Optimal policy for attracting FDI: Investment cost subsidy versus tax rate reduction

This paper examines and compares two policies (investment cost subsidy and tax rate reduction) for the host government to attract FDI. Taking into consideration the firm's indifferent FDI option value between the two policies, the government trades off the immediate and certain lump-sum cost of the subsidy against the future random flow of tax rate reduction. We demonstrate that the optimal policy for attracting FDI depends on the growth rate and the volatility of the profit as well as the discount rate. There exists a critical level in each of the three parameters. The tax rate reduction (or investment cost subsidy) is preferable when the growth rate and the volatility of the profit is higher (or lower), and when the discount rate is lower (or higher). These results are consistent with the empirical findings, which found that governments are more likely to adopt tax rate reduction for firms with high risk and high return.