RESTRICTEDWORLD TRADE
ORGANIZATIONWT/WGTI/W/56
30 September 1998
(98-3785)
Working Group on the Relationship
between Trade and Investment
THE IMPACT OF INVESTMENT INCENTIVES AND PERFORMANCE
REQUIREMENTS ON INTERNATIONAL TRADE
Note by the Secretariat1
I. INTRODUCTION
1. At the meeting of the Working Group of 30 and 31 March 1998, the Working Group agreed
that the Secretariat would consider whether it could add to its analysis in WT/WGTI/W/7 regarding
the effects of investment incentives and performance requirements and the effects of trade measures
on investment (WT/WGTI/M/4, paragraph 43).  Pursuant to this request, the present note discusses
the impact of investment incentives and performance requirements on international trade.
2. The note is organized as follows.  Section II provides some background information on the
evolving policy climate for foreign direct investment ("FDI") characterized by across-the-boardliberalization and the increasing use of incentives to attract FDI.  Section III provides an inventory of
common incentives and perfomance requirements and discusses the economic rationale of these
instruments.  The central theme of this note, the trade effects of investment incentives and
performance requirements,  is addressed in Sections IV and V.  The analysis in these Sections draws adistinction between the direct and indirect trade effects of such measures.  Section IV examines the
direct effects of such measures on trade by analysing their impact on the operations of firms on the
assumption that they do not affect the location of FDI.  Given that in the real world investment
incentives and performance requirements obviously do affect the location of FDI and hence indirectly
international trade, Section V   examines the location effects of investment incentives, accounting
explicitly for the policy interaction between competing host countries.  The following issues are
analysed:  does the competition among host countries distort the location of FDI in the world andhence indirectly international trade; and who ga ins and who loses from this competition? Finally,
Section VI reviews the empirical literature on the location and trade effects of investment incentives
and performance requirements.
3. This note analyses the issues addressed in it from an economic and not from a legal
perspective.  A discussion of WTO provisions relevant to incentives and performance requirements,including the Agreement on Subsidies and Countervailing Measures and the Agreement on Trade-
Related Investment Measures, is contained in the informal note by the Secretariat that was circulated
in May 1997 (Job No. 2988).
II. THE EVOLVING POLICY CLIMATE FOR FDI
4. The policy environment for FDI in the world, and especially in developing countries, has
changed considerably over the last couple of decades.
2 In the 1960s and 1970s developing countries at
                                                     
1 This note has been prepared on the sole responsi bility of the WTO Secretariat.  The analysis, views
and opinions expressed herein should not in any way be attributed to the WTO Members, individually orcollectively.WT/WGTI/W/56
Page 2
large were trying to reduce their dependence on multinational enterprises (MNEs) and regain control
over their natural resources.  In some parts of the developing world, serious misgivings about the
alleged interference of some MNEs with domestic political and social affairs were expressed.  Many
developing countries were also influenced by socialist ideologies based on public ownership of the
means of production.  These social and political trends resulted in increasing restrictions on FDI,
including in some cases nationalization of foreign-owned production facilities.  Where foreigninvestors were welcomed, their activities were typically circumscribed by a host of requirements and
restrictions, including sectoral limitations, local content rules, trade-balancing rules, limitations on
foreign ownership, and restrictions on earning remitt ances.  This fairly hostile investment climate
attracted very little FDI beyond traditional raw material extraction and "tariff jumping" investment for
which no alternative means existed for accessing the resources and markets.
5. The policy environment for FDI started to change in the mid 1980s, partly because of
necessity and partly because of a change in sentiment.  The necessity factors included insufficientdomestic savings to finance pressing investment needs, especially in least developed countries with
savings that sometimes fell below 10 per cent of GDP, compared to 20 to 25 per cent for OECD
countries and 30 to 45 per cent for the most thrifty developing countries in East Asia.
3  The shortages
of investment financing were exacerbated in the 1980s by falling commodity prices and export
revenues, the credit crunch in the aftermath of the debt crises, and the decline in official developmentassistance.  Moreover, loans from institutional lenders, such as the World Bank and the IMF, were
increasingly conditioned on various policy reforms, including more liberal FDI rules.  Many
developing countries were also ready for a paradigm shift after two decades of dismal experience with
inward-oriented strategies in comparison with the outward-oriented strategies followed by developing
countries in East Asia.  Attracting foreign investment became a policy priority in most countries as avehicle for modernization and global integration.  The liberalization trend has accelerated further in
the 1990s with new countries jumping on the bandwagon.  Closed sectors have been opened for
foreign investment; bureaucratic permission procedures have been simplified with the creation of
"one-stop shops"; bilateral investment treaties (BITs) have been negotiated to protect and promote
investment
4;  import duties on intermediate inputs have been reduced;  and so forth.
6. Liberalization of policies towards inward FDI has been accompanied by a more aggressive
use of incentives.  According to UNCTAD's 1997 World Investment Report, 95 per cent of all
changes in the investment regimes between 1991 and 1996 went in the direction of more liberal
investment rules and outright promotion (Table 1).  The types of changes introduced in 1996 fell into
the following categories: 34 per cent involved mo re incentives, 25 per cent liberalized operational
conditions (fewer or less stringent performance requirements), 7 per cent liberalized foreign
ownership or sectoral regulations, 7 per cent liberalized approval procedures, 4 per cent more
guarantees, and 4 per cent less control.  Moreover, many governments have established special
investment promotion agencies (IPAs) to market the country to foreign investors and assist them
through the approval procedures.5
                                                                                                                                                                    
2 A more detailed analysis of the historical evolution of FDI policies will be provided for the Working
Group's November meeting in the note on this subject which the Working Group requested the Secretariat toprepare at the meeting of 16 and 17 June 1998.
3 Ten per cent  savings are often not enough even to replace depreciated capital, implying that the
capital stock will decline and with that per capita income s. Indeed, the per capita incomes in roughly one third
of the least developed countries fell between 1960 and 1990.
4 The number of BITs has grown from 386 in 1980 to 1330 in 1996 according to UNCTAD (1997).
5 The World Association of Investment Promotion Agencies (WAIPA) has currently some
100 members.WT/WGTI/W/56
Page 3
Table 1.  Regulatory changes in investment regimes, 1991-1996
1991 1992 1993 1994 1995 1996
Number of countries that introduced
changes in their investment regimes 35 43 57 49 64 65
Number of changes in the investment
regimes 82 79 102 110 112 114
Of which:
In the direction of liberalization andpromotion 80 79 101 108 106 98In the direction of control, includingreduced incentives 2 0 1 2 6 16
Source:  Table I.4, UNCTAD (1997).
7. At least partly as a result of more liberal investment rules, FDI flows to developing countries
accelerated at the end of the 1980s after two decades of relative stagnation (Figure 1).  However, notall developing countries have benefited equally from the increased flows, nor have they reached the
same stage of the economic reform process.  The ten largest recipients account for roughly 70 per cent
of the FDI flows to developing countries (and economies in transition), led by China which in recent
years has absorbed roughly one-third alone.
6
Figure 1.  FDI flows to developing countries and economies 
in transition, 1970-95
(real flows in 1996 $, billion) 
020406080100
1970 1975 1980 1985 1990 1995Year
Source:  IFC and FIAS (1997).
8. The rapidly evolving investment climate makes it difficult to provide an accurate picture of
the current situation in regard to the prevalence of investment incentives and performance
requirements.  Even relatively recent studies may be out of date on certain points.  For example,
performance requirements are in many cases being phased out for competitive reasons and because of
international obligations.  Thus, only two dozen countries have notified any performancerequirements covered by the TRIMs Agreement to the Committee on Trade-Related Investment
                                                     
6 The ten largest recipients in 1995 in absolute terms were, in descending order, China, Mexico,
Singapore, Brazil, Hungary, Indonesia, Malaysia, Poland, the Czech Republic and Colombia.  See Table B.1,UNCTAD (1997).WT/WGTI/W/56
Page 4
Measures, and these measures, many of which concern the automotive industry, are scheduled as a
general rule to be phased out by the year 2000.
9. In order to provide a snapshot of the current state of affairs, Annex 1 contains a survey of
information posted on the web sites of eight in vestment promotion agencies: two each from four
categories of countries: least developed, developing, economies in transition, and developed.  While
this information is public, indeed meant to catch the eyes of investors, the survey does not refer to the
countries by their real names.  The purpose of this limited survey is only to illustrate the current trendin investment promotion policies as a backdrop for the discussion in this note.
10. The survey reveals some interesting similarities  and differences in the investment promotion
strategies across countries.  As far as the similarities are concerned, most IPAs emphasize the size of
the regional  market and preferential access to such markets under regional trade agreements.
7 Some
developing countries also point to the availability of preferential access to markets of developed
countries  as a result of the Lomé Convention and GSP preferences.  The emphasis on the regional
market size reflects in some cases the small size of the domestic market, which may not sustainproduction units of efficient scale, but it also suggests an explicit strategy for attracting export
(region) oriented FDI.  Indeed, the incentive schemes are often geared to export-oriented investments.
Secondly, all countries seem to be in the market  for FDI that adds value to traditional production
activities and brings in new technologies.  Special incentives often apply to such projects.  Thirdly, all
IPAs emphasize the business friendly investment clim ate in their countries.  In this regard, all the
surveyed countries claim to have the most favourable business climate in their region, a claim which
in some cases is accompanied by tables containing comparisons with the neighbouring countries.  The
use of comparison tables is one illustration of the increasing regional competition for FDI.
Developing countries and economies in transition also stress the strong protection of investment
through domestic laws, bilateral investment treaties, and multilateral agencies, presumably to signal
the change in sentiment from previous regimes.
8
11. Interestingly, the information in Annex 1 cont ains hardly any references to performance
requirements, except for export processing zones.  Investors in these zones undertake to export aminimum share of their production, typically 100 per cent.  The performance requirements are
balanced by an incentive package that is more lucrative than elsewhere in the host country, including
tax holidays, duty exemptions and unimpeded capital movements.  The absence of references to
performance requirements in other contexts does not necessarily mean that they are not used.  TheIPAs may choose to de-emphasize this point not to scare off prospective investors before they have
had an opportunity to discuss the whole package with  offsetting incentives.  In fact, incentives are
typically not specified as X per cent, but up to X  per cent, which suggests a degree of flexibility to
reward FDI that is especially coveted, for example, high-tech projects with an export orientation.
Indeed, one developed country make ss  explicit reference to negotiated incentives for projects that
involve internationally mobile production units.
9
12. Dissimilarities between the investment promotion strategies of individual countries mainly
concern the choice of incentives.  Developing countries mainly use fiscal instruments, such as tax
holidays, concessionary tax rates, accelerated depreciation allowances, duty drawbacks and
                                                     
7 Only a few countries make explicit references to the membership of the WTO.  In other words, access
to the world markets on standard WTO terms does not seem to be a compelling argument to attract FDI, while aregional trade agreement may be.
8 This quote from the IPA of one of the least developed countries (refered to as A) is a case in point: " A
offers investors rich opportunities. . . . This potential has long existed. What was lacking was the political and
economic environment in which business could do business. During the socialist decades before the (...)
government took office in (...), private investors we re squeezed out. Now they are welcomed back. . . . A has
joined the Multilateral Investment Guarantee Agency and has signed other international agreements that providesignificant protection to investors."
9 See Country G in Annex 1.WT/WGTI/W/56
Page 5
exemptions, whereas developed countries mainly use financial incentives, including cash grants
(sometimes exceeding 50 per cent of the investment co sts) and interest-free or subsidized loans.  This
presumably reflects differences in wealth, as the developed countries can afford to use up-front
subsidies to pay for some of the investment whereas developing countries can, at best, afford to ease
the tax burden ex post .
III. AN INVENTORY OF INCENTIVES AND PERFORMANCE REQUIREMENTS AND
THEIR RATIONALES AND LIMITATIONS
13. Investment incentives, as defined in UNCTAD (1996), are measurable economic advantages
afforded to specific enterprises or categories of en terprises by (or at the direction of) governments, in
order to encourage them to behave in a certain manner.  "Behaving in a certain manner" should be
interpreted broadly, including the decision to in vest in the host country rather than elsewhere.
Incentives take many different forms and can be classified in various ways.  One distinction is that
between:  (i) financial incentives;  (ii) fiscal incentives;  (iii) subsidized services;  and (iv) marketprivileges.  Financial incentives involve the provision of funds directly to firms to finance new foreign
investment or certain operations.  That is, the hos t government pays for some of the investment cost
through a grant or subsidized credit without demanding a commensurate equity stake.  Fiscal
incentives are provisions designed to reduce the tax burden for foreign investors, for example tax
holidays (sometimes exceeding 10 years), reduction in the standard corporate income tax rate,accelerated depreciation, and duty drawbacks and exemptions.  Subsidized services include
designated infrastructure and government services at less-than-commercial prices.  Market privileges
include different measures designed to enhance the profitability of FDI by biasing the market
competition in favour of the investing firm.  Fo r example, the investors may receive preferential
access to government contracts; guarantees against further entry, for example in services sectorsrequiring government licences (telecommunications, ba nking, etc.); guarantees of protection against
import competition or preferential treatment with regard to the import of certain products.
10
14. Whereas incentives try to elicit desirable market behaviour by carrots, mandatory
performance requirements are measures that mandate  certain operational undertakings.  For example,
the host government may require the investing firm to use a certain technology (mandatorytechnology transfer); to source a certain percentage of inputs domestically (domestic content rules); to
export a certain fraction of output (export performance requirements); or to balance the import with
exports (trade-balancing requirements).  Some authors would also classify requirements regarding
local equity participation, hiring of local managers,  the conduct of a certain level or type of research
and development and so on under the heading of performance requirements.
15. The traditional distinction in the literature between incentives and performance requirements
is somewhat blurred in reality since they are often linked.  For example, export performance
requirements in export processing zones are linked to special incentives that are not available
elsewhere in the host country, such as tax holidays and duty exemptions.  Or vice versa, incentives are
often linked to various operational margins or und ertakings.  For example, duty drawbacks are
directly linked to export production.  Units sold in the host market generally do not enjoy this benefit.
Likewise, some countries, such as country D in our survey (see Annex 1), link incentives to the
technology used by the investors.  High-tech projec ts are rewarded with larger incentives than low-
tech projects.  The result in terms of technology transfer can be the same as for a direct performance
requirement mandating a certain technology.  The common practice of specifying a range of
incentives ( up to X per cent ) is further evidence of this close link between incentives and operational
undertakings in that it allows for the exercise of discretion to condition the amount of incentives
                                                     
10 For example, in some countries manufacturers of cars with assembly operations that meet local
content requirements are entitled to import cars produced elsewhere at preferential rates ..WT/WGTI/W/56
Page 6
granted on the extent to which the investor meets certain operational targets.11 Some authors use the
terminology "performance incentives" to characterize incentives that are conditioned uponperformance.
Table 2.  A non-exhaustive inventory of investment measures
Investment Incentives
Financial
∙Investment grants.
∙Subsidized credits.
∙Credit guarantees.
Fiscal
∙Reduction in standard corporate income/profit tax rate .
∙Tax holiday (often time-limited).
∙Reduction in social security contribution.
∙Duty exemptions.
∙Duty drawbacks.
∙Export tax exemptions.
∙Reduced taxes for expatriates.
Subsidized services
∙Electricity, water, telecommunication, transportation, etc.
∙Designated infrastructure at less-than-commercial price, e.g., commercial buildings.
Market privileges
∙Preferential access to government contracts.
∙Closing of the market for further entry, e.g., a cap on the number of licenses issued in services
industries and promises not to grant investment permission to competing foreign firms.
∙Protection from import competition, e.g., increased tariffs or a commitment of retained trade
barriers for a specified number of years.
Performance Requirements
∙Local content (value added).
∙Minimum export shares.
∙Trade-balancing.
∙Technology transfer.
∙Local equity participation.
∙Employment targets for professionals (managers) and other categories of employees.
∙Headquarter requirements.
∙R&D requirements.
III.1 The Economic Rationales of Investment Incentives and Performance Requirements
16. Dating back to Pigou (1920), economists generally recognize that well-crafted taxes and
subsidies can play a positive role in correcting various market failures .  For example, pollution taxes
can induce firms to "internalize" the environmental cost of their production decisions .  In the case of
FDI, the "market failure" is the difference between social and private returns that arises from the
positive externalities that accrue to the host country and that is not automatically accounted for byforeign investors.  The host country may benefit fr om technology transfer, training of local managers
                                                     
11 It is extremely difficult to find out what conditions are attached to different incentives because the
details of incentive packages agreed upon between host governments and foreign investors are not normallymade public.WT/WGTI/W/56
Page 7
and workers, quality requirements imposed on domestic sub-contractors, infrastructure investment in
ports and additional linear traffic, financial infrastr ucture that follows in the footstep of MNEs and so
forth.12  However, since these social dimensions do not automatically translate into higher returns for
the private investor, investment projects that woul d be worthwhile from a broader social perspective
are not always carried out.  The purpose of granting investment incentives in this type of situation   is
to translate the social externalities into private retu rns in order to induce investors to behave as if they
had the social returns (private return plus social externalities) as their lodestar.  For example, an
investment that costs $100 million with an estimat ed income flow of only $90 million over the life
span obviously will not be carried out since the expected income does not cover the investment cost .
At the same time, the host country may estimate that this investment is worth $20 million in terms of
social externalities .  It may then be willing to provide incentives worth, say, $15 million to make the
investment profitable for the foreign investor .  This would give a return of $5 million for the foreign
investor and a return of $5 million (net of incentives) for the host country .  Thus, in principle,
investment incentives could bridge the gap between social and private returns and thereby mitigate the
tendency for under investment in projects with positive social externalities.
17. Performance requirements can be rationalized along the same lines, but in this case for the
various operational dimensions of the investment .  For example, private investment decisions may
lead to sub-optimal levels of exports, technology tran sfer or local content, in the sense that the social
benefits of additional units would exceed the private costs .  Performance requirements could thus in
principle enhance the overall social returns of the investment .  Of course, performance requirements
that are too strict may be self-defeating in the sense that the investment is not carried out because ofinsufficient private returns.
III.2 Real World Considerations
18. Many real world considerations suggest that investment incentives and performance
requirements do not always make good sense.  First, investment incentives and performance
requirements are typically not the first-best solution to the problems at hand.  For example, if the host
country uses incentives or employment targets to mitigate widespread unemployment, a more direct
policy option would be to address the underlying causes of unemployment, such as rigid labourmarket laws and high labour taxes.  Likewise, if investments are discouraged by high duties on
imported inputs needed for production, the first-best approach is the reduction of these duties to
competitive levels.
13  If  investors request a "risk premium" to compensate for the risk associated with
macroeconomic instability, runaway inflation and exchange rate fluctuations, the most sensible policy
response would be to address these underlying problems (often related to a government budget deficit
financed by the printing press) rather than to compensate investors for the poor investment climate.  Inshort, while investment incentives and performance requirements can in principle be justified as a
means to bridge the gap between social and private returns, alternative polices may do the same job in
a more sensible way, especially if the gap is due to policy failures rather than market failures.
14
                                                     
12 For a recent survey on how foreign investment affects host countries, see e.g. Blomström and
Kokko (1997).
13 Several empirical studies, e.g., Pritchett and Sethi (1994), have noted the weak relationship between
collected and statutory tariff rates. For example, if the import value is $10 million and the statutory tariff is50 per cent, one would expect a tariff revenue of $5 million, but it is normally much lower. The reason is thatthe number and scope of exemptions tend to increase with the tariff rate. Certain domestic and foreign firmsmay be exempted, certain sectors may be exempted, and imports for certain purposes may be exempted. This
raises the following question:  are high tariffs, combined with widespread exemptions, more efficient than a
revenue neutral system with lower rates and fewer (no) exemptions? Moreover, given the value of tariffexemptions, what are the costs in terms of rent-seeking or outright corruption to secure an exemption?
14 Graham and Sauvé (1996) express the same idea in the following way: "It is often argued that
investors should be compensated, through investment incentives or other subsidies, for lost returns due toWT/WGTI/W/56
Page 8
19. A second caveat is that social externalities are extremely difficult to measure, and hence
"price", correctly.  Some countries may not have the necessary expertise or inclination to undertake
careful cost-benefit analyses, but may rather base their incentives on crude rules-of-thumb or simply
match what neighbouring countries are offering.  Political considerations and vested interests may
also distort incentives away from the social optimum, especially in a situation where several countries
are competing for the same investment.  Indeed, the wide range of incentives for seemingly similarinvestment projects is not easy to explain.
15  Whether these incentives are "rational" in that they do
not exceed the difference between social and private returns cannot be determined unless cost-benefit
analyses are done and made available for public scrutiny.  However, it   cannot be ruled out that
countries are led into excessive bidding for FDI that in the end does not deliver the expected social
benefits.  This risk of exaggerated incentives is particularly serious if countries, regions or local
communities engage in bidding contests for the same investment project, which is not unusual for
prestigious projects, such as automobile plants, that yield a lot of political currency.16  The issue of
competition between countries to attract FDI is considered in more detail in Section V.
20. Thirdly, incentives must be financed somehow , and taxes have their own distortionary costs
that should be accounted for in the cost-benefit an alysis.  For example, providing selective subsidies
and tax breaks to some firms and industries is tantamount to a tax on all others.  Incentives in the form
of market privileges are no better and possibly worse.  For example, monopolistic pricing supported
by import protection or entry restrictions imposed by governments erodes the benefits to consumers.Likewise, preferential access to government contracts makes public investment more expensive and
possibly of lower quality than under free and fair tendering.  These costs should also be accounted for
in the cost-benefit analysis.  It is far from clear that in practice such costs are taken into account or
indeed, that any cost-benefit analysis is carried out at all 
17  In the absence of a comprehensive cost-
benefit analysis, it is difficult to determine whether incentives and performance requirements actually
close the gap between private and social returns rather than introduce new distortions.
21. Finally, from a global efficiency and distribution point of view, the social benefits in different
locations must be weighed against each other.  If one country offers incentives and another country
does not, investments may be diverted from locations with potentially higher social benefits tolocations with potentially lower social benefits at the detriment of global welfare.  Performance
requirements may impact on the trade of third countries and thus be detrimental to their welfare.
Thus, what make sense for an individual country does not automatically make sense for the world as awhole.
III.3 Concluding Remarks
22. To conclude, incentives and performance requirements have been more readily accepted in
reality than in theory.  The appropriate use of these instruments requires sophisticated cost-benefit
analysis, including an assessment of social externalities that are inherently difficult to measure.
Arbitrary incentives, possibly based on what neighbouring   countries are offering instead of local cost-
benefit analysis, or political considerations rather than economic considerations, are likely to create
more distortions than they correct.  In addition, th e "quick-fix" nature of these instruments may divert
                                                                                                                                                                    
government regulations or other polices that force a lower return than would otherwise have prevailed. It
probably goes without saying that, if government policies effectively suppress rates of return on particular
activities relative to others, the polices themselves might warrant rethinking. Stated differently, the first-bestsolution to the problem would be to correct it at the sour ce. Subsidies to encourage an activity that some other
polices discourage seems rather peculiar." (p. 139).
15 For example, an assembly plant for automobiles in Michigan was granted incentives worth $14,000
per employee  while an assembly plant in Setubal, Portugal, was granted incentives worth $254,000 per
employee .  See Table III.7, UNCTAD (1996).
16 In the above-mentioned cases, for example, 12 St ates in the United States bid for the Michigan
investment and three EU countries for the Setubal investment.
17 See for example Dunning (1993) 561:  "Few governments appear to have made any serious cost-
benefit analysis of MNE directed investment incentives , taken as a whole, or of different kinds of incentives."WT/WGTI/W/56
Page 9
attention from general policy reforms that would improve the investment climate, including trade
reforms, education, the rule of law, and macroeconomic stability.  Such general policy reforms have a
proven track record of generating investment and economic growth, something that is yet to be shown
for micro-managed incentives and performance requirements.18 Moreover, incentives that divert
investment from one location to another do not necessarily lead to higher global welfare since thegains in winning locations must be weighed against the forgone gains in losing locations.
IV. THE IMPACT ON TRADE
23. As noted in the introduction, in analysing the effects of incentives and performance
requirements on international trade, a distinction can be made between direct effects that arise from
the impact of such measures on the operations  of MNEs and indirect effects that arise from their
impact on the location  of FDI.  This Section studies the direct effects on trade resulting from changing
operational conditions, assuming that the locations of FDI are unaffected.  The indirect effects of
investment incentives and performance requirements on international trade that result from their
impact on the location of FDI are studied in Section V.
24. For the purpose of this analysis, we shall identify three categories of investment measures.
Firstly, mandatory  performance requirements that an investor is obliged to satisfy within a given
time-frame.
19  Secondly, advantage-based  performance requirements where an investor that satisfies
certain performance requirements obtains advantages by so doing.  Thirdly, operational incentives
that do not depend on the performance per se, but which are attached to specific operational margins
to encourage a certain behaviour.  Measures falling under these three categories are analysed inSection IV.1, IV.2, and IV.3, respectively.
25. To facilitate the analysis, it may be useful to have a specific example in mind.  We may think
of an assembly plant for automobiles destined for country X but where the remaining details regarding
the fine-tuning of incentives and performance requirements are still being negotiated.
20  Our task is to
analyse the marginal trade effects of each individual measure, divided along three dimensions:  (i) the
import of inputs (autoparts) by the local plant;  (ii) the effect on competing imports (of automobiles);
and (iii) the exports (of automobiles) by the local plant.  In addition, there may be indirect effects onthe trade performance of domestic firms arising from technological spillovers, pro-competitive
effects, changing factor prices, and so forth.  These indirect (general equilibrium) effects are not
accounted for in this analysis, however.
IV.1 The Trade Effects of Mandatory Performance Requirements
26. This Section analyses the trade effects of various mandatory performance requirements, that
is, performance requirements that an investor is obliged to satisfy.  It is assumed that these measures
are binding not just from an legal point of view but also from an economic  point of view;  that is, they
do not just mandate what the firms would do in any event.21  (Redundant performance requirements
will not have any trade effects.)  The analysis also presumes that these requirements are not linked to
                                                     
18 See Barro (1998) for a recent review of the relationship between growth and various economic
variables.
19 Such requirements are often phased in gradually to give investors a reasonable time to develop a
network of domestic suppliers and the infrastructure needed for export production.  For example, an investormay have to achieve a local content of 20 per cent within two years, 40 per cent within five years, and 60 percent within ten years.
20 The outcome of the negotiation process will depend on the type of investment and the locational
advantages of the host country relative to alternative locations.  For example, the bargaining power of the host
government may be higher for projects that depend on local raw material or the local market than on export-
assembly projects that could more easily be located elsewhere.
21 Performance requirements are apparently ofte n redundant according to interview studies with
corporate officials.  See Section VI.WT/WGTI/W/56
Page 10
any incentives, directly or indirectly.  (Incentive-based performance requirements are analysed in
Section IV.2.)  Finally, it should also be stressed that the benchmark of the analysis is what trade
would have been with the investment but without  the specific performance requirement.  In other
words, we do not compare the trade flows in the pre- a nd post investment situation, but the trade
flows in the post investment situation with and without the particular investment measure.  The
following measures are analysed:  (i) local content requirements;  (ii) export performancerequirements;  (iii) trade-balancing requirements;  (iv) foreign ownership limitations (local equity
participation requirements);  and (v) technology transfer requirements.
27. Local content requirements  force foreign affiliates in the host country to source a higher share
of the inputs from local sources than that motivated by costs and quality considerations.  The primary
effect (and indeed purpose) is thus to substitute domestic inputs for imported inputs.  Local content
requirements may also have indirect repercussions  on the plant's ability to compete in the world
market because of the cost and quality implications.
22  (Local production for the host market may still
be profitable compared to importing to the market if the trade barriers are high).  The size of theinvestment may therefore be smaller than otherwis e as the producer refrains from installing capacity
for export production.  Indeed, some empirical evidence suggests that local content requirements work
contrary to the host country's export ambitions by rendering the local firm less competitive in the
world market (see Section VI).  Finally, imports of competing product will be higher when the local
plant must abide with costly local content requir ements than if no such requirements were imposed.
23
28. Export performance requirements  force foreign affiliates to export a larger share of the local
output than that motivated by profit considerations.  This is akin to a kind of bundling.  For each unit
sold in the host country, the affiliate must export, say, one unit.  (The example presumes a minimum
export share of 50 per cent.)  If the motivation for the FDI was to "jump" the trade barrier of the host
country, the profits earned in the host market cross-subsidize the export sales.  Another way of saying
the same thing is that the export performance requ irement increases the cost of local sales with an
amount that equals the cross-subsidy needed to k eep the share between export and local sales above
the stipulated limit.  Imports of competing products will therefore be higher when the local plant must
abide with export performance requirements than if no such requirements were imposed.  Finally,
whether export performance requirements increase or decrease the use of imported inputs depends on
whether the local production is higher or lower with or without such requirements.  This cannot besaid a priori since the domestic sales are likely to be lower and export sales higher, leaving the net
effect on total production unclear, and hence the effect on the derived demand for imported inputs.
29. Trade-balancing requirements  are effectively a combination of domestic content and export
performance requirements.  They force, to the extent  they are binding, foreign affiliates to balance
their import outlays by exports.  It is difficult to say a priori which margin will be adjusted.  It
depends on whether it is less costly to use more domes tic inputs than otherwise, or export more of the
local production than otherwise.  However, under th e reasonable assumption that the adjustment costs
increase in both margins, the cost-minimizing solution is  to adjust both margins a little bit rather than
to make a large adjustment in one of the margins.  Hence, trade-balancing requirements are likely to
                                                     
22 However, under some circumstances, local conten t requirements could possibly reduce the costs of
inputs.  For example, some MNEs may continue to source from strategic partners in spite of higher costs unless
forced to do otherwise.  Local content requirements could possibly break up strategic alliances and other anti-competitive business practices and hence reduce the cost of production.  However, under normal competitiveconditions, one should expect firms to use the most competitive suppliers available, whether foreign or local.The analysis in the main text refers to this "normal" case.
23 Recall that the benchmark of the analysis is what trade would have been with the investment but
without  the specific performance requirement.  In other words, we do not compare the trade flows in the pre-
and post investment situation, but the trade flows in the post investment situation with and without the specificperformance requirement.  Of course, in comparison with the pre-investment situation, the competitive positionof importing firms may now be worse.  This is why investment by one firm is often followed by investment byits competitors in order to restore the competitive balance.  See Knickerbocker (1973).WT/WGTI/W/56
Page 11
both reduce the imports of inputs and expand the exports of the local production.  Finally, imports of
competing products will be higher when the local plant must abide with costly trade-balancing
requirements than if no such requirements were imposed.
30. The trade effects of foreign equity limitations (local equity participation) depend on how the
operations of foreign affiliates are influenced by the local partner(s).  Say, for example, the local
partner is an agency of the host government.  If the purpose is only to extract rent, there should be notrade effects.  However, the agency may use its voting power to influence the operations in certain
non-commercial ways, for example by granting preferences to local suppliers of inputs in spite of
higher prices or lower quality.  The trade effects would then be similar to those under a local content
scheme.  Likewise, the agency may push for exports beyond what is profitable, leading to trade effects
similar to those under an export performance sc heme.  Non-commercial behaviour is perhaps less
likely in the case of mandatory joint ventures with local businesses.  However, it cannot be ruled out
that the local partners will use their influence to serve their own self-interest, for example securingsupply contracts for their own firms at the expense of foreign suppliers.  In short, the trade effects of
local equity participation depend on how exactly the operations are influenced by the local partners.
For want of empirical evidence on these matters, we abstain from making any predictions on the trade
effects.
24
31. The trade effects of technology transfer requirements  are also unclear.  One cannot simply
assume that the quest for the most modern technologies will reduce the production cost of the localaffiliate and hence indirectly stimulate export production.  If that is the case, foreign investors would
presumably choose the stipulated technology voluntar ily.  In fact, the production cost may be higher
than with a simpler technology that is familiar to the host country and which also uses its surplus of
non-skilled or semi-skilled labour.  Rules on technology transfer may then increase the production
costs to the detriment of exports.  On the other hand, if the MNE is hesitating to use the most moderntechnology because it would require an entry on a much larger scale than what is profitable given the
local market size
25, a mandatory technology transfer may increase exports for the simple reason that
the additional capacity must be sold somewhere (see further the analysis in Section IV.3 on size-
dependent incentives).  Given these uncertainties, we can not sign the trade effects with any
confidence without knowing more about the specific circumstances.
32. A synthesis of the analysis is provided in Table 3.
                                                     
24 Foreign equity limitations are sometimes conditioned upon various performance requirements.   For
example, according to OECD (1998), Table A-2, Malaysia im poses foreign equity limits in all sectors except for
those investors that are export-oriented or offer high technology content.  In other words, less intrusive or no
limitations of foreign equity involvement can be used as a performance incentive.  The trade effects depend then
on the specific operational margins that are targeted by the host government.
25 Modern production technologies are often capital-intensive with substantial scale economies.  It may
not be possible to scale down the investment to fit the market size of the host country.WT/WGTI/W/56
Page 12
Table 3.  The trade effects of mandatory performance requirements26
Imports of inputs
by the local plantImports that compete
with the local plantExports of final goods
by the local plant
Local content down (up) (down)
Export performance ? (up) up
Trade-balancing down (up) up
Foreign equitylimitations???
Technology transfer ? ? ?
Note:  Indirect effects are put within a parenthesis. ? indicates that the trade effects are unclear.
IV.2 The Trade Effects of Advantage-based Performance Requirements
33. The above analyses assumed that the performance requirements were strictly mandatory, and
that they were not linked to any incentives.  Of course, that situation may nowadays be more of an
exception than the rule since most countries are today eager to attract FDI, and too demanding
conditions may simply scare away investments to more accommodating neighbours.  Often today
performance requirements are not mandatory but their fulfilment leads to advantages, which offset thefinancial implications of meeting the performance requirements.  These schemes are voluntary in the
sense that investors can choose to forgo the incentives if they find the performance requirements too
taxing in comparison with the benefits that accrue.  In the following, it is assumed that the benefits
equal or exceed the costs.  If the opposite were to hold, the trade effects would be zero since no firm
would participate.
34. The trade effects of advantage-based performance requirements depend potentially both on
the performance side and the incentive side of the scheme.  The exception is when the incentives take
the form of a lump-sum (fixed) subsidy or tax reduction, say $10 million.  Such incentives do not
have any independent trade effects above and beyond those of the performance requirement to which
they are attached.  The trade effects of such schemes are thus identical to the trade effects of
mandatory performance requirements, as analysed above, provided that the benefits outweigh the
costs so that firms are indeed participating.  The on ly difference is in the investors' bottom line.27  In
other cases, the incentives may impact on an operational margin that affects trade directly or
indirectly.  The trade effects of such performance incentives will then be a combination of the trade
effects of the performance side and the incentive side.  We shall give one example below to illustrate
the principle.
35. One variety that can be observed in reality is local content requirements cum preferential
tariff schemes.  The set-up may be the following.  Firms with local assembly of, say, automobiles, that
satisfy a certain local content requirement, say 60 per cent, are granted the right to import assembled
automobiles produced by the MNE in other locations at reduced import duties, say, a 50 per cent
rebate on the MFN rate.  The trade effect of the local content part of the scheme has been analysed
before and we need only to add the independent trade effect of the tariff preferences.  Needless to say,
                                                     
26 The premises of this analysis are set out in the introductory paragraph of this Section.
27 There may be some long-term effect on production and trade if the additional profit is reinvested in
the plant.WT/WGTI/W/56
Page 13
the effect is to bias the market competition in favour of imported automobiles produced by MNEs that
have the local assembly operations.  The import of competing automobiles will thus decline.  By
adding the trade effect of the local content requirement and the trade effect of the preferential tariff
rate, we find the resulting net effect on trade.  The calculus is detailed in Table 4.
Table 4.  The trade effects of local content requirements cum preferential tariff rates
Imports of
autoparts by the
local plantImports of
automobiles by
the MNE that
produce locallyImports of other
competing
automobilesExports of
automobiles by
the local  plant
The trade effect of thelocal contentrequirementdown (up) (up) (down)
The trade effect of the
preferential tariff rateup down
Net trade effect down up down1(down)
1 The direct effect is assumed to dominate.
36. Performance requirements can be combined with any incentives or combination thereof, and
it is not possible to go through all conceivable combinations in this note.  However, the principle of
the analysis should now be clear.  The first step is to analyse the trade effects of the performance
requirements (Table 3);  the second step is to analyse the trade effects of the attached incentives(Table 5 below);  and the third step is to add up the individual trade effects of all linked measures.
28
IV.3 The Trade Effects of Operational Incentives
37. This Section analyses the trade effects of operational incentives that that do not depend on the
performance per se , but which are attached to specific operational margins to encourage a certain
behaviour.  The trade effects of such incentives will depend on the specific operational margin that the
incentives impact on.
38. One set of operational incentives impacts on the profitability of export production.  A case in
point is duty drawbacks that lower the costs of e xport production by refunding the duties paid on
imported inputs that are re-exported as components of the processed good.  The effect (and purpose)is of course to stimulate export production.  At the same time, they should not have any direct effects
on competing imports since the same refunds are not available for production for the host market.
29
39. Another set of operational incentives reduces the variable cost of production, for example
subsidized electricity and water supply.  Reduction of or exemptions from social security
contributions also belong to this category since they lower the cost of labour.  Variable cost incentives
make it profitable for firms to expand production beyond what is otherwise profitable.  For example,an automobile plant may add another shift to take advantage of the lower production costs.  The
additional volume will partly be sold in the domestic market at the expense of competing imports and
partly in the world market.  The additional production will feed back into additional demand for
imported inputs.
                                                     
28 Of course, the net result may be theoretically ambiguous if the effects happen to go in different
directions.  In such cases, one would need a numerical m odel of the market to figure out which effect dominates.
29 However, there could be some indirect negative effects on the competing imports if there are scale
economies in production.WT/WGTI/W/56
Page 14
40. Incentives that are linked to the size of the investment have similar effects.  A case in point is
country D in our survey which grants longer tax holidays to larger investment.  (The length of the tax
holiday increases in four steps with the size of th e investment.)  Such incentives may induce investors
to enter on a larger scale than motivated by the market size of the host country.  For example, the
capacity of an automobile plant may be extended from 200 to 250 thousand units in order to qualify
for five more years of tax holiday.  The additional units will come at the expense of competingimports in the host market and competing exports in the world market.  The trade effects are thus
similar to variable cost incentives.
41. Another set of operational incentives takes the form of market privileges , for example
preferential access to government contracts, protection from import competition or restrictions on
further entry.  Such market privileges reduce the imports of competing goods and services.  The
expanded production of the local plant translates into higher demand for imported inputs.  There are
no direct effects on exports.
30
42. A synthesis of the above analysis is presented in Table 5.
Table 5.  The trade effects of operational incentives
Imports of inputs
by the local plantImports that compete
with the local plantExports of final goods
by the local plant
Export incentives(e.g., duty drawbacks)up nil up
Variable cost
incentives(e.g., lower labourtaxes)(up) (down) (up)
Scale incentives
(e.g., longer taxholiday)(up) (down) (up)
Market privileges
(e.g., import tariffs oncompeting imports)(up) down nil
Note: Indirect effects are put within a parenthesis.
IV.4 Final Observations
43. The above analysis suggests that mandatory performance requirements, advantage-based
performance requirements and operational incentives are often substitutable instruments in terms of
their trade effects.  For example, the trade effects of export performance requirements can be
replicated with export incentives or indirect measures such as variable cost and scale-dependent
incentives.  In principle, any direct performance requirement can be replicated by an operational
incentive that targets the same operational margin.
V. THE IMPACT ON TRADE RESULTING FROM LOCATION EFFECTS
44. As noted above, in addition to the direct effects of investment incentives and performance
requirements that arise from their impact on the performance of firms, such measures may also affect
trade indirectly by altering the location of FDI.  This Section examines the location effects of
                                                     
30 However, there could be indirect expansionary effects on the export if the production technology
exhibits large-scale economies.  See Krugman (1984) for an analysis of "import protection as export promotion"in the presence of scale economies.WT/WGTI/W/56
Page 15
investment measures in a strategic setting where host governments compete for FDI.  It should be
noted that the individual components of a packag e of investment incentives play no role in the
location analysis.  What matters for the purposes of this analysis is only the net impact of all measures
on the investment return, that is, the net incentive.31  All references below to incentives should
therefore be understood to mean the net value of the whole package of investment measures.
V.1 The Link between Investment Incentives, Location of FDI and Trade
45. Consider an investment characterized by large-scale economies that make a subdivision into
smaller units unprofitable, say an assembly plant for automobiles of minimum efficient scale.
Assume that the manufacturer is choosing between two locations, A and B, and that the "normal"
returns in the absence of government interventions are rA and rB, respectively.  The returns in the two
locations may differ because of  differences in labour costs, taxes, transportation costs, and import
tariffs on autoparts.  The trade barriers in the destination market(s) may also affect the returns.  For
example, A may have duty free access to the destination market(s) through a regional trade agreement
while B pays the standard MFN rate.  Alternatively, the destination market may be A itself, and if the
plant is located in B, the producer would incur additional tariff costs when exporting the automobiles
to A.  In the absence of government interventions, the plant will be located wherever the "normal"
return is the highest, say in A (rA > rB => A).  B may then be tempted to offer incentives, iB, to make up
for the shortfall in normal returns.  If unchallenged, the investment will then go to B instead  (rB + i B >
rA  =>  B).  Of course, faced with the prospect of losing the investment, A may make a counter-offer to
offset the incentives of B, possibly leading to further rounds of bidding until one side caves in.  The
linkage between investment incentives, location of FDI and trade follows immediately.  If the plant
goes to A (because of higher net incentives), A will import autoparts and export assembled autos; and
if the plant goes to B (because of higher net incentives), B will instead import autoparts (possibly from
other destinations than if the plant had been located in A) and export assembled autos.  The obvious
but important point is that investment incentives, to the extent they change the location of FDI, lead to
discrete  changes in the trade flows.
46. Apart from this relation between decisions on the location of investment and trade, it will be
recalled that the earlier note prepared by the Secretariat on the Relationship between Trade and
Foreign Direct Investment analysed the effects of FDI on trade in detail (WT/WGTI/W/7).  The
purpose here is not to repeat this analysis but to go one step backward in the nexus that links
investment incentives, investment location and trade by considering the impact of incentives on
location.
V.2 The Link between Investment Incentives and the Location of FDI32
47. In considering the impact of investment incentives on the location of FDI, and hence
indirectly on international trade, it is important  to account for the strategic interaction between
competing host countries.  Such strategic interaction may take different forms, ranging from offsetting
changes in incentives that are getting out of line with those of the neighbours to outright bidding
contests for coveted investment projects.33
                                                     
31 For example, the net incentive of a combination of an investment grant worth $100 million and a
local content requirement co sting $20 million is $80 million.
32 The analysis herein applies also to competition between regional or local communities for investment
within a nation. Indeed, much of the debate on restricting such competition has so far been carried out within
nations or members of the same regional trade agreement. An interesting account of the debate in the United
States is the collection of essays  published recently by the Federal Reserve Bank of Minneapolis (1996).
33 One task of investment promotion agencies is to follow developments elsewhere and to recommend
changes in their own rules and incentives to keep the lo cation attractive for foreign investors. Also, as stressed
before, incentive schedules are designed to be flexible in order to defend investment against piracy and perhapsWT/WGTI/W/56
Page 16
48. As a starting-point, it is useful to recall the justification that countries give for granting
investment incentives.  This is that foreign investme nt may be associated with higher social benefits
than comparable domestic investment in the same sector, for example in terms of technology transfer
and other learning externalities.34  Of course, it would be better for a host country to receive these
benefits for free, but this option may not be available if other countries are competing for the same
investment, or if the private return is not enough to  attract FDI without artificial sweeteners.  Thus, if
the only way to attract investment is to gran t incentives, governments may choose to pay incentives
up to  the expected value of the social externalities.  If less is needed, the social benefits net of
incentives will be positive, and if more is needed, the host country is better off letting the investmentgo elsewhere.  In short, it never makes sense to pay more than the absolute minimum to attract a
coveted FDI, and in any case no more than the value of the social externalities that accrue.
49. Annex 2 of this paper presents an analysis of the question of whether policy competition
among most countries distorts the location of FDI in the world and thus indirectly world trade.  It does
this by examining whether incentives divert FDI to locations where it will contribute less to global
welfare.  It also considers who will gain and lose from this competition.  The main arguments and
conclusions are summarized below.
50. The starting point is the observation that the market mechanism does not necessarily lead to
an efficient allocation of investments in the world.  Left to market forces, investments will be
allocated efficiently only if social externalities happen to be identical  in alternative locations.  In those
cases, the private returns will be perfectly correlated with overall returns.  The problem is that there is
no a priori reason to believe that social externalities are in fact identical across alternative locations.
For example, the technology used by a foreign investor may be familiar in one location (perhaps
because of a previous investment) and novel in another.  The latter location may then derive higher
social benefits in terms of technology transfer at  the same time as private rationality may dictate a
location where the technology is already familiar.  By  translating the social externalities into private
returns, investment incentives could in theory ther efore help guide investments to locations with the
highest overall return, including the benefits that accrue to the host countries.  In this scenario, the
main problem from an efficiency point of view arises in a situation where only a subset of countries
offer incentives.  The activist countries will then lure investment from passive countries for whichthey may have no comparative advantages.
51. However, there are many qualifications to this theoretical case for incentives.  The first
qualification, or question, is whether incentives indeed reflect the value of social externalities.  It is
extremely difficult to estimate the social externalities that accrue from a given investment.  Some
countries may not have the necessary expertise or inclination to undertake careful cost-benefit
analyses, but may rather base their incentives on crude rule-of-thumb or simply match what the
neighbours are offering.  Political considerations and vested interests may also distort incentives awayfrom the social optimum, especially when several countries compete for the same investment.
Unfortunately, very little is known about these matters since the specific conditions attached to
individual investment projects  and the underlying cost-benefit analyses (if any) are rarely published.
35
                                                                                                                                                                    
to lure some investment oneself. For example, a tax holiday may be given up to  25 years, an investment grant
may be given up to  50 per cent of the investment cost, and so forth. Moreover, some investment promotion
agencies state explicitly on their web sites that incentives are negotiated on a case-by-case basis for investmentthat involves international mobile production unity. This suggests a great deal of flexibility to meet thecompetition from alternative locations.
34 A brief survey of empirical evidence of technological spillovers can be found in Graham (1996),
appendix A. See also Blomström and Kokko (1997).
35 At best, one can find in official publications some aggregate figures on the amount of industrial
support, but these figures may not include items like forgone tax revenues (because of tax concessions) orforgone consumer surpluses (because of monopolistic pricing behind high trade barriers).  Moreover, suchaggregate figures are not helpful in evaluating whether the incentives make sense for individual investmentprojects.WT/WGTI/W/56
Page 17
In short, there is no knowing whether investment in centives in fact reflect social externalities and thus
actually improve the allocation of FDI in the world.  Furthermore, the incentives themselves, or the
way they are financed, can give rise to distortions.  These distortions must be weighed against the
potential efficiency gains.  Incentives that are just paid out to offset incentives elsewhere are a pure
waste because of the distortionary effects of the investment measures themselves.
52. As to the question of the distribution of gains and losses from FDI competition,  the answer is
more definite.  As analysed in more detail in Annex 2, policy competition for FDI has all the classical
attributes of a prisoners' dilemma game, in which the prisoners - the host countries - harm themselves
by pursuing their narrow self-interests.  When all countries offer incentives, the incentives may
simply cancel each other out, and investments will esse ntially be distributed in the same way as would
be the case if no country offered incentives.  The lasting effect is only to redistribute income from
host countries to the share holders of the home countries.36  This has negative repercussions on global
income distribution since some of the gains that would have accrued to poorer developing countries
(that are net recipients of FDI) are squandered on incentives to richer developed countries (that are netoutward investors).  Moreover, not all countries may be able to participate in the competition for FDI
on equal terms.  Countries with "deep pockets" ma y then win the competition for FDI in spite of
lower social returns.
53. In summary, while investment incentives could possibly be rationalized on efficiency
grounds, practical considerations suggest that the efficiency argument is often very fragile andpossibly non-existent.  The potential efficiency gains, if any, must also be weighed against possible
detrimental effects on the global income distribution, favouring home countries over host countries,
and richer countries over poorer countries.
54. To the extent that investments are made in locations that are sub-optimal from an efficiency
point of view, not only will there be distorted allocation of resources worldwide but also this can beviewed as leading to distortions in international trade flows, given the close link between decisions on
investment location and trade.  Of course, it is recognized that global efficiency is only one criterion
for distinguishing between distorted and undistorted in ternational trade flows.  Another is that which
flows from the application of the WTO rules.  These do not depend in any direct fashion on
calculations of global efficiency (although it can be argued that some represent useful approximationsto that criterion).  As indicated earlier, this note analyses the issues addressed in it from an economic
and not from a legal perspective.
VI. EMPIRICAL EVIDENCE
55. The aim of this Section is to provide an overview of the empirical literature on incentives and
performance requirements, especially on the question of whether investment incentives and
performance requirements make a difference in how firms invest and operate.  Unfortunately, because
of severe data problems, there does not appear to be much systematic evidence on this issue.  In orderto carry out a thorough statistical analysis one would need information on incentives and performance
requirements on an investment-by-investment basis (since the specific conditions are often negotiable
and may vary between different projects), includ ing the conditions offered by competing locations
and the operational data of the foreign affiliates (exports, imports, sourcing of inputs, etc.).  Such data
would allow statistical analysis of the location and trade effects of various investment measures.However, such data do not seem to exist in the public domain.  The only meagre evidence that seems
to exist is based on interview studies in which investors have been asked to rank a number of factors
determining their investment decisions, and whether or not investment measures affect the operations
of the foreign affiliates.  The interview studies were recently surveyed by UNCTAD (1996),
                                                     
36 Of course, this is not to suggest that an individual host country could eliminate its incentives
unilaterally and still attract investments.  Only a coordinated reduction or elimination of incentives will leave thedistribution of FDI in the world more or less unchanged.WT/WGTI/W/56
Page 18
Chapter IV, and previously by UNCTC (1991).  It shoul d be noted that some of the underlying studies
are by now rather old and possibly obsolete because of the rapidly evolving policy climate.
VI.1 United States International Trade Commission (1982)37
56. The study by the United States International Trade Commission (1982) covered three types of
performance requirements - export minima, import maxima, and local content - facing United States
foreign affiliates in three industries - automotive, chemicals, and computer and office equipment.  The
study revealed that 41 per cent of the foreign affiliates in the automotive industry were subject to
performance requirements, 12 per cent of the affiliates  in chemical production, and 19 per cent of the
affiliates in production of computer and office equipment.  The interviews with the MNEs revealedthat the existence of these measures had only a minor influence on their investment decisions.
Specifically, local content requirements often made it necessary to expand the investment from
assembly into local production of parts and components.  The estimated effects on United States
exports to the host countries were ambiguous with an estimated small increase to some markets
(including components and related products) and a small decrease to others.  The employment effectsin the United States of these measures were estimated at a loss of less than 3,000 jobs.
VI.2 Guisinger and Associates (1985)
38
57. Stephen Guisinger and associates (1985), under a mandate of the World Bank, investigated
the effects of both performance requirements and investment incentives on the location and operation
of foreign affiliates.  The research team interviewed more than 30 MNEs involved in 74 investment
projects in four industries - food processing, au tomobiles, computers and petrochemicals.  On
average, governments used 22 different investment measures in an effort to fine-tune the social
benefits of these investments, with different combinations for different projects.39 Out of this sample,
51 per cent of the projects were subject to explicit performance requirements.  All firms subject to
performance requirements received compensatory incentives.  As far as the location effects are
concerned, performance requirements played a role in only 5 per cent of the locations.  The effects on
the operations of the foreign affiliates were also reported to be minor.  Several corporate officialsinformed the research team that their foreign affiliates would eventually have achieved the levels of
exports and local content required by the regulations.  The principal impact of the performance
requirements was to accelerate the firms' plans to develop local suppliers and enter export markets.
At the same time, for the automotive industry, some MNEs reported that local content requirements
worked contrary to the export plans of the host government by rendering local production more costly
than otherwise, and hence less competitive in the world market.
58. In contrast , two thirds  of the investment projects were influenced by the incentive policies of
the host governments.  Interviews with government officials also revealed that they had considerable
knowledge about what kind of investment packages were offered elsewhere, and the study noted that
the governments often matched each other's offers.  At the margin, host governments were often not
in a position to reduce their incentives without losing out to more "generous" locations.  The study
also noted that direct subsidies to attract the location and affect the operations of foreign firms were
                                                     
37 This Section is based on pages 16-17 and 46-48 of UNCTC (1991).
38 This Section is based on pages 17 and 49-50 of UNCTC (1991) and Guisinger (1986).
39 Guisinger (1986) makes the following remarks on the political economy of the plethora of
investment measures: "[The] widespread use of multiple, seemingly repetitive, instruments suggests that anincentive package, consisting of multiple substitutable incentives, has advantages over a single incentive
instrument. ... Since investors usually wish to avoid aler ting competitors or the public to any special treatment
which they receive, corporations are likely to prefer an opaque jumble of incentives and disincentives to
transparent forms of public subsidy. Governments, too, have reasons to prefer a variety of incentives over a
single incentive. An array of incentives and disincentives can divert the attention of taxpayers who aresuspicious that the government is granting pref erential tax treatment for corporations." (p. 86).WT/WGTI/W/56
Page 19
more common in developed market economies, whereas developing host countries used tax and trade
instruments for essentially the same goals.
VI.3 Moran and Pearson (1987)40
59. Moran and Pearson (1987) of the Overseas Private Investment Co rporation (OPIC), an
investment insurance agency of the Government of the United States, surveyed 682 investment
projects that had applied for insurance to find out the incidence and effects of trade-related
performance requirements.  The study found that 40 per cent  of the projects were subject to such
requirements, typically a combination of export and local content requirements.  A detailed
investigation of the effects of these measures was carried out on a smaller sample of 50 investmentprojects.  One finding was that performance requirements in almost two-thirds of the cases
(63 per cent) were linked to incentives, that is, they were really performance incentives.  Another
interesting finding was that 83 per cent of the performance requirements were judged by the foreign
affiliates to be redundant , that is, non-binding.  In the case of local content requirements, the MNEs
typically reported that it was either more economical to source locally or that the sourcingrequirements were negotiable to non-binding levels.  In the case of export minima, MNEs typically
reported that they in any case had the intention to start exporting from the host country sooner or later.
In other words, in many cases the performance requirements only required what the foreign affiliates
would have done anyway, at least over time.  The study therefore concluded that the trade effects of
these measures were minor.
VI.4 Gray and Walter (1984)
41
60. The study by Gray and Walter (1984) examined a sample of 15 petrochemical projects.  They
interviewed corporate planners and headquarter personnel to determine the existence of investment
measures and their effects on the location choice among alternative sites.  The study found that
performance requirements and incentives played only a secondary role in locational choices.
Government measures were dominated by other factors such as extraction costs and market size.  Atthe margin, however, locations were affected ne gatively by ownership limitations, local content
requirements and price controls, while subsidies, tax concessions and tariff protection served as
inducement factors.
VI.5 Other Evidence
42
61. Another finding that emerges from several studies is that different types of investment
projects respond to different investment measures.  For example, Reuber et al. (1973) found that
export-oriented investors valued fiscal incentiv es (including tax holidays, duty remissions and
accelerated depreciation) more highly  than protection of the market or other incentives.  Market-seeking
investors, on the other hand, valued protection of th e market more than fiscal or other incentives.
Likewise, Lecraw (1990) f ound that the tariff rate was a significant determinant of investment oriented
towards the domestic market, but not for export-orient ed or natural resource-seeking investment.  The
latter kind of investment was more prone to respond to fiscal incentives.  Yet another study by
Kumar (1994) found that export-oriented FDI in a sa mple of 40 countries was significantly influenced
by the length of the host country's tax holiday.  In  addition, removing disincentives and improving the
functioning of the economy may be a more fruitful way of attracting investments.  For example, a recent
World Bank study on developing  countries, edited by Shah ( 1996), concluded that reducing
disincentives such as poor infrastructure and weak in stitutions matters more in fostering investment than
direct tax incentives.
                                                     
40 This Section is based on pages 18-23 and 50-51 of UNCTC (1991).
41 This Section is based on pages 51-53 of UNCTC (1991).
42 This Section is based on Chapter IV in UNCTAD (1996).WT/WGTI/W/56
Page 20
VI.6 Concluding Remarks on the Empirical Evidence
62. The two UNCTAD surveys referred to above draw  the following main conclusions from the
available empirical literature.  Firstly, regarding the location effects of incentives relative to other
factors, UNCTAD  (1996) concludes that there is overwhelming evidence to suggest that incentives
are a relatively minor factor in the locational decisions of MNEs relative to other factors, such as
market size and growth, production costs, skill levels, political and economic stability and theregulatory framework.  However, the impact of incentives is not negligible: if one country offers
incentives and another does not, then, all other things being equal, foreign investors could be
influenced in the locational choices between countrie s.  Secondly, with regard to the trade effects of
these measures, the UNCTC (1991) survey finds that the majority of the performance requirements do
not seem to require investors to undertake actions that they find uneconomical and/or are not planning
to undertake anyway.  However, the MNEs' plans to develop local suppliers and enter export markets
are sometimes accelerated by these measures.
63. It should be borne in mind that the policy environment is changing rapidly and that older
evidence may quickly become obsolete.  Moreover, interview studies are obviously inferior to
systematic statistical analysis which so far it has not been possible to undertake because of the lack of
published data on incentives and performance requirements on an investment-by-investment basis.
Yet the scanty empirical evidence broadly confirms the basic message of the theoretical analysis thatinvestment incentives and performance requirements could make a difference for the location of FDI,
the sourcing of inputs and trade patterns.
43
                                                     
43 One of the key experts in this area, Stephen Guisinger (1996), expresses the lack of data and the
consequential poor empirical understanding of the effects of investment measures in the following way:  "The
real problem lies in empirical estimation.  Estimations of investment restriction costs are much more difficult to
collect than costs imposed by trade polices because of di fferences in the way that restrictive policies are applied.
Within the same industry, tariffs and quotas apply uniformly to all importers, so that only one piece ofinformation is needed for each import product. ...  In cont rast, investment restrictions are often imposed on a
project-by-project basis even within the same industry or product category.  No two investors in the samenarrowly defined industry category face exactly the same set of restrictions or incentives.  Amassing reliable
data on a project-by-project basis, identifying the dozen or more restrictions and incentives that apply to the
typical investment in developing countries is, to put it mildly, a daunting task.  The author knows of no studywhere this detailed data has been collected even for a stratified sample.  While it would be incorrect to say thatwe know nothing about the degree of restrictiveness (of investment regimes), our knowledge is largelyqualitative and subjective." (p. 3)WT/WGTI/W/56
Page 21
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Fumagalli, C. (1998). "Competition for FDI and Asymmetric Countries", mimeograph, Universitat
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Graham, E. (1996). "Global Corporations and Na tional Governments", Institute for International
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Guisinger, S. (1996). "Foreign Direct Investment:  The Impact of Liberalization on the Economies of
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Lecraw, D. (1990). "Factors in fluencing FDI in LDCs", in Clegg, J., and P. Buckley (eds.)
Multinational Enterprises and Developing Countries , McMillan, London.
Moran, T., and C. Pearson (1987). "Trade-Related  Investment Performance Requirements", Overseas
Private Investment Cor poration, Washington D.C.
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Nations", Paris.
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The World Bank Economic Review , vol. 8(1), pp. 1-16.
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in Development", Clarendon Press, Oxford.
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the Relationship between Trade and Investment, WT/WGTI/W/7, 18 September, Geneva.WT/WGTI/W/56
Page 24
ANNEX 1
Investment Promotion in Eight Countries
1. This Annex compiles some information posted on the web sites of eight different investment
promotion agencies (IPAs), covering two least de veloped countries, two developing countries, two
economies in transition, and two developed countries.1  The countries are not referred to by their
names and some identifying information has been left out from the citations.  The purpose of this
small survey is merely to illustrate the current trend in investment promotion as a backdrop for the
discussion in the main text.
A.1 Least Developed Countries
Country A
2. The IPA web site of country A introduces the investment climate in the following manner:
"A offers investors rich opportunities.  The country has huge mineral deposits, vast forests, millions of
hectares of  agricultural land to be developed a nd water for irrigation and hydro-power.  It also has
great tourism potential and is well supplied with skilled and semi-skilled labour, while the growing
domestic and regional export markets offer unsatisfied demand.  This potential has long existed.
What was lacking was the political and economic environment in which business could do business.
During the socialist decades before the (...) government took office in (...), private investors were
squeezed out.  Now they are welcomed back.  The government's economic stabilization, liberalizationand privatization programmes are taking the shackles off the private sector and creating the conditions
that allow investors to profit handsomely.  Red tape has been cut, foreign exchange restrictions
removed and trade barriers dropped.  Inflation has fallen from 207 per cent in 1992 to an expected
15 per cent this year.  ... Today, A has one of the most open economies of all the emerging markets,
and it is eager to draw foreign investment.  The co untry is attractive to investors who want to develop
its natural resources.  The government is especially interested in downstream processing projects that
add value to traditional exports and raise non-traditional exports.  A is also attractive to investors who
want to develop tourism or to build businesses to meet fast-growing local and regional demand.
Trade pacts open up a (...) billion market of (...)  million consumers in neighbouring countries. ..."
3. "A offers investors a broad range of incentives in addition to a system of taxes and import
tariffs that was designed to minimize their burden and red tape.  The tax and tariff system itself is an
incentive compared with the headaches and high taxes and import duties investors face in otheremerging countries.  For instance, the import duty on raw materials is only 5 per cent;  on
intermediate goods it is 15 per cent; and on final products it is only 25 per cent.  There are no foreign
exchange controls, and 100 per cent of profits may be remitted.  Investment incentives include
reduced income taxes and import duties and accelerated depreciation allowances.  Special incentives
are available to mining enterprises."
4. The IPA also stresses the security of investment (against expropriation).  " A has joined the
Multilateral Investment Guarantee Agency (MIGA) and has signed other international agreements that
provide significant protection to investors."
                                                     
1 The material was collected from the web-sites of the IPAs during August and September, 1998.WT/WGTI/W/56
Page 25
Country B
5. The IPA web site  of country B introduces the investment climate in the following manner:
"B, the (...) most populous country in the world, is a nation with an exciting future.  A workforce that
is rapidly developing skills, but is yet to be affected by the alarming global increase in labour costs,
has also a large number of highly skilled professionals who herald an economic boom.  A stable
process of democratization and successive government policies geared towards economic reform have
provided the backbone for an optimism in the business community that is unprecedented.  B is at a
threshold of progress, and investors have been quick to react.  In 1990 the government announced thatprivate investment would be released from bureaucratic controls; in 1991 the government issued an
economic policy document, Industrial Policy 1991, which was revised in December 1992.  Under the
Industrial Policy scheme, exchange controls for private manufacturing firms were liberalized for
current-account transactions, the government announced its intention to end its ownership of
industrial enterprises, and the Board of Investment was given the task of facilitating privateinvestment instead of regulating it.  Since 1993 import controls have been reduced and import permits
have been abolished.  The main import controls remaining relate to the import of textiles.  Tariff
reform began in 1991.  Since then import sales tax and most of domestic excise duty has been
replaced by VAT, and tariff rates have been simplified and reduced.  In 1996 the highest rate of
import duty was cut to 45 per cent.  Export production has been encouraged through ExportProcessing Zones (EPZs).  Firms in an EPZ can import capital and raw materials free of duty, retain
foreign currency earnings, employ non-unionized labour and enjoy exemption from income tax for ten
years."
A.2 Developing Countries
Country C
6. The IPA web site  of country C introduces the investment climate in the following manner: " C
is emerging as Asia's most attractive opportunity for investment .  Central to C's  strong potential is its
geographical location between (...) and the potentially huge market of (...) .  However, of even greater
importance is C itself, offering a world class economy based on flourishing international trade .  For
the past three decades, C has remained one of the fastest growing economies in the world. ... C has as
its target nothing less than being a reformed haven for foreign corporations, and is taking every step
necessary to induce the inflow of foreign capital. ... Until now, a major obstacle to foreign investment
has been the myriad of legal and regulatory laws .  However, in order to invigorate investment, these
laws will be streamlined and incorporated into a single legal framework, the Foreign Investment
Promotion Act .  This will provide foreign investors with a one-stop service based on centralized
regulations, in sharp contrast to the present web of complex procedures."
7. The major points of the draft Foreign Investment Promotion Act are the following:
• Greater autonomy will be given to local governments in the fields of tax reduction or
exemption and rent reduction or exemption (as in the case of land).
• Efforts taken and accomplishments in inducing FDI will be the criteria by which the
central government allocates fiscal support to local governments.
• Administrative provisions in the Fore ign Investment Promotion Act will be
minimized.
• Approval and authorization procedures being facilitated to expedite FDI and current
number of provisions regulating FDI will be reduced from 66 to 36.
• The Investment Promotion Center will be established to provide a one-stop service
for FDI.
• Investor support will be enhanced through a system of various incentives, such as tax
reduction or exemption and job training subsidies.WT/WGTI/W/56
Page 26
• Foreign Investment Zones (FIZs) will be established in order to induce large-scale
FDI.
Table 6.  Investment incentives
A business accompanying advanced technology, or service industries that support the manufacturing
sector which strengthen the international competitiveness of a domestic business, is entitled to areduction and exemption of national corporate and income taxes for 10 years:
• year 1 to 7 at 100%
• year 8 to 10 at 50%
Local governments will have the autonomous power to grant tax reduction or exemption from
anywhere between 8 to 15 years.
Capital goods used in business operations already receiving tax reduction or exemption will beexempted from customs duties, special excise taxes, and value added taxes.
Country D
8. The IPA web site of country D introduces the investment climate in the following manner:
"Poised at the gateway of (...), D offers investors  a logical base to capture the massive regional
market.  Regional cooperation through (...) and the eventual (...) Free Trade Arrangement will ensurea vast market displaying considerable purchasing power in the future
.  A business-friendly
government is pursuing an active policy of economic liberalization .  D offers total foreign ownership
in most areas .  There are no restrictions on the repatriation of earnings and capital, nor on foreign
exchange transactions relating to current account payments .  The safety of foreign investment is
guaranteed by the constitution of D and by bilateral agreements with 20 countries .  Intellectual
property - copyrights, industrial designs, patents, trademarks, service marks, trade names, and unfair
competition - is protected under the Code of Intellectual Property Act of 1979 .  An International
Centre for Arbitration resolves commercial disputes expeditiously, economically and privately .  The
private sector plays a key role in the privatization programme of the government with private sector
investment welcome into the infrastructure and service sectors .  Key State institutions such as (...) are
being prepared for privatization .  Several key multinational financial institutions have been
conducting business in D for a number of years. ...  D offers one of the best educated and most
productive resources of skilled and semi-skilled labour in the region."
9. As far as the investment incentives are concerned, the IPA web site presents these in very
instructive tables which we have merged into a single table .  The incentives are designed to encourage
export production .  The higher the export undertakings, the higher the incentives .  High technological
industries, referred to as "thrust" industries by the IPA, are also rewarded with special incentives .
Another interesting feature is that the incentives increase with the size of the FDI.WT/WGTI/W/56
Page 27
Table 7.  Investment incentives
QUALIFYING
CRITERIAINCENTIVES
Import duty exemption
INDUSTRYMinimum
inv. sizeMinimum
export req.Full Tax
HolidayConcessio
nary tax
rate after
tax holidayon capital
goodson raw
materialsExemption from
exchange control
50 -
149990% 10 years 10 years yesyes,
for exportyes
1500 -
249990% 12 years 8 years yesyes,
for exportyes
2500 -
499990% 15 years 5 years yesyes,
for exportyesNew export-oriented
investment in a "ThrustIndustry"
Above
500090% 20 years special yesyes,
for exportyes
None up to 49% Noneyes, on
export
incomeyesyes,
for exportNo
None50-89%
(within 5
years)5 yearsyes, on
export
incomeyesyes,
for exportyesExisting enterprise in a
"Thrust Industry."
Incentives forachieving exportorientation
None90% or
more
(within 5
years)10 yearsyes, on
export
incomeyesyes,
for exportyes
500 -
149990% 10 years 10 years yesyes,
for exportyes
1500 -
249990% 12 years 8 years yesyes,
for exportyes
2500 -
499990% 15 years 5 years yesyes,
for exportyesNew large-scale
export-oriented
projects
Above
500090% 20 years nil yesyes,
for exportyes
5 0-49% Noneyes, on
export
incomeyes yes no
550% or
more
(within
5 years)5 yearsyes, on
export
incomeyes yesif 90% is
exportedTextile & ancillaryindustries (existing andnew) including yarn,thread, etc.
Above
500Incentives as enumerated under large-scale projects
A.3 Economies in Transition
Country E
10. The IPA highlights ten important reasons to invest in the country:  (1) ongoing accession
negotiations with the intention of becoming a full member of the European Union;  (2) a seven-point
package of investment incentives;  (3) rapid integration into the global economy;  (4) strong
international inward investment record;  (5) wage s and on-costs that are only a fraction of western
European levels;  (6) proven productivity growth potential;  (7) strong quality levels;  (8) good R&D
capabilities;  (9) established infrastructure and supply base;  (10) regional position and strategic hub
status with excellent accessibility to nearly 500 million customers in the growing markets of Centraland Eastern Europe and the European Union.WT/WGTI/W/56
Page 28
Table 8.  Investment incentives
General criteria:
1. Only for greenfield and joint venture investments into all manufacturing industries pursuant to the
“OECD Classification of High-Technology Products and Industries”;
2. Minimum investment of US$25m;
3. Investment only into environmentally friendly production.
Incentive package:
1. Deferred payment of corporate tax for the first 5 years.
2. Accelerated tax depreciation of machinery and of production buildings.
3. Location of the new production in the current Customs Free Zone, or creation of a new Customs Free
Zone so that the land selected by th e investor falls within its range.  The latter requires that the investor
can demonstrate exceptional long-term benefits of their investment in an independent feasibility study.
4. Remission of duties and deferred VAT on machinery and equipment.
5. Provision of an interest-free loan of up to US$2,470 per person for the creation of each job for citizens
of E.
6. Provision of an interest-free loan for training and re-training of E citizens up to 50 % of the total training
costs.
7. Provision of a site prepared for investment for a symbolic price with infrastructure provided to the border
of the site.
Country F
11. The purpose of the foreign investment policy is described in the following way:  one of the
main tasks in the stabilization and growth of the F economy is boosting investment activity, including
the attraction of foreign investment.  For this purpose substantial work is being carried out to improve
the investment climate, creating a favourable envi ronment for foreign investors, promoting a positive
image of F as a country attracting foreign investment.  Some success has been achieved along this
line.  Influx of foreign investment in the F economy has been growing during the last two years.  The
government policy for attracting foreign investments for the period of 1997 to 2000 will lead to the
following actions:
• development and establishment of a stable and "transparent" regulatory and legal
basis for foreign investments, including the systems of taxation and customs control;
• establishment of a system of guarantees, protection and insurance of foreign
investments;
• development of the sphere of contract and legal basis for F’s participation in
international investment cooperation, including participation in multilateral
agreements on investment;
• investment cooperation with international financial institutions and organizations;
• working out the basis of the state policy for repatriation of the capital exported from
F;
• establishment of local free economic zones in the most promising regions as concerns
attraction of foreign investments and development of the export potential of F and its
regions;
• further liberalization of norms and rules for conducting transactions involving capital
movement by non-residents;
• aid to regions in attracting foreign investments.
12. The current incentive system includes exemption on VAT on imported technological
equipment and spare parts, plus exemption of custom duties for certain products and investors.  Inaddition, some regions of the country offer regional tax concessions to foreign investors.WT/WGTI/W/56
Page 29
A.4 Developed Countries
Country G
13. The IPA web site of country G introduces the investment climate in the following manner:
"There are a number of positive factors leading to increased investment in G:  opportunities created by
G’s membership in (...) with a population of over (...)  million.  Political and social stability.  Business-
friendly government.  Favourable policy towards foreign investment including financial and tax
incentives, unrestricted  freedom to establish in all sectors and the free transfer abroad of dividends,
capital gains, and proceeds from the sale of investment.  One of the lowest rates of industrial disputes
in [the region].  Availability of a technically competent workforce.  Well-developed technology base.
Modern infrastructure providing easy access to the world’s main markets."
14. Five incentive programmes for industrial development and modernization are outlined on the
web page.  The objective of the first programme is to assist enterprises in implementing their medium-
and long-term development plans, including support of research and development, quality upgrading,
participation in the capital market, and small compan y development.  The incentives take the form of
cash grants and interest-free loans up to 80 per cent of  the investment cost for a period of between two
and seven years.  Training expenses are eligible for a separate cash grant of up to 90 per cent of thedirect training costs and 50 per cent of training materials.  The second programme is targeted to assist
the textile sector in certain eligible regions.  The incentive may be in the form of cash grants, venturecapital, and interest-subsidized loans.  The third programme aims at promoting job creation and
product diversification in less-developed internal regions.  This incentive includes cash grants of up to70 per cent of the cost of fixed assets and/or subsidized loans.  The fourth programme aims to
promote the continuous development and growth of commercial companies.  Investment projects
which fit within one of the following categories are eligible:  (i) revitalization of trading companies by
rationalization, innovation and expansion;  (ii) actions which promote inter and intra-sectorial
cooperation;  and (iii) actions promoted by associations of companies in the trading/commercial sector
and which envisage the strengthening of their presence in the sector.  The incentives are in the form ofcash-grants, interest subsidies or subsidized lease rentals under leasing contracts.  The fifth
programme includes a variety of financial and infrastructure support schemes geared at fostering thecreation of enterprises and jobs.  Only enterprises owned and managed by individuals aged between
18 and 35 years qualify.  The available incentives are up to 75 per cent of the qualifying investment.
15. There are also sector-specific programme for tourism, energy, agriculture and fishing.  The
incentives are awarded as a mix of cash grants and interest-subsidized bank loans.
16. Finally, G offers targeted incentives, negotiated on a case-by-case basis, to foreign investors
with projects that:  (i) involve in vestment in an internationally mobile production unit;  (ii) involve an
investment of more than (...);  and (iii) cont ribute to the innovation and modernization of G's industry.
Country H
17. "The H government is committed to stimulating and attracting business investment from both
domestic and international sources.  For the past decade, successive federal governments have basedinvestment policies on the fundamental principle of being "open for business".  This principle is
enshrined in the 1985 Investment Act, the purpose of  which is to encourage and facilitate investment
from domestic and international sources. ...  A variety of government support programmes and
investment incentives are available at the federal, regional, provincial and municipal levels in  H.  The
Government of H has a number of programmes that support the development of trade, investment and
technology.  These are offered through various federal departments and agencies, such as ... .  In
addition to federal programmes that apply across H, there are four federally funded regional
development programmes. ...  These vary greatly and may take the form of repayable contributions,
interest-free or interest-reduced loans, training, tax incentives and business consulting."WT/WGTI/W/56
Page 30
Table 9.  Investment incentives
Custom duty
reliefprogramme"[I]n instances where duties or taxes are payable on imported goods, the federal
government has programmes to provide full or partial relief from payment.  Theprogrammes cover a wide range of situations and categories of goods. ...  The programmesof most interest to potentia l foreign investors are the Duty Deferral Program, the Duty
Drawback Programme and the Machinery Programme.  The latter programme provides forrelief of customs duties on certain machinery and equipment that are not available from H
manufacturers.  Other programmes assist H-based companies when otherwise dutiable
materials and components are used in the production of goods for export."
R&D incentives "Tax incentives to encourage R&D in H are widely recognized as being among the most
favourable in the world. ...  Fe deral tax law provides for a dir ect tax incentive by way of a
federal Investment Tax Credit (ITC) earned in respect of both current and capital R&Dexpenditures.  ITCs may be used to offset up to 100 per cent of a corporation’s or anindividual’s federal tax liability relating to business income in a year. ...  Each provincehas its own R&D incentives provided by way of either tax credits or tax deductions. ..."
Preferential taxrates formanufacturingand processingCorporations with income fr om an M&P business may qualify for a special M&P tax credit
of 7 per cent.
Financialassistance andguarantees"The business development bank of H was set up mainly to provide both established and
new businesses in all parts of H with financial assistance and management services.
Smaller businesses are given particular attention.  The Bank provides loans to businesseswhich have been unable to obtain financing from other sources on reasonable terms. ...The Machinery Program provides for the remission of customs duties and a portion ofexcise taxes on certain machinery imports, related equipment and parts not produced in H.
...  The objective of the Advanced Manufacturing Technology Initiative  is to enhance the
international competitiveness of H  industry by stimulating more effective use of advanced
manufacturing technology. ...  Any taxable company or group of companies operating in H
and engaged in manufacturing or secondary processing can apply for funding.
Exportassistance"The Export Development Corporation ... offers financial facilities to assist H export sales.
Specifically, the EDC provides exporters with various types of export insurance and relatedguarantees and also grants loans and loan guarantees to foreign buyers of H-made products.
Normally, the goods or services for which loans are made or insurance is given must havea certain minimum level of H content, usually around 60 per cent ... ."WT/WGTI/W/56
Page 31
ANNEX 2
Investment Location, Trade and Welfare:  An Analysis Based on Game Theory
1. It should be emphasized that this analysis aims to look at the effects of investment incentives
if governments behave rationally, in terms of maximizing domestic economic welfare.  (It is, of
course, recognized that this is a considerable assumption and that in reality many other political and
administrative considerations may enter into play.)   The analysis below draws on game theory and
presents a simplified model based on numerical examples.1
2. Suppose that there are only two host countries in the world, A and B, and only two investment
projects to compete for.  If the first investment is located in A, it will give the foreign investor a return
of $500 million in the absence of incentives, and if located in B, it will give a return of $400 million.
Assume that the social externalities ("host return")  in terms of technology transfers etc. are equal in
both locations, worth, say, $200 million.  (Needless to say, these gains only accrue to the country in
which the investment is located).  The second investment is just the mirror image with the highest
"foreign return" in B.  In other words, each country is assumed to have a comparative advantage for
one investment each.  The data of this example are presented in Table 10.
Table 10.  Basic data
if located in A if located in B
Investment foreign
returnhost return total return foreign
returnhost return total return
1 $500m $200m $700m $400m $200m $600m
2 $400m $200m $600m $500m $200m $700m
3. Consider the following policy scenarios:  (1) Neither A nor B use incentives;  (2) only A uses
incentives;  (3) only B uses incentives;  and (4) both countries use incentives.
4. If neither party offers incentives, they will receive one investment each.  The first investment
will go to A since the private return to the foreign investors is $100 million higher than in B, and the
second investment will go to B for the same reason.  Each country will derive $200 million in social
externalities from the investment which it receives.  The allocation is efficient in the sense that each
investment is located wherever the overall returns (foreign plus host) are the highest.
5. If only A offers incentives, both investments will go to A.  There is no need for A to offer any
incentives to attract the first investment since the nor mal return to the foreign investor is higher in A
anyhow.2  (The returns in both locations are assumed to be known.)  However, to lure the second
investment requires the foreign investor to be compensated for the $100 million lower normal returnin A.  Since there is no need to offer more than necessary, it is assumed that A offers $101 million.
This will give the foreign investor a return of $501 million ($400 million plus $101 million in
                                                     
1 For more sophisticated analyses, see, for example, Black and Hoyt (1989), Fumagalli (1998), Halland
and Wooton (1998), and Haufler and Wooton (1998).
2 Actually, the host country could impose a performance requirement that costs the foreign investor
almost $100 million and still attract the investment because of the natural advantage enjoyed by A.WT/WGTI/W/56
Page 32
incentives) as opposed to $500 million in B.  The social gains net of incentives are $99 million, which,
together with the first investment, yields a total return of $299 million for A and nothing for B.
6. If only B offers incentives, the situation is reversed.
7. The fourth scenario with competitive bidding for the investments is slightly more difficult to
analyse.  Consider the bidding for investment one.  Since the natural return is $100 million lower in B,
B must bid at least $100 million to lure the investment.  Suppose that B offers incentives worth
$150 million.  What is the best response of A to this bid? There is no need for A to match B's bid
dollar for dollar.  Due to the $100 million advantage in  natural returns it is sufficient for A to make a
bid of slightly more than $50 million, say, $51 million.  That would still give the foreign investor a
$1 million reason to locate in A.  B may then raise its offer, followed by a counter-offer by A.  The
contest will end when B has reached its limit of $200 million, that is, the value of the estimated social
externalities.  The maximum bid leaves B just indifferent between having and losing the investment.
By offering slightly more than $100 million, say, $101 million, A will win the investment by assuring
the foreign investor a return of $601 million ($500 million plus $101 million in incentive) compared
to $600 million ($400 million plus $200 million in incentive) in B.  The net gains to A are $99 million.
The situation is the reverse for the second investment that will go to B.
8. Table 11 shows the location of the two projects under the four scenarios and the resulting
gains to the different stake-holders.
Table 11.  The location of FDI and associated gains under different policy scenarios
Neither A nor B
use incentivesOnly A uses
incentivesOnly B uses
incentivesBoth A and B use
incentives
Location of inv. 1 A A B A
Location of inv. 2 B A B B
Distribution of thegains
Host A $200m $299m  $99m
Host B $200m $299m   $99m
MNE 1 $500m $500m $501m $601m
MNE 2 $500m $501m $500m $601m
World $1400m $1300m $1300m $1400mWT/WGTI/W/56
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9. A number of insights arise from this simple example.  First, the example demonstrates the
"prisoners' dilemma" character of the incentive game:  what is individually rational for both host
countries (the "prisoners" in this application), namely to offer incentives, is collectively irrational.  To
see this more clearly, it is helpful to list the return s (or "payoffs" in the parlour of game theory) to the
host countries under the four scenarios in the familiar prisoners' dilemma matrix (Table 12).  The first
entry within the parentheses is the payoff to country A and the second entry is the payoff to country B
under the combination of policies given by the row and column labels.
Table 12.  The prisoners' dilemma of FDI competition
B
No Incentives Incentives
No
incentives(200, 200) (0, 299)
A
Incentives (299, 0) (99, 99)
10. To analyse the prisoners' dilemma matrix, assume first that B offers no incentives.  What is
the individual rational choice for A in this case?  The answer is given in the first column of the matrix.
If A abstains from incentives, only one of the investments will be attracted with a social value of
$200 million.  By offering incentives (on the second investment), A will pirate that investment from B,
thereby securing an additional $99 million in net gains, giving a total of $299 million.  Thus, theindividual rational choice of A is to offer incentives.  Suppose instead that B is offering incentives (the
second column).  If A abstains from granting incentives, it will now lose both investments and get
zero in returns.  With incentives, A can at least secure the investment for which it has a natural
advantage and receive a net social return of $99 million.  Thus, regardless of what B does, the
dominant strategy for A is to offer incentives.  The situation for B is symmetric.  Regardless of what A
does, the dominant strategy for B is to offer incentives.  Thus, the individually rational choice for both
host countries is to offer incentives, leading to a collectively irrational outcome.  Instead of gaining
$200 million each if collectively abstaining from incentives, they end up with $99 million each when
pursuing their individual rational strategies.  By bidding for the investment project for which the other
host country has a natural advantage, they essentially cut the gain in half for each other by forcing the
other party to provide offsetting incentives.  The only winners of this game are the shareholders in the
home countries who will pocket the additional profit ($101 million in incentives per project).
11. Second, another important point emerging from the analysis above is that the competition for
FDI did not result in any changes in the location of  FDI.  Each host country just ended up with the
investment for which it had a natural advantage, the "only" difference being that the competition made
them pay for what they otherwise would have received for free.  In this sense, investment competition
does not necessarily lead to any distortions of the location of FDI in the world.  In fact, as will beshown in the next example, it may guide FDI to its most productive location by "internalizing" the
social externalities in each location.
12. In the above example, a problem from an efficiency  (as opposed to a distributional) point of
view resulting from competition to attract FDI arises when only one of the countries uses incentives.
If only A uses incentives, it will attract one investment that would have given a higher total return in
B, and vice versa.  Indeed, note in Table 11 that the overall gain for the world as a whole is
$100 million lower ($1,300 million instead of $1,400 million) if only one of the host countries usesWT/WGTI/W/56
Page 34
incentives instead of both or neither.  Of course, the same improvement would be achieved if all
countries would abstain from incentives.
13. The example analysed above was somewhat special in that the social externalities in both host
countries were assumed to be the same.  There is absolutely nothing that suggests that this is the
normal case.  Consider again an assembly plant for automobiles.  Assume that the plant will use a
technology that is new to B but standard for A.  The technology may already have been transferred to
A through a previous investment whereas country B is in much need of new technology to revive its
backward domestic auto industry.  Accordingly, assume that the social benefits derived by B would be
twice as high, or $400 million as opposed to $200 million.  Arguably, the most valuable location
would then be in B, since the combined return to the foreign investor and the host country is
$800 million as opposed to $700 million if A receives the investment.  Yet, private rationality dictates
a location in A since the private return in the absence of incentives is $100 million higher.  Suppose
the countries bid for the auto plant.  With the same reasoning as before, the bidding contest will endwhen one country has reached its limit defined by the social benefits, in this case A with a final bid of
$200 million.  By offering $301 million, the investment will go to B, leaving a net host return of
$99 million, a gross foreign return of $701 million, and an overall return of $800 million.  The overall
return is thus $100 million higher than without the investment competition.  Thus, to the extent
investment incentives reflect the true social externalities in alternative locations, incentives mayactually assist in the process of guiding FDI to their most productive locations by inducing investors
to "internalize" the social externalities' various locations.  Of course, as mentioned earlier, in reality
there is little evidence that governments do make co st-benefit analyses to assess social externalities as
a guide to their decisions on investment incentives.  Given this and political factors that intrude, there
is no reason to believe that in reality incentives will more often divert investment to more welfareenhancing locations rather than the opposite.
14. The potential efficiency gains of FDI competition are reduced or possibly negated if the
incentives themselves, or the way they are financed, are distortionary.  For example, investment
grants financed by taxes introduce new distortions in the economy (unless the revenue is raised by
taxing negative externalities, such as polluting production or consumption activities).
3  Incentives that
do not show up directly in the government's budget balance are no better and possibly worse.  Forexample, monopolistic pricing, supported by import protection or government entry restrictions,
erodes the benefits to consumers.  Such costs should be accounted for in the cost-benefit analysis.  To
illustrate this point, let us reconsider the first ex ample with the additional assumption that each dollar-
worth of incentives has an associated distortionary cost of 25 cents.  If governments are rational, they
will take these costs into account and hence bid less a ggressively for FDI.  For example, if the social
externalities are worth $200 million, it does not make sense to pay more than $160 million for the
investment since a distortion of $40 million (0.25 ×$160 million) is simultaneously introduced.  The
outcomes under the four policy scenarios with distortionary incentives are shown in Table 13.
                                                     
3 Of course, a rational government would tax such activities anyhow.WT/WGTI/W/56
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Table 13.  The location of FDI and associ ated gains with distortionary incentives
Neither A nor B
use incentivesOnly A uses
incentivesOnly B uses
incentivesBoth A and B use
incentives
Location of inv. 1 A A B A
Location of inv. 2 B A B B
Distribution of thegains
Host A $200m $274m - $124m
Host B $200m - $274m $124m
MNE 1 $500m $500m $501m $561m
MNE 2 $500m $501m $500m $561m
World $1400m $1275m $1275m $1370m
15. As shown in the table, policy competition for FDI can reduce not only the welfare of the
competing host countries but also of the world as a whole because of the distortionary effects of the
investment measures themselves or the way they are financed.  In this example, the investment
competition did not change any location compared to where the investments would have gone if both
countries abstained from incentives.  The only impact was to introduce new costly distortions to theworld economy, thereby reducing the gains from $1,400 million to $1,370 million for the world as a
whole, and from $200 million to $124 million for each host country.  Again, the shareholders of the
home countries gain from this competition.  In fact, incentives can only be beneficial from a global
efficiency point of view if they lead to a relocation from low return to high return locations, and if
these gains outweigh the associated distortionary co st of the incentives themselves.  Incentives that
are only granted to offset incentives elsewhere are a pure cost for the world economy.
16. As emphasized before, it is extremely difficult to estimate the social externalities that accrue
from a given investment and determine the appropriate level of incentives.  Some countries may not
have the necessary expertise or inclination to undertake careful cost-benefit analyses, but may rather
base the incentives on crude rules-of-thumb or on what the neighbouring countries are offering.  Inaddition, political considerations and pressure from vested interest groups will often lead to non-
optimal economic policies, as shown by the huge literature on political economy.
4 For example,
investors have every reason to present the social externalities in as favourable a light as possible to
elicit the best possible conditions.  If no "reality check" is carried out, there is an obvious risk of
excessive incentives.  Likewise, political cons iderations may favour visible and prestigious
                                                     
4 See, for example, Hillman (1989).WT/WGTI/W/56
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investment projects which do not necessarily bring high social returns.  Finally, competition among
host countries for the same investment projects may occasionally lead to outcomes that at the end of
the day do not deliver the expected social benefits, a phenomenon known as the "winner's curse".5  In
summary, it is far from certain that the political and bureaucratic process is getting the incentives
right, in particular when several countries are competing to host an investment.
17. It was noted before that developed countries mainly use financial incentives, sometimes
exceeding $100,000 per job, while some developing countries can only afford to ease the tax burden
ex post .  This asymmetry introduces a bias in the competition for FDI in favour of those countries
with "deep pockets".  Specifically, poorer developing countries may not be in a position to provide
incentives up to the full value of social externalities, for instance because of lending constraints that
prohibit the use of up-front financial incentives.  The point is that, if only one set of countries can
afford to internalize the social externalities to  the full extent, some investments are bound to be
misplaced.  This distortion will be especially large if the countries less well placed in this regard alsotend to be the ones whose social externalities are largest.  This will not only reduce the overall returns
of the world's investment but also have negative repercussions on the global income distribution.
After all, the countries that face the strictest financia l constraints in providing incentives tend to be the
poorest countries in the world, which incidentally may also be the countries that are most in need of
foreign investment to supplement the domestic shortfall.
__________
                                                     
5 The concept of the "winner's curse" refers to a phenomenon that is often observed in the context of
competitive bidding contests:  if a participant has no precise idea about the value of the object of the contest,
that participant's perception of the value of the object may be influenced by the price which other participantsoffer to pay for the object. In this type of situation, this participant may end up winning the contest by paying aprice that far exceeds the price that he would have been prepared to pay if he had made a careful assessment of
the value of the object.