Evaluating the tax incentives for foreign investors policy
Reporting to the Manufacturers league

Executive Summary
This report has been written in response to the government’s proposed tax incentive policy for foreign multi-national corporations to increase foreign direct investment within Australia.
The report draws attention to the reasons behind the government’s proposal. These include the slow growth trends of the manufacturing industry, restoring the dropped level of foreign investment caused by the global financial crisis as well as a desire to increase levels of employment within the manufacturing sector.
It continues by drawing attention to the resultant competitive issues that may be caused by such a move as well as issues that may arise due to inflation. It also draws attention to the tendency for foreign investment to result in less government intervention which may affect the industry in the longer term.

It is recommended that: * The government increase the breadth of its proposal to all investors in the manufacturing industry so as to reduce competitive pressures on local manufacturers. * The government increases investment in training to provide a skilled workforce and reduce inflationary wage pressures.

Introduction
This Report shall be to determine whether or not tax incentives, with relation to foreign direct investment (FDI), are beneficial, holistically. First we must say a word about the nature of FDI.
FDI can be defined as
“...investment made to acquire a lasting interest in an enterprise operating in an economic environment other than that of the investor, the investors purpose being to have an effective voice in the management of the enterprise.”(United Nations, 1992)
Policies to promote FDI take a variety of forms. The most common are partial or complete exemptions from corporate taxes and import duties. These policies are typically the result of formal legislation which apply to all foreign corporations that meet certain restrictions. These restrictions are highly variable. In some instances they require multinationals to establish production facilities in the host country in specified lines of activity. Direct subsidies and other types of concessions are often negotiated between multinational firms and host governments on a case by case basis.
Other policies clearly do favour FDI. A country that offers exemptions to value-added taxes or import duties to foreign but not domestic corporations favours FDI since domestic corporations which receive foreign bank loans, issue bonds to foreigners, or have a non-controlling portions of their stock owned by foreigners do not receive comparable tax breaks. a) The only justification for favouring FDI over both foreign portfolio investment and domestic investment is the existence of market failure that is specific to multinational production b) G-24 and other countries offer myriad concessions to FDI, which violates the resident principle (by taxing non-resident income) and subjects FDI and foreign portfolio investment to unequal tax treatment; c) In theory, FDI raises national welfare by bringing foreign technology and other foreign resources into an economy, which raises the productivity of domestic factors, but in the absence of externalities there is no justification for taxes or subsidies which are specific to FDI; d) In theory, externalities associated with FDI may raise or lower national welfare, depending on whether productivity spill-overs from multinationals more than offsets the loss in profits due to crowding domestic firms out of the markets;
According to traditional views, tax incentives for investment, specifically FDI, is not recommended(Bergsman, 1999). This holds true in theory as well as in practice. Theoretically, they hold to be un-recommendable since they cause market distortions. Practically, they are un-recommendable as they are ‘ineffective and inefficient’(Easson, 2004). Therefore, “the standard advice given by institutions like the World Bank and the IMF to developing countries is to refrain from offering tax incentives to foreign investors(Avi-Yonah, 2000).”
What policy makers seldom take into consideration are the unintended distortions that tax incentives create, contingently(Sanchez-Ugarte, 1987). For example, tax incentives for foreign investors may place domestic businesses at a competitive disadvantage(Kaunda, 2000) and in effect whilst new jobs may be created, old jobs are dispensed with. FDI appears to be quite sensitive to host-country characteristics. Higher taxes deter foreign investment, while a more educated work force and larger consumer and industrial markets attract FDI. Far too often, tax incentives are legislated without adequate consideration to their possibly undesirable side-effects(Tax Notes International, 2002).
For host countries, there are four considerations: a) Capital- Multinational National Corporations (MNC) could bring in the capital that the country or local companies need to develop or expand their operations; b) Technology- MNCs might introduce new or/and advanced technology; c) Managerial skill- MNCs often have greater managerial skills and could train local people for managerial positions d) Markets- since most large MNCs are from developed countries, they have the knowledge and information of and connection with much larger and better developed markets.
FDI can bring with it increased competitiveness, through exposing local management to international standards and exemplary practices, and through technology transfer associated with the establishment of new business provide high-productivity and well-paid jobs in the future (Moran, 2009).
However, the capacity of host countries governments to regulate MNCs and their investment is of crucial importance in ensuring the national economic and social development. Considerations that need to be factored in include whether host government have policies in place that encourage investment in the sectors that are in favour of the overall development; whether they have the capacity to assist their own companies to negotiate with MNCs and to exploit competition among different corporations; and how they regulate MNCs and their operations to ensure the country would not be exploited by the investment.
The very capacity of the government to negotiate and regulate also depends on the sectors that the MNCs seek to invest in. The success, and long-term growth of FDI depends on the bargaining between MNCs and host countries Before and After the investment is made.
It is to be noted that developing countries do not, in general terms, attract headquarters of companies. However there are exceptions. Malaysia, Singapore and the Philippines employ tax incentives (primarily in the form of reduced corporate tax rates) to appeal to the establishment of headquarters of companies(United Nations, 2000).

The policy’s effects on the Industries
The second part of this report investigates how the policy proposed by the government could affect the automotive and electronics industries. Below some positive and negative effects of the policy on the industry will be examined, starting with the positive effects.
Positive effects of the policy
Foreign funds
The automotive industry in Australia has been severely struck in the last couple of years. The production of cars went down by more than 30% due to the global financial crisis (FCAI, 2011a). Moreover, Mitsubishi closed down their Australian production plant because it persistently made significant losses (Carswell, 2008). Furthermore, it is expected that the Australian automotive industry will suffer significantly from the carbon tax that will be implemented in the coming years (PWC, 2011). Due to the combination of these factors, some Australian manufacturing companies were, and still are, in need of support and money. That is why the Australian government implemented several bills to support the industry (Carr, 2011a). Nevertheless, this was not enough since the industry needed to acquire some extra funding. However, due to the global financial crisis, banks were not all too willing to lend out a lot of money (Ivashina and Scharfstein, 2010). Therefore it was difficult for the automotive industry to acquire the necessary funds/investments in the national money market. Hence, a possible advantage of giving tax incentives to foreign investors is, that they should be more willing to invest some money in domestic companies. Therefore, some companies that would otherwise have had it really difficult, may survive due to these tax incentives proposed by this policy.
Productivity increase
There has been a lot of discussion whether the presence of foreign direct investments increases the productivity and efficiency of domestic companies or whether it does not. Some studies found that FDI does indeed raise the productivity (Javorcik, 2003;Buckley et al, 2007;Chuang and Lin, 1999). Others found that there is no significant relationship between the degree of foreign direct investment and productivity (Blomstrom and Kokko (2003); Haskel, Pareira and Slaughter (2002); Hanson (2001)). However, from a theoretical point it makes sense that FDI increases productivity. As there are more businesses who invest in a particular industry, there will be more competition amongst them. With more competition, businesses need to try harder to maintain their market shares. Companies will cut prices to achieve this. For these companies to still make a profit, they will need to be more efficient with their resources. Thus, they are forced to either increase their productivity, or exit the market entirely. This view favors (incentives that encourage) FDI. As productivity and efficiency increase, so will the global competitiveness of the industry. Thus, a possible advantage of the suggested policy could be that it will increase the productivity of the industry, which will lead to long term gains.
Job creation
One obvious effect of the policy is that it will increase jobs in the manufacturing industry. More investment usually means more production which in turn leads to more jobs. As the Australian government has claimed at several occasions, the manufacturing industry has a crucial role in the Australian economy(Carr, 2011b). More than 200,000 workers are employed in the industry(Carr, 2011c)and the government has made it clear that they are: “committed to a strong automotive industry”(Carr, 2011a). Therefore by implementing this policy they can make sure that the automotive industry stays strong and that more jobs are created.
Negative effects of the policy
Unfair competition
One of the main negative effects of the proposition is that it leads to unfair competition in the manufacturing industry. Because foreign investors are given perks that domestic investors do not get, they have an unfair competitive advantage. An OECD (2002, p176) paper argues that: “incentives to foreign investors can only be justified if the foreign firms differ from local companies in that they possess some firm specific intangible asset that can spill over to local firms”. This is definitely not the case for the policy suggested. The automotive industry is a highly technical industry and most automotive factories work according to the same principles. Australia already has Ford, Holden and Toyota factories and it would not encounter a spillover effect if, for example, Volkswagen would enter the market. So if foreign investors are given an advantage over domestic investors, this would lead to market distortions. The companies funded by foreign funds would be able to do business with lower costs and thus they could drive the domestic companies out of the market. Therefore it does not make sense to only give tax incentives to foreign investors. The Australian government should give the same tax incentives to domestic investors.
Repatriation of profits
Another negative effect is that, because the owners of the firms are foreigners, they could repatriate the profits they make in Australia. These profits will not be reinvested in Australia which would have been the case if the investors in the companies were domestic. Because the profits leave Australia, they will not benefit the Australian society in the future. These profits would not experience a multiplier effect. The Australian government could prevent this by putting some limit to the amount of profit that can be repatriated. However this would limit the free flow of capital and may harm Australia’s position in the international money market.

The Policy’s Effects on companies
The proposed new tax incentive to foreign investors will have some significant effects on domestic companies. These domestic companies will not have the same tax benefits as international companies do, leading to higher costs for the former. This may create problems for them to compete with the international companies as it creates unfair competition.
Policy geared at certain sectors of the economy
The policy the government wants to implement is a policy that is only directed at two industries; the automotive industry and the electronics industry. There is consensus in the literature on policy that general policies to attract foreign investment are more effective than specific policies, geared at particular industries (Görg & Greenaway, 2003). Policies that are geared at particular industries only lead to a different dsistribution of investments, they do not lead to more investment (Görg & Greenaway, 2003). There is great evidence that the general characteristics of the economy, such as infrastructure, labor market conditions, communications systems etc. are more important than policies similar to what the government wants to introduce at this moment (Görg & Greenaway, 2003).
Competition issues
Grossman (1984) argued theoretically that foreign direct investment is unbeneficial for the formation of an entrepreneurial class in developing countries. Because international competition leads to lower prices in the international markets it becomes harder for domestic companies to compete and this leads theoretically to a crowding out effect of local firms by foreign firms (Grossman, 1984). A similar thing might happen in Australia if these tax benefits for foreign investors will be established. Firms that receive a lot of foreign investment will be able to produce cheaper, making it harder for local entrepreneurs to compete. This in turn leads to a fall in the number of local companies. De Backer and Sleuwaegen (2003) performed an empirical research to the effects of foreign direct investment to entry and exit of firms in the Belgian economy. They showed in their paper that import competition and foreign direct investment have a significant crowding out effect of domestic entrepreneurs, this is also in line with the theoretical model by Grossman (De Backer & Sleuwaegen, 2003). It is shown that foreign direct investment and import competition lead to a decrease in domestic entry in industries and an increase in domestic exit in the short term (De Backer & Sleuwaegen, 2003).
Kosova (2004) performed a similar research as De Backer and Sleuwaegen. Kosova (2004) analyzed the effects of foreign presence on growth and survival and exit of domestic firms in the Czech Republic. She found similar results to De Backer and Sleuwaegen; entry of foreign firms leads to a crowding out effect of domestic entrepreneurs (Kosova, 2004). However, she does find that it is a static effect; i.e. upon realization of foreign presence the number of domestic firms exiting the market will rise, however this will stabilize in the long run (Kosova, 2004).
Effects on labor market
Another important factor for domestic firms to take into account is that the entry of foreign firms may lead to an increased competition in the labor market (De Backer & Sleuwaegen, 2003). Foreign firms may be able to pay higher wages or provide better working conditions than domestic firms. Because of this, domestic firms are not able to attract the best available working force, since they will choose for the higher wages they get from international firms. Furthermore, these international firms want to attract the best people available to lead their subsidiaries. Since the international firms are often able to pay a high wage to these people it can also lead to a lower number of entrepreneurs starting up a business (De Backer & Sleuwaegen, 2003). They rather choose to work as an employee for one of these foreign firms, since they can often make more money and face less risk than when starting up their own business (De Backer & Sleuwaegen, 2003).
Spillover effects
Often it is argued that foreign entry will lead to positive spillover effects to domestic firms. It is argued that domestic firms will benefit from the expertise and good management of foreign companies (Görg & Greenaway, 2003). If the foreign entrant is not able to protect its superior technology and management completely some of these elements may be absorbed by domestic firms leading to better performance by them (Görg & Greenaway, 2003). This however is a theoretical point of view. Görg & Greenaway (2003) performed an empirical research to these spillover effects. They do not find any robust empirical evidence for the existence of these spillover effects. This could mean that foreign companies are in fact able to fully protect their superior technology and management (Görg & Greenaway, 2003). This research invalidates the argument that domestic firms could benefit from the entry of foreign firms.
The proposed new tax incentive for foreign investors will lead to a higher number of foreign entrants in the automotive and electronics market. This is potentially dangerous for local firms in these already challenged markets (PwC, n.d.). The tax advantages offered to foreign investors lead to unfair competition. Local firms will not be able to compete against foreign firms and they will cease to exist. Furthermore, there will be increased competition on the labor market; the best people in the industry will choose for the higher wages of the international companies. Therefore it can be argued that the proposed policy will have negative effects on the domestic market and should not be implemented.

Conclusions
Tax incentives, arguably, represent a type of state interference with the economy. If the economy is flourishing and efficient, tax incentives naturally distort this. There is a concern that politicians with an emphasis on re-election concern themselves with providing tax incentives in order to pursue financial support as opposed to seeking to enhance social welfare. Tax incentives also contain equity concerns. Capital income is prioritized rather than labor, thereby furthering the inequality between labor and capital.
An increase in foreign direct investment provides both positive and negative effects for local manufacturers in the short term. Tax incentives for foreign investors allow the government to achieve its aim of increasing investment in the manufacturing industry with the further effect of increasing the number of job opportunities available.
In the longer term we start to see negative effects creeping in as domestic manufacturers are placed at a disadvantage due to higher costs and market distortions(Easson, 2004). Further, without an increase in training available the limited number of employees applying for an increasing number of positions threatens to place inflationary pressure on wages and further erode the ability for domestic manufacturers to compete as well as reduce any savings made by multi-national corporations with the tax incentives.
Traditional views also maintain that tax incentives for FDI is not a recommended solution for stimulating economic activity(Bergsman, 1999), and institutions such as the World Bank and International Monetary Fund strongly recommend that countries refrain from such practises where possible(Avi-Yonah, 2000).
It should also be questioned as to whether the automotive manufacturing industry is in need of tax incentives to increase its size. There is evidence that often it is cheaper for companies to produce vehicles locally for the relevant market rather than in a location far removed from the market. This can be explained by the existence of higher shipping costs, higher importation costs and tariffs, and more onerous approval procedures(Trade and foreign direct investment, 1996). It could be reasonably argued that current manufacturing for automotives is already at such a level to meet market demand and that any decrease in the level of taxation would merely end up as profits for the companies concerned rather than providing any benefits to the economy.
Recommendations
After consideration of the numerous pros and cons of the government’s proposal we feel that it achieves the government’s aims of increasing employment, increasing investment, and securing the future of manufacturing in Australia. However we feel there is legitimate concern about the continued existence of Australian based firms caused by unequal taxation and competitive pressures with the proposal in its current form.
We would therefore recommend that the instead of the government limiting tax incentives to foreign multi-national corporations looking to invest, said incentives should be applied on an equal basis on any investor willing to invest in Australia’s manufacturing industry. This would provide foreign investors with incentive to invest funds in Australia, while also allowing Australian businesses to compete on an equal footing and not be forced from the market.
We also feel there is concern with education and training, and recommend that the government should increase its investment in training relevant skills for the manufacturing industry so as to ease inflation pressures on wages by maintaining a larger skilled workforce. This would aid in maintaining the benefits offered by the governments proposed tax incentives.

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