Subsidies for FDI: Implications from a model with heterogeneous firms

This paper analyzes the welfare effects of subsidies to attract multinational corporations when firms are heterogeneous in their productivity levels. I show that the use of a small subsidy raises welfare in the FDI host country, with the consumption gains from attracting more multinationals exceeding the direct cost of funding the subsidy program through a tax on labor income. This welfare gain stems from a selection effect, whereby the subsidy induces only the most productive exporters to switch to servicing the host's market via FDI. I further show that for the same total subsidy bill, a subsidy to variable costs delivers a larger welfare gain than a subsidy to the fixed cost of conducting FDI, since a variable cost subsidy also raises the inefficiently low output levels stemming from each firm's markup pricing power. (C) 2009 Elsevier B.V. All rights reserved.