Top Dogs, Puppy Dogs, and Tax Holidays

Why do host-country governments offer tax holidays to foreign multinational firms that establish local subsidiaries? This paper shows that a tax holiday has the effect of preventing the foreign firm from monopolizing the local market. This pro-competitive effect stems paradoxically because a tax holiday makes the multinational firm temporarily a "tougher" competitor and induces local firms to delay entry into the market. Removing the threat of imminent rivalry assures the multinational firm of greater profitability and prompts it to abandon the costly entry-deterring strategy. In contrast, a permanent and uniform tax reduction tends only to strengthen the foreign firm's incentive to monopolize the host-country market.