Competition in Taxes and Performance Requirements

for Foreign Direct Investment

Ronald B. Davies and Christopher J. Ellis

Abstract: Tax incentives offered to attract firms engaged in foreign direct

investment are often tied to performance requirements such as domestic

content restrictions. The tax competition literature has repeatedly shown

that competition between municipalities for mobile firms tends to drive

taxes to low levels. One would expect a comparable result for burdensome

performance requirements. Despite this, the evidence suggests that while

taxes have indeed been driven down, performance requirements are as popular

as ever. We explain this seeming conundrum by showing that in the presence

of spillovers, binding performance requirements can act as a coordination

device for firms. In equilibrium, municipalities choose performance

requirements which maximize joint surplus from investment. Competition

between municipalities then transfers this surplus to firms via taxes.