Foreign Direct Investment and Spillovers: Gradualism May Be Better

The standard argument says that in the presence of positive spillovers foreign direct investment should be promoted and subsidized. In contrast, this Paper claims that the very existence of such spillovers may require temporarily restricting and taxing inward FDI. Our argument in favour of gradual liberalization is based on two stylized features of spillovers: first, technology transfers – and subsequent spillovers – are limited by the economy’s absorptive capacity; and second, spillovers take time to materialize. By letting in capital more gradually, initial investment has the time to create spillovers – and upgrade the economy’s absorptive capacity – before further investment occurs. This allows subsequent capital inflows to benefit from greater technology transfers. As a result, the economy converges to a steady state with a superior technology and a greater capital stock.