Competing to lose: FDI, investment incentives, and taxation capacity under fiscal federalism

This article examines how subnational fiscal competition over foreign direct investment affects both the siting of new projects and the ability of local governments to raise tax revenue for social spending. We leverage a quasi-natural experiment, an unexpected declaration by the Brazilian Supreme Court in 2017 that reduced states’ ability to offer investors differentiated tax subsidies. Our results show that disadvantaged regions did not see a major shift in investment patterns after the change in investment law. We do not find a consistent relationship between the incentive law change and state revenue generation, but we do find that incentives are associated with less revenue. The results are consistent with arguments that investment incentives exacerbate inequality by reducing states’ capacity to collect revenue while doing little to affect investment location. Our results illustrate that economic agglomeration is difficult to reverse through tax policy and that fiscal federalism often cannot provide strong enough inducements to drive investment into less advantaged regions.