI: http://doi.org/10.1111/roie.12430
• Author: Ming‐Jen Chang,Shikuan Chen,Yen‐Chen Wu
• Date: 01 November 2019
• Published date: 01 November 2019

Rev Int Econ. 2019;27:1427–1459. wileyonlinelibrary.com/journal/roie

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© 2019 John Wiley & Sons Ltd

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INTRODUCTION

The reduction in barriers to international investment and the globalization trend of the world economy

over the past two decades (1996‐2016) have led to substantial increases in foreign direct investment

(FDI). The growth in FDI has induced a phenomenon (see, for example, Figure 1’s global FDI in-

flows) whereby the competition to attract capital inflow from multinational corporations (MNCs) is

rather pervasive. Many countries keen on attracting FDI claim that it not only promotes economic

performance for them as the host country, but also brings other benefits, including the possibility of

advanced technology transfers, the infusion of much‐needed capital, a substitution for imports, and

job creation. Since FDI subsidies typically induce a direct consumption gain for the host country,

because those new MNCs utilizing the subsidy scheme relocate their production facilities and then set

Received: 17 December 2018

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Revised: 4 June 2019

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Accepted: 1 July 2019

DOI: 10.1111/roie.12430

ORIGINAL ARTICLE

Foreign direct investment subsidy in a dynamic

stochastic general equilibrium model with

heterogeneous firms

Yen‐ChenWu1

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ShikuanChen1,2

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Ming‐JenChang3

1Department of International

Business,National Taiwan University,

Taiwan

2Chung‐Hua Institution for Economic

Research, Taiwan

3Department of Economics,National Dong

Hwa University, Taiwan

Correspondence

Yen‐Chen Wu, Department of International

Business, National Taiwan University,

No.1, Sec. 4, Roosevelt Rd., Taipei City

10617, Taiwan.

Email: yenchen1978@gmail.com

Abstract

This study analyzes the macroeconomic impacts of subsi-

dies to attract multinational corporations when firms are de-

termining whether to enter or how to serve foreign markets.

We show that a small FDI subsidy scheme induces con-

sumption gains and delivers short‐term welfare improve-

ment for the FDI host country if firms differ in productivity.

However, the subsidy generates a new problem and results

in the wealth reallocation effect, leading to welfare deterio-

ration for the host country in the long run. Moreover, we

find that a subsidy program induces a welfare improvement

for the host country if it is offered to all domestic producers

instead of foreign producers only in the host country.

JEL CLASSIFICATION

F12; F13; F23; L23

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lower prices in the host country as a result of savings on cross‐border transport costs, the usage of FDI

subsidies has become increasingly common (Figure 2).1

However, the direct costs of funding such as

a policy intervention result in a negative effect on the host country’s consumption. Thus, there is no

guarantee that the aggregate consumption in the host country increases when the government adopts

an FDI subsidy program to entice more MNCs.

The earlier literature is theoretically ambiguous as to whether the FDI subsidy policy induces a net

welfare improvement for the host country.2

Chor (2009) shows that a small subsidy delivers a welfare

gain for the host country when firms differ in productivity levels. However, he fails to consider that

such a small subsidy would also cause a substantial reduction in the number firms in the host country

as well as the aggregate income of the host country’s households in the long run. In order to cope

with the decrease in wealth, the host country’s households will gradually reduce their consumption.

Accordingly, the net effects of FDI subsidies on the host country’s welfare are still ambiguous when

taking into account the subsequent change in the number of firms in both countries.

This study builds a two‐country dynamic stochastic general equilibrium (DSGE) model with het-

erogeneous firms and endogenous entry as developed by Ghironi and Melitz (2005). It allows firms to

serve foreign markets via exports or horizontal FDI, following Helpman, Melitz, and Yeaple (2004),

in order to analyze the dynamic impact of offering subsidies to encourage more MNCs. Since the

channel chosen by heterogeneous firms to serve foreign markets depends on whether they earn more

profit from doing so, we can examine how the host country’s consumption is affected in the short run

and long run when a government offers a subsidy, which then improves foreign firms’ profits after

implementing FDI in the host country.

The major contribution of this work to the existing literature on FDI subsidies is that we investigate

the impact of FDI subsidies on the host country’s welfare, including both short‐run and long‐run ef-

fects. We also find that FDI subsidies generate a new problem of delivering welfare deterioration upon

the host economy. In order to examine how welfare in the host country is affected by the use of an FDI

subsidy, we analytically explore the effects of this subsidy in Section 3, focusing on a change in the

host country’s consumption. If firms are heterogeneous in their productivity levels, then a small FDI

subsidy only induces the most productive foreign exporters to switch to conduct FDI and generates a

selection effect of lifting consumption in the host country owing to the consumption gain from luring

more MNCs, which exceeds the consumption loss from financing such a subsidy.3

However, an FDI

subsidy not only increases the ex‐ante profitability of potential entrants to the foreign market but also

transfers the profits from the host country’s firms with relatively lower productivity to foreign firms

FIGURE 1 World foreign direct investment inflows. Source: UNCTAD, FDI/MNE database (www.unctad.org/

fdist atistics) [Colour figure can be viewed at wileyonlinelibrary.com]

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implementing FDI in the host country. The new problem stemming from the reallocation of profits

among firms makes the host country’s market become a less attractive location for prospective en-

trants. Only a few potential entrants would enter the host market, leading to a reduction in the number

of firms engaged in production in that market. The decreases in total profit (returned to equity holders

as dividends) and wage income reduce consumption in the host country.

Section 4 examines the welfare implications of subsidies used to reduce the costs of executing FDI

in the host country. Although the selection effect and the labor switching effect induce a consumption

gain for the host country immediately, the profit shifting effect gradually offsets the consumption gain

and even reverses the initial change in the host country’s consumption in the long run. It implies that

using a fixed cost subsidy plan to attract more MNCs delivers a welfare gain for the host country by

partially counteracting the inefficiency arising from the higher fixed cost preventing some foreign

firms to serve the host economy directly through FDI, but it also generates a new problem leading to

a long‐run deterioration of welfare in the host country. Moreover, we show that a subsidy used for re-

ducing the variable costs of production delivers a greater consumption gain than a fixed cost subsidy,

but also leads to a more severe situation in the reallocation of firms’ profits.

We finally discuss the case that the government has to subsidize all domestic producers if it is not

allowed to discriminate between home and foreign firms producing in the domestic market when of-

fering a subsidy program. Since home firms have the incentive to pretend to be foreign firms when the

government is looking to attract more FDI by offering subsidies to foreign firms, it creates difficulty

for the government to only subsidize the foreign firms. Our analysis in Section 5 closely relates to the

work of Pflüger and Südekum (2013), who examine how subsidies used to reduce the sunk entry costs

of domestic producers in a Melitz‐type model affect the welfare. In their paper, subsidizing all domes-

tic producers’ sunk entry costs encourages more prospective entrants to produce in the domestic mar-

ket. Thus, more goods are produced and sold at lower prices along with the increase in the number of

higher productive firms, delivering welfare improvement for the domestic country. Instead of used to

reduce domestic firms’ entry costs, we discuss that subsidies used to increase the profits of domestic

producers’ production help lure more firms to manufacture in the domestic market. By attracting new

entrants, such a subsidy policy counteracts the profit shifting effect and delivers welfare improvement

to the host country. However, it may encourage too many prospective entrants to engage in the market,

resulting in inefficient resource allocation and welfare deterioration.

The rest of the paper is organized as follows. Section 2 introduces the model. Section 3 analyzes

the effect of subsidies for FDI. Section 4 describes the impulse responses of policy interventions.

FIGURE 2 Changes in national investment policies, 2002–2016. Source: UNCTAD [Colour figure can be

viewed at wileyonlinelibrary.com]