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FDI drivers and barriers in the business environment

An 'FDI-friendly' location may sound easy to define, but is it as simple as offering a favourable tax regime and low barriers to entry?

China-media-FDI
China has a negative list for foreign investment in strategic sectors such as the media, but such barriers have not prevented the country from becoming one of the biggest recipients of FDI in the world. (Photo by Greg Baker/AFP via Getty Images)

A country or region’s ‘business environment’ consists of its tax regime and regulatory framework, and these two factors that can play a pivotal role when a multinational enterprise (MNE) is looking to expand into another country. However, these factors need to be considered in a wider context.

Beyond costs, all the other foreign direct investment (FDI) drivers come under the quality filter. This mainly consists of the tax regime, but also takes in the regulatory framework, and this forms that all-important business environment.

If a country has an enabling FDI regulatory regime, it is clearly going to be a preferable destination when compared with one that has higher barriers to entry or maybe has an FDI blacklist for certain sectors that it deems strategic and intends to protect from foreign ownership and influence.

From a tax perspective, large multinationals have often sought to invest in countries that apply lower corporate tax rates. Ireland, for instance, has been successful in attracting Google and Microsoft for this reason.

Investment Monitor’s chief economist Glenn Barklie explains, however, that it is important to put these things in perspective.

“Although a lower tax rate can attract foreign investors, it is often only part of the puzzle,” he says. “In Ireland, for example, the 12.5% corporate tax rate attracts many foreign investors, particularly from the US.

“However, Ireland also has a strong talent base to service many software, financial and life science-related companies. Without the talent base, among several other factors, the low corporate tax rate may not be as appealing to sway an investor decision.”

Indeed, both aspects can act as an enabler more than a deal-breaker to FDI location decisions and need to be compounded with the other characteristics of a specific location for MNEs to make the best choice.

It’s not all about (corporate) tax

Industry studies have shown that while corporate tax has a considerable impact on FDI location choices, focusing only on taxation in home and host countries can lead to an overestimation of tax elasticities – the changes in tax revenue in response to changes in tax rate.

An OECD paper explains that changes in corporate tax can influence FDI decisions by creating a wedge between the pre-tax and post-tax returns on investment.

“The relevant tax wedge, however, depends on whether MNEs’ investment is incremental or involves the creation of entirely new plants,” says the paper. “Moreover, the size of the wedge depends on the whole set of tax policies implemented by the home and host countries – including, for instance, exemption or credit regimes for foreign source income, withholding taxes on repatriated profits or dividends, and FDI-specific tax incentives.”

There are also other ways in which MNEs can close the wedge implied by international corporate taxation. For instance, they can implement the so-called ‘triangular’ strategies that exploit cross-country differences in tax policies to defer or avoid tax obligations.

The OECD paper argues that while most studies on this subject use a range of tax indicators, most of them concentrate exclusively on taxation, ignoring the potential effect of other policies that impact the business environment in the host country where foreign affiliates operate.

“[…] estimates imply that the effects of taxation on FDI are quantitatively much less relevant than the effects of other policies that contribute to make a location attractive to international investors, such as openness, labour costs and regulatory hurdles”, the paper concludes.

Why corporate governance matters

Data collected by Investment Monitor to assess how lowering corporate tax can affect FDI attraction shows that in some instances tangible results are visible.

The chart below shows how Italy, Japan, the UK and the US all witnessed an increase in the number of greenfield FDI projects (as well as GDP growth) after cutting corporate tax on foreign investment.

However, cutting corporate tax alone may not have been the only or even the main factor that brought about a rise in FDI and GDP in those countries.

The chart below shows that Angola, Argentina, Hungary, Sri Lanka, Thailand, Tunisia and Ukraine saw FDI projects drop after cuts in corporate tax rates were implemented. When compared with the World Economic Forum’s Corporate Governance Score, almost all of those countries ranked slightly above or just below 50 in a scale from 1–100.

Behavioural barriers to entry

Regulatory frameworks implemented by countries to regulate inward FDI can clearly act as barriers when it comes to MNEs selecting them as a location for a new operation. This too, however, is true only to an extent and needs to be put into a wider context.

For example, China applies FDI screenings that vary by industry, and it even has a negative list for foreign investment in strategic sectors such as the media and the armed forces, and FDI is significantly restricted in others. However, the country still came second globally as FDI destination in the UN Conference on Trade and Development’s World Investment Report 2020.

Government bans or limitations on FDI into certain sectors are not the only barriers to entry that an MNE needs to consider when looking at a location’s business environment.

Another OECD paper explains how, for instance, trade restrictions can make a national market too small for certain investments that require minimum economies of scale to be viable.

“More generally, and apart from outright government prohibitions on investment, barriers to entry usually consist of the various costs faced by prospective investors in the relevant market,” the paper says.

So-called ‘behavioural barriers’ can also play a role in limiting the presence of FDI in a country. Such barriers affect the various ways in which incumbent firms (domestic, foreign or state-owned) can impede market access by abusing their market power.

“For example, if a firm maintains exclusionary arrangements with retail or wholesale distributors in a given market (reciprocal exclusivity), and access to this distribution network is essential for serving the market in question, this effectively acts as a barrier to entry (assuming that the cost of establishing a second distribution network is prohibitive),” the OECD paper explains. “Another type of behavioural barrier concerns predatory behaviour, which involves undercutting rivals with a view to eliminating these from the market in question (or ‘foreclosing’ the market to new entrants).”

Governments are therefore faced with challenges to distinguish between structural and behavioural market barriers, treading the fine line between those that do not harm competition and those that do and therefore need to be eliminated.

“The local and national business environments are a key factor for FDI,” concludes Barklie. “Companies want to locate in areas that make them feel welcome, offer strong market access and provide the ability to grow.”