Most liberal advocates of development through FDI find the widespread use of investment incentives somewhat embarrassing, and generally caution against them (OECD 2003; Blomström & Kokko 2003; Moran et al. 2005a). This is because incentives often appear to be pure rents to the multinationals. They are almost never sufficient to fully sway a decision on investment allocation - surveys among investors generally rank incentives as far less important than the quality of structural and institutional features of the potential host country – but they become decisive when the competition is between very similar locations (Morisset & Pirnia 2000; Oman 2000; Thomas 1997; 2000; Harding & Javorcik 2011). This means that investment subsidies can be particularly high when they are least necessary from the standpoint of attractiveness of the location. At the same time, for the host country they represent significant opportunity costs, and can distort competition by conferring an unfair advantage on the incoming multinationals vis-à-vis the resident firms. In this view, the best the governments can
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65 do is to abandon selective intervention altogether and concentrate on building up a generally favourable investment climate (OECD 2003; World Bank 2004).
Given the spread of FDI-related subsidies, however, it would appear that very few governments have heeded this advice. Among the economists, the most common reluctant defence of incentives is that they are not really pure rents, but a form of compensation for the anticipated externalities from FDI which cannot be fully recouped by the firm in the form of profits, but are of particular interest to the host location (Blomström & Kokko 2003; Görg &
Greenaway 2004). As the benefits of multinationals’ presence trickle down through investments in suppliers and workforce training, the original subsidy to foreign firms eventually becomes a subsidy to domestic economy as a whole. Unlike general deregulation, special incentives can be therefore used by the governments to enhance these processes, targeting particular regions or activities.
From the standpoint of the host states, then, the problem of incentives can be separated into questions of cost and control – the ability to assess and limit the “price” of new investment in terms of required subsidies, and the degree to which the government can ensure that the desired spillovers do indeed take place. Horizontal deregulation, of the kind commonly recommended to “improve business environment” - i.e. lower taxes or better infrastructure - is the least cost-effective in that regard, since the states commit to large public investments or forgo tax revenues without having any say in how the firms use these benefits. At the other end of the policy spectrum are targeted incentives, either in the form of direct subsidies or selective deregulation, which the governments negotiate directly with each incoming multinational, and can also set the terms of investment in exchange. Whether or not the latter approach really yields a better outcome for the host government will, however, depend on its bargaining power vis-à-vis the multinational.
The bargaining power of an individual location is not only determined by its objective characteristics, or even by the nature of anticipated benefits, but is influenced by a variety of external factors such as timing, scarcity of investment, availability of alternative locations and
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66 the interest of their governments, past experiences, and not least by the dominant ideology toward FDI (Kindleberger 1983 (1965); Fagre & Wells 1982; Moran 1977; 1978; Dunning 1998). However, in addition to the raw bargaining power, the form of incentives offered to the incoming multinationals also has an impact on its relative cost to the host government. We have seen that the earlier generations of late developers relied heavily on trade barriers to manipulate the behaviour of foreign investors. Although they create market distortions and impose additional costs on consumers, customs duties as a form subsidy to resident producers are understandably popular since they are actually a form of revenue for the government, unlike direct payments of exemptions from corporate taxes. Moreover, some regulatory measures are better at bundling subsidies with other objectives of industrial policy. Trade barriers increase the specificity of the local market, and as long as they are applied to both finished products and inputs, encourage local production. There is no such incentive in direct subsidies and tax deductions, which means that to achieve the same outcome the governments might have to exert more explicit pressure on the firms.
However, the choice of policy used to attract foreign investment is not determined solely by preferences of host governments. In the hyper-integrationist model in particular, which requires a variety of foreign resources to succeed, the governments must count more carefully with the international regulatory environment and market conditions. In principle the ECE states, as any developing country, could choose to rely on trade barriers to encourage local production, but the price may be prohibitive if their access to other countries’ markets depends on adoption of a liberal trade regime. Moreover, competition for FDI among developing (and developed) countries has a particularly strong effect on the choice of policy, creating pressures to imitate the actions of successful peers and to avoid being left behind by their regulatory innovations.
East Central Europe is a particularly good case on which to study how such changes in policy affect the cost of foreign capital and the ability of governments to direct it. In the two short decades since the collapse of socialism, the countries of this region experimented with a
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67 variety of tools, from discretionary measures based on selective regulatory derogations to direct payments and horizontal deregulation. The alliance between the ECE states and the multinationals which today characterises their version of hyper-integrationist model of development evolved gradually over the years, and the policy changes took place in response to three major shifts in the way each of the partners viewed their position within this relationship.
The first transformation, which took place relatively early in the 1990s in response to the weaknesses of East European markets and trade liberalization with Western Europe, concerns the changing status of the ECE regions in the eyes of multinationals from a market to a production location. The second transformation, partly concurrent but culminating in the late 1990s, was the change in ECE’s perception of the multinationals as a more or less necessary evil, or at best a useful tool for local development, to reliance on FDI as the main driver of development and the lynchpin of economic policy – not only worth having, but also worth competing for. Finally, the process of accession to EU changed the status of ECEs from outsiders to insiders within a transnational system of competition control, radically reducing their policy space, but also eliminating the worst effects of inter-governmental competition for investment.
The following sections examine how each of these shifts affected the relative bargaining power of ECE states vis-à-vis the multinationals, and the consequences for their ability to harness FDI for local development goals.