FDI Selection: Crowding Out and Distributional Effects
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We analyze optimal host country policy toward multinational production in a three country model. Oligopolists from two source countries invest in a common host country to take advantage of low costs. The country with the smallest labor supply per firm has the highest wage in the absence of foreign direct investment (FDI). When FDI is allowed without intervention, wages become equalized across countries. Firms from the source country with the smallest labor supply per firm shift the most production into the host country as they enjoy the largest cost savings. We then examine the host country's optimal policy towards FDI. Any tax on multinationals can be thought of as the tax relative to domestic firms; any common tax across all firms merely bids up wages without shifting production. Hence, the main issue is whether foreign firms are taxed differently from each other. When free to discriminate, the host country imposes a higher tax on firms from the country with the stronger natural tendency to conduct FDI. A discriminatory tax on multinational production from one source encourages FDI from the favored source country while crowding out FDI from the disfavored source country. Such a tax also shifts rents across firms and alters wages in all countries. Firms from the favored source country benefit while firms from the other source country are harmed by the discriminatory treatment. Wages in the disfavored source country rise while those in the favored source country fall due the bias created in FDI toward originating from the favored source country. The source country subject to the larger tax would benefit from a nondiscrimination clause that requires the host country's FDI policy to treat all foreign firms equally. Source countries whose firms face the highest costs at home will push the hardest for multilateral agreements covering international investment.
