Tax incentives for import-substituting foreign investment:: Does signaling play a role?

This paper constructs a game-theoretic model to study host country policy to attract import-substituting foreign direct investment (FDI). Investors are assumed to be incompletely informed about local investment conditions, and taxes and tariffs are determined endogenously. We show that in certain situations countries will offer tax incentives while in others they will impose a tariff wall to induce FDI. Tax incentives are motivated by the need to signal favorable investment conditions. The paper predicts that tax incentives are more likely to be used the larger is the investment risk, the smaller is the local market, the smaller is the stock of previous FDI, and the lower are trade barriers. Moreover, we conjecture that incentives are positively correlated with the number of jobs created by the investment. We test these predictions using data from the US Department of Commerce benchmark survey of US foreign investment and find that they are supported by the empirical evidence.  1998 Elsevier Science S.A.