SMU ECONOMICS & STATISTICS WORKING PAPER SERIES Paper No. 04-2007
This paper analyzes the welfare effects of subsidies to attract multinational corporations, in a setting where firms are heterogeneous in their productivity levels. I show that the use of a small subsidy raises welfare in the FDI host country, with the consumption gains from attracting more multinationals exceeding the direct costs of funding the subsidy program through a tax on labor income. This welfare gain stems from a selection effect, whereby the subsidy induces only the most productive exporters to switch to servicing the host's market via FDI. I further show that the welfare gain from a subsidy to variable costs is larger than from a subsidy to the fixed cost of conducting FDI, since a variable cost subsidy also raises the ineciently low output levels stemming from each firm's mark-up pricing power.