This paper analyzes the welfare effects of subsidies to attract multinational corporations when firms are heterogeneous in their productivity levels. I show that the use of a small subsidy raises welfare in the FDI host country, with the consumption gains from attracting more multinationals exceeding the direct cost of funding the subsidy program through a tax on labor income. This welfare gain stems from a selection effect, whereby the subsidy induces only the most productive exporters to switch to servicing the host's market via FDI. I further show that for the same total subsidy bill, a subsidy to variable costs delivers a larger welfare gain than a subsidy to the fixed cost of conducting FDI, since a variable cost subsidy also raises the inefficiently low output levels stemming from each firm's markup pricing power.
FDI subsidies, heterogeneous firms, fixed versus variable cost subsidies, import subsidies
Journal of International Economics
Subsidies for FDI: Implications from a model with heterogeneous firms. (2009). Journal of International Economics. 78, (1), 113-125. Research Collection School Of Economics.
Available at: http://ink.library.smu.edu.sg/soe_research/1216
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