Why Governments Continue to Offer Inefficient Investment Incentives? The Role of Bureaucratic Design

This blog is based on a paper by the authors in the Review of International Political Economy (here).

Governments worldwide use a myriad of tax incentives to promote investment and yet, there is little evidence that these incentives actually work as intended. Moreover, although the striking lack of transparency makes it hard (if not impossible) to accurately estimate their fiscal cost, the available data indicates that the loss in tax revenue on investment incentives is significant. In the absence of this revenue, governments have less ability to invest in critical infrastructure projects, education and social services, health care, support to citizens, or other high priority projects that are critical for development outcomes.

So why do countries continue to offer tax holidays, subsidies, and other tax incentives for foreign firms to locate an establishment in a specific jurisdiction? We argue that governments are more likely to do so when individuals working in investment promotion have limited private sector experience and when they face institutional structures that incentivize short-term, deal-oriented behavior.

Several existing explanations for tax incentives for investment have emerged, including the electoral benefits of using incentives as a form of political pandering, particularly in the US context. The tax competition literature has focused on the role of mobile capital and the perceived need to offer greater concessions to businesses in order to attract investment. Still others have focused on the tendency of decentralization to generate self-defeating competition for capital. We instead focus on three factors:

• how variations in bureaucracies and governance influence the incentives government officials tasked with economic development face,
• the ways in which individual staff members’ professional backgrounds impact their beliefs over what motivates investors, and
• how these organizational and agency factors combine to shape the investment facilitation policies and strategies that governments pursue.

In our paper, we administer a survey experiment of individuals within investment promotion agencies (IPAs). Over 160 countries have at least one IPA charged with attracting multinational firms through a combination of image promotion, tax incentives, and assistance with bureaucratic procedures associated with investment. IPAs are the bureaucratic gatekeepers of incentives, and are the institution working the closest to multinational enterprises (MNEs) to boost local investment.

Using a conjoint experiment – which allows individuals to select between different policy packages – we measure how investment promotion professionals react to different investment packages, including tax incentives for investment, as well as other potentially important factors such as job training, business matchmaking, aftercare services, business-to-business matchmaking and investment in domestic physical infrastructure and human capital. We find that investment promotion professionals are more likely to view tax incentives as an effective tool when they have limited private sector experience, when they work for investment promotion agencies that are more integrated into the national bureaucracy, and when employee performance is evaluated based on deals closed. On the other hand, individuals with private sector experience are more likely to understand that tax incentives are usually not a crucial component of firms’ locational decisions.

Ultimately, we demonstrate that public deference to international business is not just a product of apolitical, anonymous market forces. Instead, the persistent idea that tax incentives are necessary to attract foreign investment is a reflection of socialization processes that make policymakers believe firms have great capacity to exit their jurisdictions. These beliefs vary in predictable ways across individuals, and can be changed by altering the hiring structures, professional incentives, organizational norms, and inter-agency relations that shape the use of investment incentives.

Our findings have important implications for the design of effective and fair bureaucratic structures. Many commentators assume that tax incentives for MNEs are justified by the structural advantage that their global mobility provides them over governments. In contrast, our research suggests that relatively small institutional changes can reduce the use of tax incentives by altering beliefs about their usefulness. IPAs can be restructured and redesigned to help overcome biases toward tax incentives for investment through insulating management from electoral cycles, evaluating employees on service quality rather than deals closed, and hiring more individuals with private sector experience. While our findings are based on a relatively small sample (n=63), and require further validation, they suggest actionable steps forward to rebalance tax revenue sources.