By Riccardo Crescenzi (LSE), Marco Di Cataldo (LSE) and Mara Giua (LSE, University Roma Tre)

National and sub-national governments around the world have deployed a wide array of public policy tools to attract Foreign Direct Investment – from tax breaks and light regulations to subsidised facilities and new transport infrastructure. The problem is that there is very limited evidence to tell us if any of these actually work. Equally limited is the evidence on the practical effectiveness of policies to embed (and possibly retain) foreign investors in their host economies.

Scholars and practitioners alike have extensively discussed what makes different firms choose to invest in different places, and have looked at what this can mean for both the host countries and sending countries.

But what can policymakers do in practice to make a real difference to their country or region? Do the classic “tried and tested” methods really do their job?

The standard go-to strategy has been to offer a variety of locational incentives to attract foreign investors. But empirical evidence on whether these really work in practice remains very limited. For example, if two countries or regions initiate a “price war” to bring in one big multinational, they’ll just drive down the overall benefits to themselves until the costs will probably exceed the benefits (see for example the incentive packages offered by hundreds of North American cities to try and attract Amazon’s second headquarter[1]).

Recent research by the Global Investments and Local Development team has investigated Foreign Direct Investment (FDI) policies in an attempt to demonstrate which policies really work, when compared to just doing nothing. This approach is based on counterfactuals, i.e. scenarios describing what would have happened if no measure were put in place. This makes it possible to isolate the effect of the policy from any other element which may affect its impact, capturing its ‘additional’ effect on top of the status quo.

This approach has shaped our new research on one of the main ways countries and regions try to bring in investment: investment promotion agencies (IPAs). We then evaluated one of the most widely used tools to embed investments in regions by facilitating collaborations between Multinationals and domestic firms: targeted subsidies for innovative collaboration.

Investment promotion agencies exist around the world to try to attract foreign investors either on behalf of a whole nation, or for a city or region – solving problems for investors, lobbying policymakers, running ad campaigns or even actively seeking out investors. The activity of IPAs is now an essential component of national and local government strategies to attract inward investment and their number has grown rapidly across the globe. National and sub-national IPAs registered at the World Association of Investment Promotion Agencies (WAIPA) have increased from 112 in 2002 to 170 in 2018[2]. Notwithstanding their growing importance IPAs have remained understudied and there is no existing systematic research on sub-national regional agencies.

Our research has tried to fill this gap. The counterfactual assessment of the impact of European national and regional IPAs is based on the first census of all the national and regional investment agencies across Europe and offers a real sense of how effective they are, comparing the sectors and regions of an economy where an agency is actively seeking investment with those where it is not. This new dataset[3] was gathered by sending out an ad hoc survey to all investments agencies and was analysed by means of rigorous counterfactual methods (differences-in-differences models and synthetic control method to estimate IPAs effectiveness in attracting foreign investments to the host regions).[4]

The results suggest that regional agencies work – regardless of what kind of region they’re set up in, they bring more foreign companies, more investment and more local jobs. The analysis reveals that the most effective strategy for regional IPAs involves the definition of a specific targeting plan towards key sectors of local economy. Conversely, evidence on the impact of national agencies is more mixed. When national IPAs try to target specific sectors they might be simply diverting towards specific regions (where targeted sectors are strong) investments that would have arrived regardless in their country. This can become zero-sum – just redistributing FDI, rather than bringing in new investment.

The attraction of FDI is only a small part of the broader picture that policymakers should take into account when looking at ways to boost their local economies through internationalisation. Embedding foreign firms into the local economy is at least as important as their attraction – unless these outside firms build new links with local ones, the benefits will be negligible.

Recent research has also looked into what it takes to bring about collaboration by assessing a key policy tool leveraging collaboration between firms[5]. Here the counterfactual analysis goes to the micro level of the individual (beneficiary and non-beneficiary) firms and looked at a €1bn public subsidies programme in Italy’s less-developed regions. The programme was designed to foster innovative investment based on collaborative projects between all types of firms, both domestic and foreign. Importantly in this case, much of these funds have been given out on the condition that firms work together.

So, does this incentive pay off when innovative multinationals collaborate with local firms? Unfortunately, not really. Many of the most innovative firms involved just “crowd-out” their investment – that is, they take the money from the subsidy and then cut that amount from the investment they were already planning to provide. They also fail to encourage innovative industries like ICT and healthcare any more than they support ones like farming. What’s more, there’s no significant effect on the largest multinationals – they just don’t react anywhere near as much as hoped. Participation in collaborative projects is expensive for multinationals in terms of bureaucratic and transactional costs. Therefore, when they collaborate, they divert resources away from their core innovative activities.

By taking an evidence-based approach, our research has been able to shed light on two widely used policy tools that governments use to attract foreign investment and foster collaboration with domestic firms. This approach offers policymakers new evidence to make informed decisions and opt for well-tested ‘medications’ beyond anecdotal evidence, offering the best possible returns to taxpayer money invested in these policies in Europe and beyond.

Riccardo Crescenzi is a Professor of Economic Geography at the London School of Economics

Marco Di Cataldo is an ERC Post-Doctoral Fellow at the London School of Economics

Mara Giua is an Assistant Professor of Economics at the University Roma Tre (Italy) and a Visiting Fellow at the London School of Economics

The authors are part of the ERC GILD (Global Investments and Local Development) Team at the LSE

[1] https://blogs.lse.ac.uk/gild/2018/11/30/why-foreign-investment-clicks-in-some-cities-and-regions-while-others-are-left-behind/

[2] http://www.waipa.org/members-list/

[3] ERC MASSIVE Project National and Regional IPAs Database at the London School of Economics

[4] Crescenzi R., Di Cataldo M. and Giua M. (2019) FDI inflows in European regions: What role for investment promotion agencies?, paper presented at the ERSA Conference 2018.

[5] https://voxeu.org/article/smart-specialisation-strategies-italy-s-mezzogiorno or read the full article: https://www.tandfonline.com/doi/full/10.1080/00343404.2018.1502422