1 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

2 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.

3 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).

4 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”.

5 The purposes of this study are: 1.To verify that highly qualified managers who consider decisions under uncertainty are influenced by the psychological effects. 2.To recommend Pareto improvement changes in the incentives structure for both: the government and the foreign investor. 3.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. Purpose

6 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. Experimental Procedure

7 Scenarios

8 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.

9 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.

10 Results

11 A brief summary of some of the results: 1.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.

12 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.

13 2. Increasing cash flow risks causes subjects to ask for a higher minimum grant for waiving a 10% tax relief (except in the 4 th 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.

14 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.

15 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.

16 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.

17 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. Explanation of the results

18 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.

19 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.