During the last three decades, developing countries have made enormous strides in opening up their protected domestic markets to international trade and foreign investment. Yet most countries have not simply opened up their markets. They have also instituted a range of policies to encourage exports, attract foreign direct investment (FDI), promote innovation, and favour some industries over others.
This set of government interventions is often referred to as industrial policy. There is a long-standing line of reasoning that suggests these policies are unlikely to improve economic performance (see Baldwin 1969 and Pack and Saggi 2006). But what is the evidence for and against these policies?
Does industrial policy work?
While many kinds of market failures could justify government intervention in theory, the critical questions remain: Does industrial policy work in practice?
There are three general approaches that have been used to evaluate the effectiveness of industrial policy.
The first approach focuses on particular industries that have received protection, such as the steel rail industry in the US and semiconductors in Japan.
The few studies of this nature suggest that the conditions necessary to generate positive net welfare gains from infant-industry protection are difficult to satisfy (see for example, Baldwin and Krugman 1989, Hansen et al. 2003, Head 1994, Irwin 2002, and Luzio and Greenstein 1995). Typically, these studies find that protection may lead to higher growth but result in net welfare losses. More studies of this type – especially focused on developing countries – would be helpful.
A second empirical strategy exploits the variation in productivity growth and different measures of support (including protection and production subsidies) across industries to see whether supported industries exhibit faster growth.
While most studies find that protected sectors grew more slowly, the evidence is mixed (see for example, Harrison 1994 which shows the fragility of Krueger and Tuncer 1982). There are almost no studies that attempt to go behind correlations and show causal links. A big challenge is that governments wishing to encourage fledging sectors may not see benefits for years – if these efforts are successful, then protection will fall. In such a scenario, researchers would find that protection is negatively associated with growth, even if there are benefits from industrial policy.
Research generally neglects to identify whether interventions were motivated by industrial policy reasons or rent-seeking considerations. In fact, there is no evidence to suggest that intervention for industrial policy reasons in trade even exists. Instead, existing evidence suggests that protective measures are often motivated by optimal tariff considerations, for revenue generation, or to protect special interests (see Broda et al. 2008, Gawande et al. 2005, Goldberg and Maggi 1999, and Mobarak and Purbasari 2006). Tariff protection is also frequently granted to less successful firms or declining industries that have political power (Beason and Weinstein 1996 and Lee 1996).
The third approach to evaluating industrial policy is the cross-country approach.
These types of studies fall into two general types: those that evaluate the pattern of protection and those that follow a reduced-form approach that examine the broad relationship between openness to trade and long-run growth. Perhaps most interesting are the studies emphasising the importance of the pattern of protection. Clemens and Williamson (2001) and O’Rourke (2000) both find a positive correlation between import tariffs and economic growth across countries during the late nineteenth century. These two studies hypothesise that protection was associated with growth because of an expansion of emerging sectors characterised by learning effects and the kinds of Marshallian externalities discussed earlier. The argument is that this could explain how first Britain, and then the US, were able to emerge as economic leaders in conjunction with tariffs that were very high in the eighteenth and nineteenth centuries (other studies include Chang 2002 and Irwin 2001).
As pointed out by Lin (2009) and Lehmann and O’Rourke (2008), what you protect matters. Lin (2009) for example, argues that countries that protect sectors that do not exploit their (latent) comparative advantage grow more slowly. Lehmann and O’Rourke examine the pattern of protection and growth for a sample of developed countries during the period between 1875 and 1913 and find that while agricultural tariffs were negatively correlated with growth, industrial tariffs were positively correlated with growth.
FDI policies as industrial policy
Many countries encourage inward FDI through tax holidays, tariff exemptions, and subsidies for infrastructure because they expect that foreign firms will enable domestic enterprises to become technologically more advanced. In 1998, 103 countries offered tax concessions to foreign companies that set up production or other facilities within their borders (Hanson 2001). China, for example, offered significantly lower corporate tax rates to foreign companies locating there until 2008 and continues to subsidise infrastructure investments for multinationals locating in foreign enterprise zones.
This is nothing other than industrial policy, although it is rarely identified as such. While economists are generally sceptical of the benefits of intervening in trade, they are much more likely to have interventionist priors when it comes to FDI. Is this pro-interventionist stance with respect to FDI justified?
There is significant research interest in FDI as a vehicle through which developing country firms learn about new technology. Most of the existing research tries to identify whether foreign firms convey productivity benefits to domestic enterprises or helps them enter new export markets. On technology transfer, a consensus has emerged that:
- firms that receive FDI (joint ventures) or are acquired by multinationals generally exhibit higher productivity levels than comparable domestically owned firms
- there is evidence of positive vertical spillovers from foreign firms to domestic suppliers and buyers (backward and forward linkages, respectively)
- but horizontal linkages (between foreign firms and domestic enterprises in the same sector) are generally small or negative.1
These stylised facts are surprisingly consistent across countries. Research to date has evaluated a number of countries in Eastern Europe, Africa, and Asia.
Given these results, are fiscal incentives for foreign enterprises warranted? If the primary reason for giving these incentives is to encourage technology transfer, then the answer should probably be no: if foreign firms are the only ones that use the inputs that benefit from backward spillovers and there are no horizontal spillovers, then there is no need to subsidise FDI. The justification of FDI subsidies would have to lie elsewhere, such as encouraging new firm entry, fostering competition, and broadening the local tax base.
Studies have also found that foreign firms help exporters break into new markets (Aitken et al. 1997) and pay workers in the host country higher wages. While the first research in this area found large wage premiums of around 20%, the estimates failed to adequately control for individual characteristics of workers, such as education and experience. More recent studies that use matched worker and employer datasets do find a wage premium for workers employed by foreign-owned firms, but the premium is much smaller. There is also evidence that foreign firms are more susceptible to pressure from labour groups, leading them to exhibit greater compliance with minimum wages and labour standards (see Harrison and Scorse 2010).
What are the implications for developing country policies?
There are hundreds of studies showing a strong correlation between increasing trade shares and country performance and no significant correlation between tariffs on final goods and country outcomes. The evidence can be interpreted as suggesting that trade and FDI policies are most successful when they are associated with increasing exposure to trade. One implication is that interventions that increase exposure to trade (such as export promotion) are likely to be more successful than other types of interventions (such as tariffs or domestic content requirements).
Similarly, new evidence suggests that industrial policy through FDI promotion may be more successful than intervention in trade, in part because FDI promotion policies focus on new activities rather than on protecting (possibly unsuccessful) incumbents. If such measures are part of a broader effort to achieve technological upgrading then they may be helpful, whereas if they are implemented in isolation they are likely to fail.
So should governments pick winners?
The long-running discussion about “picking winners” can be sidestepped by subsidising private efforts to “discover” new areas of comparative advantage (as argued by Hausmann and Rodrik 2003) or by simply working with existing industries and clusters to deal directly with the coordination failures that limit their productivity and expansion. For example, instead of blanket subsidies for exports and FDI, one can try to attract multinationals to produce key inputs or to bring specific knowledge needed by clusters with the ability to absorb them. As Chandra and Kolavalli (2006) have put it, “without host-country policies to develop local capabilities, MNC-led exports are likely to remain technologically stagnant, leaving developing countries unable to progress beyond the assembly of imported components” (p. 19).
There is an important role for what we refer to as “soft” industrial policy, whose goal is to develop a process whereby government, industry, and cluster-level private organisations can collaborate on interventions that can directly increase productivity. The idea is to shift the attention from interventions that distort prices to interventions that deal directly with the coordination problems that keep productivity low in existing or raising sectors. Thus, instead of tariffs, export subsidies, and tax breaks for foreign corporations, we think of programmes and grants to help particular clusters by increasing the supply of skilled workers, encouraging technology adoption, and improving regulation and infrastructure. While “hard” industrial policy is easier to implement than “soft” industrial policy measures, tariffs and subsidies become entrenched and are more easily subject to manipulation by interest groups.
In comparison with the more traditional approach to industrial policy, the soft industrial policy that we propose has two additional advantages. First, soft industrial policy reduces the scope for corruption and rent seeking associated with hard industrial policy such as protection or selective production subsidies. Second, soft industrial policy is much more compatible with the multilateral and bilateral trade and investment agreements that many LDCs have implemented over the last decades (see Harrison and Rodriguez-Clare 2010).
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1 Carluccio and Fally (2008) argue that the small overlap between the inputs used by foreign and domestic firms may be the reason why the latter do not seem to benefit from the upgrading of domestic suppliers induced by foreign firms in LDCs. Kee (2010) shows that when such an overlap exists, vertical spillovers to lead to positive horizontal externalities.