The Impact of FDI through the Production Network: Evidence from Costa Rica

This projects studies the impact of FDI and multinational firms’ entry on domestic firms’ productivity in Costa Rica.

Many developing countries compete over foreign direct investment (FDI) by promising tax breaks and productive public inputs. Policy-makers expect foreign firms to become active members of their country’s business community, establishing local partnerships and sourcing inputs locally. In doing so, foreign firms are expected to transfer technology and know-how whose value is above and beyond what foreign firms gain back from domestic firms. This project aims to investigate these critical assumptions behind FDI policy-making in developing countries. How integrated are foreign firms in the production network of a developing country? How do they interact with local firms? Do benefits from FDI really offset the large commitments of public funds? Do the effects to local firms come mostly from foreign firms sourcing local inputs (demand effects) or transferring know-how (positive externalities)? The researchers aim to answer these questions using rich Costa Rican administrative data.

The project builds upon a constructed dataset that will include a panel of the entire universe of Costa Rican firms with information about sales, value added, assets, workers, wage bill, exports, imports and all the transactions with other firms in Costa Rica (including foreign firms and the government). Most of the information will be available for the 2005-2015 period. In order to study the causal effect of FDI on the performance of domestic firms, the researchers make use of a Matching Programme used by the Ministry of Commerce to establish contacts between foreign firms and domestic suppliers. As this programme creates short-lists of potential suppliers for each multinational entrant, the researchers plan to use ‘losers’ from the short-list as a control group for those firms which ultimately established business relations with the entrant foreign firms.

Although the project is based in Costa Rica, its findings will be particularly important for LICs, given that attracting FDI usually implies tax benefits and valuable public productive inputs offered to foreign investors. The difficulty LICs face to collect their taxes and the multiple needs their population face raises the question whether tax benefits to foreign companies is the best use of their taxes. This project studying the impact of FDI in the developing world will shed light on the actual benefits of FDI and the channels most likely to potentiate and propagate these benefits.