Subsidies for FDI: Implications from a Model with Heterogenous Firms

This paper develops a two-country version of the Helpman, Melitz and Yeaple (2004) model with heterogenous firms to analyze the welfare effects of subsidy schemes to attract multinationals. Considering policies financed by a tax on labor income, I show formally that the use of a small cost subsidy by the host country to multinational firms raises welfare in that country. This welfare improvement stems from a selection effect: The subsidy attracts the most productive home country exporters to switch to servicing the foreign market via FDI, allowing foreign consumers to access these firms' products at a lower price by saving on cross-border transport costs. This consumption gain to the foreign country outweighs the direct costs of funding the subsidy precisely because it is the most productive home country exporters that respond to the FDI subsidy. Some benchmark calibrations show that the magnitude of the welfare gains from a subsidy to variable costs is substantially larger than from a subsidy to the fixed cost of conducting FDI. Intuitively, a variable cost subsidy also helps to raise the inefficiently low output levels of each firm stemming from their mark-up pricing power