Benefits of foreign direct investment subsidies: The role of funding sources

Abstract Using a two‐country model with heterogeneous firms, we show that the optimal level and welfare gains of foreign direct investment (FDI) subsidies critically depend on how they are funded. In a setting that resembles tax distortions in emerging markets, we compare the effects of distortionary taxes that are imposed to fund FDI subsidies and examine their cross‐country spillovers. We find that the optimal level of FDI subsidies and the associated welfare gains are much lower than those for non‐distortionary taxes. FDI subsidies funded by distortionary taxes are also found to be beggar thy neighbour, although they generate positive cross‐country spillovers if funded by non‐distortionary taxes.