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Working Paper Abstract

How to Maximize Domestic Benefits from Irreversible Foreign Investments

by Enrico Pennings (IGIER and Universita´ Bocconi)

When a foreign monopolist can either export to a host country or undertake an irreversible foreign direct investment (FDI), it is shown that the host government maximizes net domestic benefits by nearly fully subsidizing the investment cost in combination with taxing away benefits that exceed the gains from exporting. Since a higher tariff increases the firm’s propensity to invest and increases tax benefits, maximizing net domestic benefits yields an optimal tariff that is higher than the one derived in previous studies that disregard the dynamics of FDI and the interaction between optimal tax and tariff policy. Keywords: Foreign Direct Investment, Tax Policy, Tariffs, Irreversibility, Uncertainty. JEL-Codes: E62, G31, H21.

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Last updated March 4, 2003