Multinationals and Linkages: An Empirical Investigation
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Multinationals and Linkages:
An Empirical Investigation

Policymakers and academics often argue that foreign direct investment (FDI) can be a source of valuable productivity externalities for developing countries.1 Prominent among the mechanisms often highlighted for these externalities are knowledge spillovers and "linkages" from multinational corporations to domestic firms in host countries. In pursuit of such benefits, governments in both developed and developing countries have not only reduced barriers to FDI over the last two decades, but have also offered special incentives to attract foreign firms and foster relationships between multinationals and local firms (especially suppliers).2 Surprisingly, however, the empirical literature has not been able to confirm the existence of positive externalities from FDI to host countries.3 There thus appears to be a significant gap between the consensus among [End Page 113] practitioners and the empirical literature regarding the importance of positive FDI externalities.

Policies to promote FDI take a variety of forms. In general, incentives fall into two categories: fiscal incentives, such as tax holidays and lower taxes for foreign investors; and financial incentives, such as government grants, credits at subsidized rates, government equity participation, and government insurance at preferential rates. Other incentives can include subsidized dedicated infrastructure, subsidized services, contract preferences or foreign exchange privileges, and even monopoly rights. In 1998, 103 countries offered tax concessions to foreign companies that set up production or administrative facilities within their borders.4

One popular argument is that this kind of policy is justified as a way to generate employment, but—of course—this is not a valid argument in economies under full employment. Even in the presence of unemployment, it is not clear that more investment will solve the problem; this would depend on the causes and nature of unemployment. A more sophisticated argument is that FDI incentives can increase the capital stock and thereby allow wages to increase. For this mechanism to be cost efficient, however, the rate of return to capital in the host country would have to be higher than in source countries—and if this were the case, then the subsidy would not be necessary. A related and valid reasoning is that FDI incentives are justified as part of an optimal tax policy, if it is believed that the investment elasticity to taxes is higher for FDI than for national investment. This is ultimately self-defeating, however, because countries would compete away the rents and pass them on to multinationals.

This paper focuses on productivity externalities arising from multinationals to domestic firms in the host country as a possibly valid reason for subsidizing FDI. Several recent papers use plant-level data and panel econometric techniques to carefully explore the existence of this type of externality. One conclusion that emerges from this literature is that it is difficult to find evidence of positive externalities from multinationals to local firms in the same sector (horizontal externalities). In fact, many studies find evidence of negative horizontal externalities stemming from multinational activity while confirming the existence of positive externalities from multinationals to local firms in upstream industries (vertical externalities). In this paper, we explore the channels through which these [End Page 114] positive and negative externalities may materialize. We emphasize the role of backward linkages, which have not received enough rigorous theoretical and empirical attention.

Under certain conditions (benefits of specialization, increasing returns, and transportation costs), an increase in demand for specialized inputs would lead to the local production of new types of these inputs, which would bring positive externalities to other domestic firms that use those inputs. This mechanism, however, has been called into question because of the general finding that the share of inputs bought domestically by multinational corporations is lower than the share bought by local firms. Many papers interpret this finding as implying that multinationals generate fewer linkages than domestic firms. We argue that the share of inputs bought domestically is not a valid indicator of the linkages that multinational corporations can generate. Instead, we use the model of linkages developed by Rodríguez-Clare to propose an alternative indicator for the linkages that a firm can generate, and we then proceed to calculate it...