Fundamentals, tax incentives and foreign direct investment

For open economies with a threshold level of human capital, foreign direct investment (FDI) can bring benefits in terms of technology transfer, employment, foreign reserves and competition. Governments have endorsed this view and many have taken steps to court FDI, including the adoption of investment incentives. This thesis analyzed the role incentives play in the investment decision, revisiting the hypothesis that the investment climate is more important than pecuniary incentives in attracting FDI. Firm level data from South Africa was compared to that from other developing countries, confirming the hypothesis. Pecuniary incentives played a negligible role in the investment decision for the majority of firms. This confirmation undermines the economic justification for defined incentives to attract FDI, and suggests that governments would be best advised to keep improving their countries' economic, social, and institutional fundamentals as the most equitable and cost-effective way of stimulating new investment. The areas where incentives can play a role are also identified and suggestions made on how to minimize associated distortions.