Foreign investments are good, but let’s not attract them with taxes

(GotCredit, CC BY)

FDI were perceived as exploiters and poisoners, but investors have developed their policies in the social responsibility of business to fight this perception, and they partly succeeded, said prof. Beata Javorcik. 

CE Financial Observer: An increasing number of researchers argue that foreign direct investments (FDI) are not always profitable for the country they are coming to. Are they good or bad, what do you think?

Beata Javorcik: Most economists still believe that the net effect of FDI is positive. It can be examined in a simple way. We need to single out a group of companies that were at some point purchased by foreign capital and a group of similar companies that remained as local capital. This allows us to see how the second group would have done if its owner had not changed. Research shows that it would have been relatively worse in terms of productivity, profitability and market shares. Indirectly, it also shows that foreign investors bring better know-how and newer technologies to a given country, and it is thanks to them that they gain an advantage.

In order to determine the impact of FDI, shouldn’t one compare companies that are bought by foreign capital to similar companies that are bought by local capital, i.e. examine the effects of two different but simultaneous changes in ownership?

There is such research and usually it turns out that companies sold to foreign investors also develop better. Recently, such research was conducted based on American data and it showed that companies bought by foreign capital do better.

Does the fantastic influence of FDI apply to every sector? For example in the banking sector, shouldn’t domestic capital have some advantage over foreign capital? Let’s say — in order to support the economy when it slows down?

It would not be dangerous in itself, under the condition that we do not identify domestic capital with state capital. EBRD has recently published studies where it analysed the operation of Turkish banking. In Turkey, there are state-owned banks, as well as private ones. It was found that in places where the governing party candidate to local elections was “endangered”, the state-owned banks granted more loans, and in turn, where the opposition was strong, they granted less. Nationalised banking was used for political purposes.

And yet, shouldn’t the state control the inflow of FDI by choosing those that bring the greatest added value to the economy?

That depends on what we are specifically talking about. If, for example, we are talking about offering selected companies tax exemptions or grants, then the benefits of such activities will be smaller than the costs. Moreover, the significance of such a strategy in attracting foreign capital is marginal. If company X wants to invest in China, it will do so even if Poland offers favourable concessions, because such company does not invest for concessions, but for the market. The situation is different if it wants to invest in Slovakia. Here, exemptions may be important due to the short distance and similarity of economies. They may be a significant advantage.

I have the impression that there is a lot of pretending in attracting foreign capital with tax exemptions. Companies pretend that it is an important issue, as such exemptions always mean an additional profit, and the governments willingly offer them in order to boast that it was them who brought another new factory to the country.

Precisely. The only solution is to make a decision not to apply such methods. In any case, in the European Union such practice is limited — if we offer, in a given region, tax exemptions to company X, then other companies investing there should also be entitled to such exemptions. Companies should not be discriminated.

Is it possible to verify which FDI projects operating today in Poland in Special Economic Zones would have come to our country even without tax incentives?

It is very difficult. It would require an access to database of all companies that applied for tax exemptions, and no government would voluntarily disclose such information. It is also quite difficult to estimate whether a given investment was worth the costs in the form of taxes, which were not earned by the state budget. However, this is not impossible. For example, economists studied the external effects of FDI in the UK and it turned out that it brought local companies about GBP2,000 per one job place created by a foreign investor. Considering the amount of exemptions that investors often receive, this additional GBP2,000 is not much.

Did the UK pay too much?

I think so. It does not mean that there are no effective forms of supporting foreign investors. The first step is to diagnose which sectors stand a real chance of attracting investors and then investment promotion policy must be applied.

What does it mean?

I mean joint marketing campaigns targeted at a given sector, and not one ad in The New York Times titled: “Invest in Poland”, but various marketing tools describing the attractiveness of a given sector, how investing in sector A in Poland is profitable due to a supply of educated workers, developed infrastructure, pool of contractors, etc. Each campaign must be accompanied by reliable information for potential investors explaining where can they look for business partners or how to deal with local administrative procedures.

And can such campaigns really be effective?

Yes. I have researched it myself when I worked for the World Bank. I collected data from 60 countries and which countries promoted which sectors in order to compare them later with the development of other, unadvertised sectors. Then, it can be seen that, in fact, as a result of government advertising the promoted sectors received more foreign investment. This strategy works mostly in emerging economies and is relatively cheap. I would rather not answer which particular sectors should be advertised. It requires a detailed analysis, bearing in mind what the main objective of FDI is. And as I said, it is, from the point of economic policy, the import of the latest technologies conducted in such a way that local enterprises make use of it.

Such import may be done in every sector, not only in those automatically seen as innovative. Looking at retail and Wallmart, the world’s third employer, after the American Department of Defence and the Chinese People’s Liberation Army, and its entrance to the Mexican market. When Walmart came to Mexico, it demanded from local suppliers to deliver goods to central warehouses at specific dates and have them packed on the pallets according to specific requirements.

Logistic improvements reduced distribution costs and prices but were also taken over by other local and Walmart-competitive retail chains. Walmart did not share its methods with them on purpose, did it?

No, they simply tried to imitate Walmart through observation. Local companies copy the management systems or marketing campaigns of new competitors, obviously to their dissatisfaction. No wonder that research shows that the most positive external effects related to FDI appear in different industries than those in which FDI operates.

Such as?

Those where the investors’ suppliers operate. Suppose that as a car manufacturer I am building a factory in Poland. My interest is that local spare parts producers meet the highest possible standards, use resources economically and are up-to-date with technologies. They know that if they meet these requirements, they can count on a long-term cooperation with me. It is a mutual benefit.

Let’s stop at local companies that have to compete with foreign investments. Have they got any chances in this battle?

It is obvious that an inflow of foreign investors will limit the profits of local companies, but it does not mean that it will completely push them out of the market. The effect of limiting the profits of local companies is smaller the more open the local economy is in terms of foreign trade. If there are many imported products on the market, the competition is already large and the additional competitor makes less difference compared to the situation where there are not enough products. FDI used to hit local companies harder 20 years ago, when Poland only entered the process of economic transformation. It is also worth noting that FDI raises wages in the economy, because companies compete more strongly for employees.

The issue of the FDI impact on the local economy is associated with the ban on trade on Sundays introduced in Poland in 2018. It was argued that although large, foreign retail chains lose, smaller local shops gain. Does is make sense from an economic point of view?

This issue should be judged by answering the question whether PLN1 lost by a supermarket equals PLN1 gained by a local shop. It is not an economic but political question. It is a question to a sociologist or a social scientist to answer whether people want small shops to survive or to be able to do shopping on Sundays anywhere they want.

All right, let’s get back to the economy. In one of his works, Thomas Piketty suggested that some countries, including Poland, had been colonised by foreign capital. Would you also use such a statement to describe capital flows?

No. Using the word colonialism in this context is exaggerated and inappropriate. This does not mean that FDI does not have any negative sides. It does.

Which?

They are visible in the tax sector. Tax systems do not keep up with globalisation and are based on an archaic assumption that we are, as a state, able to valuate transactions made within companies. After all, there is a proven phenomenon of shifting profits to jurisdictions with lower taxation.

Famous optimisation.

Yes. In short, it is exporting to those jurisdictions at undercut prices. This way, in country A with high taxes the profits are low, and in country B, with low taxes, the profits are high. These are transactions between companies belonging to one structure, so it is difficult to appraise them objectively from the outside. However, there are studies showing that there is a significant difference between the prices of internal transactions and those of open market transactions between independent companies, depending on where the export was directed to, whether to a low- or high-tax country. Such a correlation cannot have any other justification than that someone is undercutting prices in order to optimise.

Are you in favour of global tax harmonisation that could prevent this?

Harmonisation of the rules on which corporate taxes are calculated, closing tax loopholes and greater exchange of information would be a good step, but it is politically difficult. Despite the efforts of the G20 and the Organisation for Economic Cooperation and Development (OECD), there is still too little happening in this area. On the other hand, local tightening of tax regulations will not help, but only deter foreign capital and increase tax evasion. In my opinion, however, it is in the interests of the corporations themselves to change this. Tax evasion arouses social opposition, which in effect constitutes a barrier to the inflow of new investments. It translates into the ease with which politicians, such as Donald Trump, engage their countries in trade wars.

Could corporations support tax harmonization?

It is not impossible. We do not need idealism here, but an ordinary awareness of what is in the best interest of all economic actors. Optimization is beneficial for the companies in the short, not long term due to negative public perception. History has shown that this perception is really important and may change market practices. In the 1990s, the times of Central and Southeast Europe transformations, foreign companies were regarded – also in Poland – as exploiters and poisoners. Since then the corporations have developed their policies in the field of social responsibility of business in order to fight this perception and they partly succeeded. 

In the 1990s, Poles became convinced that it was foreign investments that made it impossible to develop their own large corporations and build strong brands. People argue that Poland no longer has its own car brand, though even the Czechs do. In your opinion, was it possible to carry out the transformation in such a way that in 2019 modern Polonez cars would drive off the production lines?

In practice, Skoda is a Czech brand indeed, but the company is German. Similarly, Dacia is a brand of Romanian origin, but it belongs to Renault. It is possible that the Polonez brand could have been saved, but thanks to a foreign investor. But it did not succeed, because, for some reason, nobody was really interested in it.

Prof. Beata Javorcik is a Doctor of Economics at Yale University and a titular professor of Economics at Oxford University. From September 2019 she will be the new Chief Economist of the European Bank for Reconstruction and Development.

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