Behavioral approaches to optimal FDI incentives

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Behavioral approaches to optimal FDI incentives

• Authors
• Mosi Rosenboim- Ben Gurion University and Sapir
  Collage
• Israel Luski- Ben Gurion University
• Tal Shavit- Ben Gurion University
• Israel

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Introduction

• The two main incentives for attracting foreign
  investment are grants and tax reliefs.
• Government preferences and investor decisions are
  determined by calculating the net present value
  (NPV) of the grants and tax reliefs.
• Under complete information the costs and the
  benefits of these incentives can be easily
  estimated.
• Uncertainty and incomplete information complicate
  the decision process.

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• Government and investors differ with regard to
  their optimal structure of incentives
  governments prefer tax reliefs over grants to
  avoid moral hazard and adverse selection while
  investors prefer grants to avoid future changes
  in the tax structure.
• Most of the analyses of the efficiency of these
  (and other) incentives is based on the Expected
  Utility Theory of Von-Neumann Morgenstern
  (1944).

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• Experiments as well as real cases have shown that
  investment decisions do not satisfy all the
  assumptions of Expected Utility Theory.
• Kahneman Tversky (1979) proposed the Prospect
  Theory as an alternative to Expected Utility
  Theory.

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Purpose

• The purposes of this study are
• To verify that highly qualified managers who
  consider decisions under uncertainty are
  influenced by the psychological effects.
• To recommend Pareto improvement changes in the
  incentives structure for both the government and
  the foreign investor.
• We try to find pairs of incentive baskets that
  consist of two values the amount of the grant
  and the tax rate reduction such that the investor
  is indifferent to which basket he chooses. Such
  pairs of values are found for various levels of
  risk.

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Experimental Procedure

• The participants in the experiment consisted of
  102 MBA students of whom 86 subjects were used in
  the analysis.
• First we asked the participants about their risk
  preference and found that they are risk averse.
• We presented the subjects with four different
  scenarios of cash flow from the investment in the
  host county.

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Scenarios
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• All scenarios had an equal expected value
  (1,000,000 NIS) but different risk levels.
• For each scenario the subjects were asked if they
  prefer a 100,000 NIS grant or a 10 tax relief
• The subjects were confronted with these two
  incentives and were asked what would be minimum
  grant they would be willing to accept in order to
  concede the tax relief.
• A similar question was then asked about the
  minimum tax cut they were willing to get in order
  to concede the grant.

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• In addition, the fourth scenario considered the
  possibility of losses. The subjects were asked to
  state the amount they would be willing to pay to
  be insured if losses occur.

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Results
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A brief summary of some of the results

• It was found that investors ask for compensation
  if they concede the tax relief for a grant.
• This result contradicts expected utility theory,
  since the grant is certain and is supposed to
  improve the investors utility when a tax benefit
  is replaced by a grant.

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• This contradiction can be explained by the
  Status Quo Bias (Kahneman, Knetsch and Thaler,
  1991), which claims that individuals tend to
  remain in existing situations which may cause
  them to reject better alternatives.
• This tendency could lead the host country, who
  competes with other countries for FDI, to pay
  overly high incentives to foreign investors in
  order to attract them.

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• 2. Increasing cash flow risks causes subjects to
  ask for a higher minimum grant for waiving a 10
  tax relief (except in the 4th scenario).
• The behavioral bias, which explains this
  behavior, is known as the Regret Effect
  (Loomes, 1988 Loomes Sugden, 1987). According
  to this effect, subjects are motivated by the
  possible regret they will experience if they give
  up the tax relief and it turns out that the cash
  flow is at its higher value.

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• 3. The required minimum tax relief increases
  between scenario A and B, but the difference
  between scenarios B and C is not significant.
• Policy implications Since the tax relief is the
  same in scenario B and C, in case of a risky FDI
  project it could be cheaper for the host country
  to give a tax relief rather than a grant.

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Insurance

• We analyze the cases in which subjects can insure
  their loss (the fourth scenario).
• In the first case, the grant of 100,000 NIS was
  reduced to 50,000 NIS and if a loss will be
  incurred the subjects will get a refund.
• In the second case of insurance, the tax relief
  of 10 was reduced to 5 and if a loss will be
  incurred the subjects will get a refund.

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• The average refund the subjects were willing to
  accept in the case of a loss in order to accept
  the grant reduction was 69,468 NIS and in order
  to reduce the tax relief it was 68,829 NIS
• The difference in the average expected value of
  these two cases is not significant, so the
  average refund was about 69,000 NIS.
• Since the probability of loss is 0.5, the
  expected refund was 34,500 NIS.
• The total incentive cost was about 84,500 NIS.

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Explanation of the results

• These results can be explained by the "Insurance
  Effect (Slovic, Fischhoff and Lichtenstein,
  1982), which states that since losses are more
  intimidating than costs, individuals are willing
  to pay a higher premium than the expected damage,
  in order to avoid the possibility of loss. This
  means that subjects are willing to reduce their
  expected value in order to avoid the possibility
  of loss.

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Conclusions

• Our results show that investors tend to make
  decisions that may contradict expected utility
  theory.
• A policy maker in the host country can take these
  effects into account to reduce the costs of
  incentives.
• From the point of view of the host country, tax
  reliefs are cheaper than grants for risky FDIs.

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• The lowest cost incentive for the host country is
  to offer the investor a partial incentive in the
  beginning with another partial incentive to
  insure him against losses.
• In this incentive scheme, the host country should
  carefully screen FDI projects so as to avoid
  moral hazard and adverse selection.