DP13573 Targeting FDI
We study the tax/subsidy competition between the governments of two countries to attract the FDI projects of two firms. We assume that governments lack the capacity to target every potential inward investor with a tailored fiscal offer. Consequently, each government is constrained to bid for a single firm. In this environment, we show that subsidy competition, where both governments bid for the same firm, arises only if there is uncertainty over which country offers the more profitable location for the firm’s plant. Intuitively, such uncertainty leads to both governments believing that they might win the subsidy competition. In contrast, when the characteristics of the two countries are common knowledge, subsidy competition never arises in equilibrium, as the losing country would prefer to target the other firm. We also explore some of the welfare implications of governmental targeting constraints.