Financial and fiscal incentives and inward foreign direct investment: When quality institutions substitute incentives

We analyze the impact of host country investment incentives on inward foreign direct investment. Building on institutional economics, we argue that financial and fiscal incentives are effective in attracting greenfield projects because they reduce the short-term establishment and long-term operational costs, respectively. We also propose that the effectiveness of the incentives varies with the institutional quality of the host country because institutional quality reduces the indirect cost of transacting in the location; thus, quality institutions have the potential to act as substitutes for incentives. The analysis of greenfield projects in 106 countries in 2010-2017 reveals that although financial and fiscal incentives have a positive impact on greenfield investments when studied separately, financial but not fiscal incentives are effective in attracting greenfield projects when analyzed together. This is a novel finding as much of the literature has concentrated on studying one type of incentive at a time. Additionally, we find that financial incentives are more effective in attracting greenfield projects in countries with high-quality institutions, while fiscal incentives are more effective in countries with low-quality institutions. Policymakers may want to concentrate on creating high-quality institutions not only because of their direct effect in attracting foreign investments, but also because they substitute for the need to provide incentives to attract foreign direct investment.