What attracts FDI actually?

Attracting Foreign Direct Investment (FDI) has been the focus and continues to be a priority for many national and sub-national governments the world over. Providing the right incentives to attract FDI has also been part of the policy debate. What are the right bouquet of incentives to boost FDI? What actually attracts FDI? Should incentives be sector specific or across the board? How do we evaluate their impact? Do incentives really matter?

Hania Kronfol in this blogpost in the Columbia FDI Perspectives explains that tax incentives to attract FDI should be crafted intelligently and with a purpose.

On the need to use tax incentives sparingly and not as a general policy tool:

Use tax incentives sparingly to address identified market failures. The purpose of granting tax incentives should be clearly defined. Is the primary objective to create more jobs, promote the absorption of foreign technology or diversify the economy through investment in new sectors? Once the objective is articulated, policymakers should identify the underlying barriers and market failures (e.g., underinvestment in public goods, skills mismatch or incomplete information to link foreign firms and domestic firms); evaluate whether tax incentives can effectively change investors’ behavior to address these barriers and failures; and assess whether tax incentives are optimal, considering other measures 2 (e.g., legal or regulatory changes, broader reform of the tax system or direct government investment in public goods)....

On using merit based incentives rather than non-performance linked tax incentives:

 Directly link incentives to defined policy objectives. Developing countries, in particular, rely on profit-based tax incentives, such as tax holidays and corporate income tax reductions, for FDI promotion. These instruments generally do not result in cost-efficient outcomes as they confer a blanket benefit, often based on upfront granting mechanisms, rather than actual investor performance. Instead, governments should consider shifting to merit-based incentive instruments, such as investment allowances, tax credits and accelerated depreciation. These tools have the advantage of directly tying incentives to targeted outcomes, e.g., by providing allowances for R&D expenditures or tax credits for staff training programs. 

On strategic targeting of investors rather than spreading oneself too thin:

Target investors strategically. Policymakers first need to prioritize the type and quality of FDI they seek to attract, and then identify the subset of investors that are most responsive to incentives. Developing cost-efficient incentive schemes largely rests on identifying which type of investors ultimately decide to invest in one country over another because of tax incentives. Globally, incentives are more influential in attracting efficiency-seeking FDI, which is export-oriented, since such investors are mainly driven by competitive cost advantages in host countries, as opposed to natural resource- or market-seeking FDI....

FDI incentivisation ahs been at the centre of industrial policy for a long time in many developing countries for a long time now. But what exactly ensure FDI incentivisation - a good Bilateral Investment Treaty, stable political environment, a transparent regulatory atmosphere, an encouraging market, value chain advantage or just good schools and social environment?