Tax Competition, Policy Competition and the Strategic Use of Policy Restrictions on Foreign Direct Investments

In a dynamic two-period model of tax competition where competing countries strategically choose foreign investment restrictions which increases sunk cost of investments, we show that choosing a higher level of restriction is beneficial for the competing countries. A higher level of restriction reduces competition and increases tax revenue in the later period, which allows the government to offer large tax holidays during the initial period of investment. The result is counter-intuitive as it is widely believed that sunk cost reduces foreign direct investments. Moreover, even though competing countries are ex-ante symmetric, equilibrium choice of the level of restrictions may not be equal. The result provides sunk cost as another rationale for tax holidays in the presence of competition.