Subsidies for FDI: Implications from a model with heterogeneous firms |
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Authors: | Davin Chor |
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Affiliation: | School of Economics, Singapore Management University, 90 Stamford Road, 178903, Singapore |
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Abstract: | 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. |
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Keywords: | F12 F13 F23 L23 |
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