Subsidizing foreign direct investments in Serbia – effects and consequences

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Foreign direct investment (FDI) is often cited as a significant factor in the economic growth of developing countries (Basu & Guariglia, 2007; Blomström et al., 2003). In such economies, attracting foreign direct investment, mainly through the investment of multinational companies, is seen as a way to transfer knowledge, technology and business organization to domestic companies, as well as to increase labor demand and increase exports.
A key argument in favor of attracting foreign direct investment is the “spillover effect” (Lu et al., 2017). In the economic literature, the spillover effect, ie the positive external effects that foreign direct investments have on the domestic economy, is a justification for their subsidization. Due to the connection of domestic companies with foreign investors and their inclusion in the value chain, their productivity and product quality increase. Such a “spillover” of productivity from foreign to domestic companies primarily refers to those that are vertically integrated into the value chain. It also affects foreign trade relations and contributes to the exchange of goods, primarily through the growth of exports. Domestic companies that are competitors to FDI-based companies are under additional pressure to increase efficiency, and may also benefit from improving the quality of domestic suppliers and the workforce. The results in empirical research show that the effects of FDI are not exclusively positive (Aitken & Harrison, 1999).
Due to the connection of domestic companies with foreign investors and their inclusion in the value chain, their productivity and product quality increase.
On the other hand, economic analysis usually emphasizes the harmfulness of subsidies, including FDI subsidies. The benefits that consumers and producers have as a result of subsidies are less than budget expenditures, so that they lead to a loss of social welfare. In the context of FDI subsidies, a reasonable approach implies that subsidies are justified only if the spillover effect is greater than the expenditure or miscellaneous costs borne by the state. Determining the spillover effect is very complex. Although spillover effects are present, the costs of subsidies can be many times higher (Haskel et al., 2007). Also, it should be borne in mind that the spillover effect is limited by the absorption potential of the domestic economy and the quality of the labor force (Crespo & Fontoura, 2007) and, as a rule, does not act in the short term.
Although spillover effects are present, the costs of subsidies can be many times higher.
The scope and approach to FDI subsidization depends on a number of factors. First of all, the lack of human resources, poor macroeconomic and institutional environment affect the abundance of the offered subsidies. In other words, monetary and other incentives are often seen by decision makers as a substitute for such shortcomings. The more unfavorable the circumstances, the more generous the subsidies will be. In this context, the availability of subsidies may have negative effects on the incentives of politicians to undertake the necessary reforms. Another question is whether the state will use financial subsidies (which have a current effect on the budget) or will opt for tax incentives (whose overall effect is unknown and has a long-term effect on the budget). In principle, tax incentives are a lesser evil, especially if investment projects are riskier but carry higher returns (Tian, 2018). Finally, FDI subsidies are often politically motivated. For example, in the case of high unemployment, attracting FDI is a politically tempting option because FDI is associated with increased employment, and the government is seen as someone who directly creates new jobs.
The more unfavorable the circumstances, the more generous the subsidies will be.
The practice of attracting FDI through subsidies in the Republic of Serbia has lasted for more than a decade, but it is no exception in relation to a large number of countries. Numerous countries offer various forms of incentives to attract FDI. Incentives differ in terms of the conditions required, the sector to which they apply, the types (tax incentives, direct subsidies, land grants, etc.). Criteria for subsidizing FDI in Serbia depend on the sector in which it is invested, the number of newly created jobs, the value of investments and the development of local self-government in which investments are made.
There are two key issues regarding the effectiveness of subsidies:
Do subsidies decisively influence an investor’s decision regarding location? There is no solid empirical evidence in the literature to confirm the importance of subsidies by final investor decision (Chor, 2009). However, the exception is a situation in which two or more countries with similar levels of institutional and economic development (within the observed region) compete for the investor. Although it cannot be answered with certainty, examples (especially in the case of the automotive industry) indicate that incentives play a significant role in location decisions (Christiansen, Hans; Oman, Charles; Charlton, 2003) or at least the perception of their importance is high. This indicates that racing (both between Tao and within countries) will be present in the coming period as well.
Does subsidizing foreign direct investment create a spillover effect? In other words, an answer is sought to the extent to which certain economic parameters and their changes can be related to foreign direct investments that are the subject of subsidies. The parameters observed can be gross domestic product, value added, employment, investment in research and development or productivity. Of course, it is first necessary to determine whether FDI really led to the “spillover effect” and if so, how much is the magnitude of that effect. There are a number of problems that make it difficult to answer that question. Intuitively, the effect will be greater if investments are made in the “tradable” sectors, which affects exports and increases productivity, but this does not mean that the subsidy was profitable.
Country competition often leads to a “race to the bottom” so incentives are far more generous than states would initially offer. The state that “wins” is often the victim of the “winner’s curse”, ie the costs of attraction are inappropriately high, and the final outcome is unprofitable. Coordination of states (for example in the Western Balkans region) is desirable, but like the outcome of the prisoner’s dilemma, in the “subsidy game” Serbia, BiH or Western Macedonia end up in a worse position. The time dimension of subsidies also plays a significant role. It is desirable that if it is already subsidized, it will not be “in advance”, because that can lead to negative investor selection and profitable behavior. Such investors remain only as long as the incentives last or until they are offered more favorable ones in another country. Therefore, in practice, in most countries, taxes still dominate in relation to financial incentives. Similar effects are manifested within the country, when local governments compete with each other when attracting the same investor.
Has there been a spillover effect in Serbia? In the World Bank study (Brussevich & Tan, 2018), FDI in Serbia in the period from 2006 to 2015 was analyzed. The results show that FDI in Serbia has the effect of increasing productivity, and in addition to the increase in supplier productivity, the finding of the existence of a “horizontal” spillover is particularly interesting. The presence of FDI leads to an increase in the productivity of domestic competitors. On the other hand, the presence of FDI leads to a negative “downstream” effect. Domestic companies at the end of the value chain are often at a disadvantage compared to those before the advent of FDI. This finding indicates that if companies are already subsidized, then one of the criteria should be export orientation. Of course, the effects on productivity are not uniformly distributed. There are significant positive effects of FDI on SMEs when they are suppliers, but also negative effects when these companies face a foreign competitor. Although the existing framework is designed to encourage investment in less developed areas, another empirical analysis (Delevic, 2020) finds that the effect of subsidies on employment is much greater in developed local governments in Serbia, despite the fact that subsidies are more generous for underdeveloped municipalities. This indicates that the importance of skilled labor and infrastructure is more important than financial subsidies. This confirms the findings of previous research that the absorption power, and thus the spillover effect, is greater where the workforce is more educated and the local infrastructure is more developed.
Achieved macroeconomic stability and an improved business environment and access to large markets indicate the possibility for Serbia to significantly reduce budget allocations for FDI subsidies. Given that the quality of institutions significantly affects the level of FDI (Buchanan et al., 2012), further reforms and comparative advantages of Serbia will certainly contribute to the influx of new investors without additional incentives. On the other hand, deciding on the allocation and amount of subsidies involves complex economic and political decisions. The analysis of investment projects that were subsidized in the period from 2006 to 2016 (Bojovic & Obradovic, 2019) indicates that the budget could have allocated about 20% less money allocated for subsidies. In other words, such decisions carry the risk of unnecessary or excessive subsidies to FDI. In that case, the policy should be much more selective and directed towards export sectors in which the absorption power of domestic sectors of the economy is higher, Talas reports.