Typically, countries that are formerly planned economies that are transitioning to market economies use different forms of tax and non-tax breaks to attract foreign companies for foreign capital. The countries in the Western Balkans are not an exception. 

For over a decade, all of the countries in the Western Balkans have adopted policies for attracting foreign  investments through an abundance of breaks, reliefs and incentives. The extent of this differs, from total to partial profit tax breaks, tax-holidays for employee benefits, subsidised salaries, investment grants, custom tax reliefs and ‘special’ treatments in provision of public services. This is then coupled with legislative and specially designed agencies, or other forms of public entities for attracting and catering to the investors, as well as special economic zones. Most, if not all of the assistance, through public funds can be categorised as state aid, since it is made on a selective basis. The justification behind it is almost exclusively that the assistance is aimed towards economic development. 

In the past decade, it seems that the these countries have competed among themselves in who is going to provide more for the foreign investors. This ‘race to the bottom’ phenomenon occurs when a country reduces taxes while increasing the state aid for foreign companies in order to attract investment. The negative consequence of such policies being inadequately designed and implemented include public revenue erosion, both nationally and regionally. This phenomenon is especially pronounced if the foreign investments do not contribute to the economic growth and development.

Controlling state aid

As the countries in the Western Balkans aspire towards full EU membership, they have largely adopted its legislation on state aid control; however, at the same time, the European Commission’s regular progress reports note the need for enhanced transparency in the process of granting state aid, as well as the need for an effective enforcement of the regulations.

State aid control is a concept specific to the EU, with the aim of protecting the common European internal market. As the European national economies and markets are not characterised by homogeneity, “supranational” control of state aid is more than necessary to protect the public interest. As a result, all candidate countries be negotiate under the so called ‘Chapter 8’, which deals with competition protection and state aid control within the internal European common market. 

Although the EU sets certain limits on the amount of approved state aid for the candidate countries, the Union is not so restrictive of the forms of state aid until their full membership, which may place them in a more favorable position compared to the EU member states while attracting foreign direct investment (FDI). 

In addition to state aid and low taxes, the Western Balkan countries have other benefits, such as the geographical proximity to the large European market, the free trade agreements with the EU and other major economies, and high percentage of the highly educated unemployed etc.

The essence of state aid is that it must not distort competition in the internal market. State aid is only justified when it is an attempt to correct market imperfections, or when it is intended to achieve certain social goals or measures aimed at protection of the environment. As such, there is a risk that in the process of attracting FDI, the countries may reach out to discretionary, non-transparent and harmful decisions for granting state aid instead of granting state aid as part of socio-economic policies for improved performance of the national economies.

In this manner, when attracting FDI, countries risk increasing public spending and decrease public revenues, often by lowering tax rates for better attractiveness of foreign capital. By competing with neighboring countries in building the image of the most favorable destination for FDI, countries can easily fall into the ‘race to the bottom’ trap.

Data evidence

The data show that countries in the Western Balkan region that have higher value of state aid also have higher inflows of FDI. However, it is also noteworthy that countries in the region with higher economic growth also have higher foreign investment compared with the countries with lower economic growth.

Furthermore, the data suggest that, contrary to the expectations, the three countries with higher profit tax rates (Serbia, Slovenia and Croatia) have higher inflows of FDI, while countries with lower profit tax rates (North Macedonia, Bosnia and Herzegovina and Montenegro) have lower inflows. 

It is clear that the countries in the region which are already EU member states are using broad measures to attract FDI compared to the neighboring non-EU countries which are using narrow measures, such as lower tax rates to attract investment. In other words, North Macedonia, Montenegro, Bosnia and Herzegovina and Serbia, are ‘paying a higher premium’, as it were, to attract investment through lower tax to gross domestic product, due to their inability to compete with criteria such as rule of law, corruption control, trust in institutions — areas in which Croatia and Slovenia are more competitive.

This leads these countries to the practice of ‘beggar thy neighbor’, where countries try to outdo each other with more generous stimuli and incentives to attract investment, causing the ‘race to the bottom’.

Graph 1: Foreign Direct Investments in the Western Balkan countries

Source: Data from World Bank https://data. worldbank.org/

Graph 2: State Aid in the Western Balkan countries

Source: National authorities for competition protection and state aid control 

What are investors attracted to?

The empirical analysis shows that there is a positive correlation between FDI and the gross domestic product (GDP) growth, but also between FDI and the granted state aid within the Western Balkans. The causality test indicated that with a time lag of six periods, the growth trend of the GDP predicted the trend in FDI, while with a time lag of two periods the trend in the granted state aid predicts the trend in FDI.

Hence, the empirical analysis for countries in the region (North Macedonia, Serbia, Albania, Kosovo, Montenegro, Croatia, Slovenia, Bosnia and Herzegovina) for the 2008–2018 period shows that state aid has a positive effect on attracting FDI in the short-run; however, in the long-run, foreign companies are directing their capital to the countries with high GDP growth rates. 

This can indirectly mean that sustainable FDI are looking for stable and developed markets where rule of law prevails and where there is institutional trust. 

Final recommendations for the Western Balkans countries to attract FDI:

• Strengthening and clearer criteria and procedures for granting state aid while discarding the strategy for attracting FDIs which relies mostly or only on granting state aid in a non-transparent manner;
• Availability of data and information not only of the allocated state aid but also availability of cost and benefit analyzes for the granted state aid;
• Forsaking narrow measures, such as low profit tax rates, as an argument for attracting FDI to countries in the region;
• Recognition of the importance of the rule of law, trust in institutions, control of corruption, in attracting FDI, which are the primary motives of the foreign investors in choosing the destination for their investments.

Based on the Public policy study: Attracting foreign investments in the Western Balkans and state aid: race-to-the-bottom or necessity, developed by Center for Economic Analyses (CEA), Full Report Available at (https://cea.org.mk/wp-content/uploads/2020/07/0.-STUDIJA-FINAL-State-Aid-and-FDI-designed-ENG.pdf) 

Article prepared by Vesna Garvanlieva Andonova, Senior Economist at the Center for Economic Analyses-CEA, Skopje, North Macedonia, co-author of the full analysis, with Kovachev, G., Velkovska, I., Nikolov, M.

This article first appeared in the December/January print edition of fDi Intelligence.