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This paper examines spillover effects of the activities of multinational firms. Such effects are most likely to be found in host countries, where the operations of foreign multinationals may influence local firms in the MNCs own industry as well as firms in other industries. However, there is no comprehensive evidence on the exact nature or magnitude of these effects, although it is suggested that host country spillovers vary systematically between countries and industries. In particular, the positive effects of foreign investment are likely to increase with the level of local capability and competition. The spillovers to the home countries of MNCs are often more difficult to identify, for various reasons. Earlier studies suggest that the effects are generally positive, but the increasing international division of labor within multinationals complicates the analysis. The impact on the home country is likely to depend on what activities these firms concentrate at home.

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This paper suggests that the use of investment incentives focusing exclusively on foreign firms, although motivated in some cases from a theoretical point of view, is generally not an efficient way to raise national welfare. The main reason is that the strongest theoretical motive for financial subsidies to inward FDI n spillovers of foreign technology and skills to local industry n is not an automatic consequence of foreign investment. The potential spillover benefits are realized only if local firms have the ability and motivation to invest in absorbing foreign technologies and skills. To motivate subsidization of foreign investment, it is therefore necessary, at the same time, to support learning and investment in local firms as well.1 UNCTAD (2001:6-7) reports that nearly 95 percent of the 1,185 changes in national FDI legislation during the period 1991-2000 were favorable to foreign investors. A significant share of these changes focused on incentives and FDI promotion. 2 See UNCTAD (1996) and Brewer and Young (1997) for definitions of various FDI incentives.

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