Attracting FDI is regarded by most countries, developed and less-developed alike, as a key policy tool for generating economic growth and employment.1 In many OECD countries, employment in multinational firms now accounts for more than 25% of total employment in the manufacturing sector (OECD 2008). In the international competition for FDI, countries and regions with strong trade unions and relatively high wages are often surprisingly successful. Theoretical economic reasoning would typically suggest that unionisation, which tends to increase the level of wages, will act as a deterrent to FDI (Naylor and Santoni 2003; Munch 2003). Nevertheless, several empirical studies find instead a surprising positive effect of unionisation on direct investment (e.g. Friedman et al. 1992).
One solution to this puzzle is the use of large government subsidies, which are paid in regions with strong union power and high unemployment, such as eastern Germany or southern Italy. As shown in Table 1, multinational firms locating in these regions have often been able to receive subsidy rates of 25%-30% of the total value of the investment. This raises the further question, however, of why high-wage countries or regions are willing to offer such high subsidy levels to multinational firms, thus outcompeting their lower-wage neighbours.
Table 1. Approved investment subsidies in EU member states (2000-2007)
Notes: ∗ present value of state aid divided by present value of investment
† 1 British Pound is converted to 1.5 €, ‡ upper limit
Source: Official Journal of the European Communities, C and L (http://eur-lex.europa.eu)
In recent research (Haufler and Mittermaier 2011) we show that high subsidy payments can be a rational policy for governments, as they give trade unions an incentive to exert wage restraint in exchange for additional jobs that are created in the newly-attracted firms. A government that acts in the best interest of its citizens will therefore be willing to offer multinational firms a subsidy that more than compensates the firm for the higher wage cost in that region. These subsidies not only induce the multinational firm to locate in the unionised country, but they also ensure that the union prefers a situation with lower wages and FDI to the alternative of setting a high wage but accepting low employment (which then occurs only in domestic firms). As a result, the unionised country or region is able to “win” the competition for FDI over its less-unionised neighbour. The subsidisation policy benefits the high-wage country in the aggregate, because union power is effectively curbed and wages are lower than they would be in the absence of the successful bid for FDI.
Previous work has also shown that, when countries compete over FDI, the multinational firm locates either in the larger market (Haufler and Wooton 1999), or in the market where it faces fewer competitors (Bjorvatn and Eckel 2006). The incentive to subsidise FDI induced by union power is so strong, however, that it may even offset other such locational considerations. Hence, the unionised country may attract the multinational firm in equilibrium, even if it has the smaller home market and the larger number of competitors, in comparison to its low-wage neighbour.
The results of this research do not imply that unionisation is “good” for a country. In fact the high-wage country remains worse off than its lower-wage neighbour because of the high subsidies it has to pay to attract FDI. However, if the unionised country is not able to control wages directly (for example, because they are determined in a bargaining process between employers and employees, with no government involvement), then attracting multinational firms is an attractive solution for governments, in order to mitigate the effects of union power.
Bjorvatn, K and C Eckel (2006), “Policy competition for foreign direct investment between asymmetric countries”, European Economic Review, 50:1891-1907.
Friedman, J, DA Gerlowski and J Silberman (1992), “What attracts foreign multinational corporations? Evidence from branch plant locations in the US”, Journal of Regional Science, 32:403-418.
Görg, H and E Strobl (2001), “Multinational companies and productivity spillovers: A meta-analysis”, Economic Journal, 111:F723-F739.
Haufler, A and F Mittermaier (2011), “Unionisation triggers tax incentives to attract foreign direct investment”, Economic Journal,121:793-818.
Haufler, A and I Wooton (1999), “Country size and tax competition for foreign direct investment”, Journal of Public Economics, 71:121-139.
Munch, JR (2003), “The location of firms in unionized countries”, Scandinavian Journal of Economics, 105:49-71.
Naylor, R and M Santoni (2003), “Foreign direct investment and wage bargaining”, Journal of International Trade and Economic Development, 12:1-18.
OECD (2008), OECD Factbook 2008.
1 Görg and Strobl (2001) summarize the substantial empirical evidence showing that multinational companies foster technological progress in the host country.