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Attracting foreign investments or promoting domestic
multinationals?
Evidence from productivity spillovers in Italy
Davide Castellani
University of Perugia
Antonello Zanfei
University of Urbino “Carlo Bo”
Very preliminary version
November 2006
Submitted to the EITI Conference 2007
Abstract
The main rational for attracting foreign multinationals is that they bring in the host
country a bundle of intangible assets which increase the average productivity in the
country, both through a composition effect and through spillovers to national firms. In
this paper we argue that domestic multinationals can be equally a good source of both
direct and indirect effects on the home country. Using data on firms active in Italy in
1993-2000, this paper examines differences in productivity and innovative behaviour
of multinationals (both foreign and domestic-owned) and national firms, as well as
productivity spillovers to domestic firms. It is shown that parent companies of
domestic multinationals are more productive than foreign-owned firms and exhibit a
higher propensity to carry out innovative activities. As far as spillovers to domestic
firms are concerned, exporters benefit relatively more from foreign presence than non
internationalised companies. However, the latter seem to benefit from the activities of
domestic-owned multinationals. These results are consistent with the idea that
outward and inward FDIs might have complementary effects.
JEL Codes: F23, O33
Keywords: multinational firms, productivity spillovers, innovative behaviour
Contact details
Davide Castellani: Dipartimento di Economia, Finanza e Statistica, Università degli Studi di Perugia,
Via A. Pascoli, 20 - 06123 Perugia, Tel. 075 585 5060 (direct) 5279 (segr.) 5299 (fax). Email:
davide.castellani@unipg.it
Antonello Zanfei: Istituto di Scienze Economiche, Università degli Studi di Urbino “Carlo Bo”, Via
Saffi, 42 - 61029 Urbino (PU), Italy, Tel. +39 (0)722 305562, fax. +39 (0)722 305550. E-mail:
zanfei@econ.uniurb.it
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1. Introduction
The last decades have witnessed an important change in governments’ attitude
towards multinational firms. While in the ‘60s and the ‘70s countries tended to
discourage inward investments based on a presumption that foreign multinationals
would deplete local economies, over the last 25 years, many (developed and
developing) countries have eliminated their restrictions to inward FDIs (Unctad, 1999,
Unctad 2005). More importantly, it is all the more frequent that (national and
regional) governments support investment promotion agencies and grant special tax
concessions and financial incentives to foreign multinationals (Hanson, 2001). This
different attitude is largely the result of a changing view of the role played by MNFs
in knowledge creation and dissemination. Multinationals are less and less seen as
‘quasi-colonial’ institutions that exploit technological advantages on a global scale,
by monopolizing markets and appropriating rents in host economies (Hymer, 1960,
Vernon 1966). Instead, the role of MNFs as key players in the global generation,
adoption and diffusion of technology is increasingly recognised. In particular, firms
belonging to multinational groups are larger, concentrate mainly in high-tech
industries, exhibit higher productivity and pay higher wages, and have a higher
propensity for innovation, for carrying out R&D. This has a direct effect on the
countries where they operate: average productivity and innovation in a given country
increase as the share of activities due to multinationals in the economy rises. This has
to do with the fact that multinational firms bring in a bundle of assets which might not
be available locally, such as technologies, market and employment opportunities,
capital, and management skills (Barba Navaretti and Venables, 2004). This kind of
direct effect might be relevant per se, justifying, for example, a significant increase in
public incentives to attract foreign multinationals which we have witnessed in the last
decades both in developed and developing countries (Hanson, 2001). However, while
the most common view (which informs most of the policy measures) is that this effect
is reached through the attraction of foreign multinationals (that is inward FDIs) in this
paper we will argue that foreign-owned multinationals may not outperform the most
dynamic component of the host economy, such as the domestic-owned multinationals.
Nor will foreign firms necessarily generate more spillovers than the latter. This will
3
induce us to pose the dilemma whether attracting foreign investment is really more
effective than promoting the expansion of domestic owned multinationals.
Using firm level data on ownership structure and performances of Italian firms
over the 1993-2000 period, we investigate whether foreign-owned firms actually
outperform domestic-owned ones, distinguishing uni-national and multinational firms.
Results suggest that indeed parent companies of Italian multinationals outperform,
both in terms of productivity and in terms of propensity to innovate affiliates of
foreign multinationals in Italy. This leads us to question whether the expansion of
foreign multinationals actually determine larger productivity gains for Italian firms.
Our econometric evidence supports that exporters benefit more from foreign
multinationals than non-internationalised firms. However, the latter benefit from the
expansion of domestic multinationals in their home country. This result indicates that
the expansion of domestic multinationals can be a source of spillovers for their home
countries. Moreover, their spillovers accrue to different categories of local firms, as
compared to those created by foreign multinationals. Our results thus suggest that
domestic and foreign MNFs may play a complementary role as sources of spillovers,
accruing to the benefit of uni-national firms and exporters respectively.
2. Domestic multinationals as a source of spillovers
The literature on multinational firms and productivity spillovers as largely
addressed the impact of foreign firms in host countries1. One of the main reasons for
this focus is that foreign affiliates of multinational firms bring in host countries a
bundle of tangible and intangible assets which can contribute directly and through
spillovers to innovation and productivity in the host country. Empirical evidence has
been finding that foreign affiliates of multinationals tend to outperform domestic
firms, supporting the idea that expanding the activity of foreign-owned firms (i.e.
attracting inward FDIs) will raise the average productivity and innovation in the
economy, while less robust evidence has been provided on the spillover effect of
foreign multinationals on host country firms (see Castellani and Zanfei, 2006 for a
review). However, a growing literature has also been discussing the role of
1 Notable exceptions are the works of Vahter and Masso (2005) using firm-level data on Estonia, Bitzer
and Gorg (2005), Braconier et al. (2001) and van Pottelsberghe de la Potterie and Lichtenberg (2001)
using sectoral and aggregated data from a panel of countries.
4
multinationality as opposed to foreignness in explaining differences in productivity
and innovation. In particular, domestic multinationals share many characteristics of
foreign-owned firms in given country and can be at least as productive, innovative
and prone to invest in R&D (Criscuolo and Martin, 2003; Pfaffermayr and Bellak,
2001; Ietto-Gillies and Frenz, 2004, Castellani and Zanfei 2005). From this
perspective, one could view domestic firms going abroad as a further source of
externality for other domestic firms. When addressing spillover effects from domestic
multinationals to other domestic firms, one needs to take into account that in this case,
the focus of the analysis is on parent companies (PC), rather than on foreign affiliates
(FA). The different position a firm occupies in the organisational structure of
multinational groups may per se affect the amount of knowledge it gains access to. It
is well known that the core activities and capabilities, such as R&D, strategic
management and finance, are largely concentrated in PCs. These are the main sources
of proprietary advantages of multinational firms and only part of these technological,
managerial and organizational capabilities are transferred to FAs abroad in order to
allow them to overcome the cost of doing business abroad and to face competition of
other local and multinational firms in host countries. In principle, one may thus expect
domestic PCs to have more knowledge to transfer than FAs. The dominant role of PCs
in this respect is partially compensated by the fact that FAs can indeed accumulate
further knowledge and capabilities through local R&D activities, learning and though
external linkages with host country counterparts. Overall, the relative position
between PCs and FAs cannot be expected to change significantly, though: in spite of
the growing role of the latter in technological accumulation and knowledge
absorption, the former are likely to keep a stronger grasp on technology. In fact,
domestic PCs can also absorb external knowledge available locally, and it will
eventually gain access to foreign knowledge through their foreign subsidiaries’
reverse technology transfer.
How effective will technology transfer be vis a vis local counterparts?
Conflicting forces might determine the overall extent of knowledge transfer of
domestic multinationals (see Castellani and Zanfei 2006 for more extensive
discussion on these forces). On the one hand, they can be expected to be more rooted
in the home economy. Domestic multinationals do not need to overcome cultural and
linguistic barriers, which on the contrary can hinder the relationships of foreign-
5
owned firms with the domestic economy. By contrast, in many instances foreign
multinationals are perceived as ‘invaders’ by other domestic firms and this could
make cooperation and knowledge transfer more difficult. The perception that foreign
firms are more ‘footloose’ than domestic ones, or in other words, that they can move
their establishments abroad when it becomes less convenient to produce in a given
host country, may nourish the fear that it is too risky to rely on these firms for long
term plans. For instance, this can happen both to firms which have to adopt a new
client-specific organisational routine or to institutions which have to commit to
building railways or pipeline to serve a specific plant. This sort of mistrust can thus
reduce the potential externalities from foreign firms and increase the relative
advantage of domestic multinationals.
On the other hand, competition effects may play a different role in the case of
foreign versus domestic multinationals. Domestic multinationals are competing with
domestic exporters in the international market. Think at two Italian shoemakers, one
which delocalize some stages of production abroad, and the other which controls only
national plants. Say that they both sell in the U.S. market. In our view the first is a
multinational firm and the second is an exporter. However, in the U.S. market their
products will be both perceived as Made in Italy and the two firms will be competing
very hard to differentiate and gain international market shares, presumably at the
expenses of the other Italian competitor. In the light of such a tough competition we
can expect that the two firms will place a considerable effort in preventing
information leakages which could advantage their competitor. FAs are less likely to
consider local exporters as direct competitors outside the host country: provided that
they both are active in the same foreign markets, their product will be perceived as
more different (and eventually trade barriers might have different intensity) given
their country of origin is not the same.
3. Sample and descriptive statistics
In this section we provide some evidence on the direct and indirect effects of
multinational firms on productivity and innovation in Italy. Data for this empirical
investigation come from the Cis-Elios dataset, which results from the intersection of
two different sources: the Second Community Innovation Survey (CIS II) and ELIOS
6
(European Linkages and Ownership Structure). The former is a survey based on a
common questionnaire administered by Eurostat to firms from all European countries,
which aims at assessing various aspects of firms’ innovative behaviour and
performances. Subject to a confidentiality agreement, we were allowed to access
micro data for Italy from the survey carried out in 1997 and covering innovation
occurring in 1994-1996. Innovation data were complemented with ownership,
multinationality and economic performance data from ELIOS dataset developed by
the University of Urbino, Italy, which combines information from Dun & Bradstreet’s
Who Owns Whom and Bureau Van Dijck’s Amadeus. The sample resulting from this
matching comprises a 634 firms with manufacturing plants in Italy2. Exploiting
information on the ultimate owner, available from ELIOS, we broke down the sample
distinguishing between Italian affiliates of foreign multinationals (187), and domestic-
owned firms (447). The information on subsidiaries controlled abroad, available from
ELIOS, allowed us to further distinguish parent companies of Italian multinationals
(87), from uni-national firms. The information on export status available from CIS,
allows us to identify, within the 360 uninational firms, those serving the international
market through exports (203). For each firm we have data on innovative behaviour
(from the Second Community Innovation Survey, CISII) for the year 1996, while
output, capital, labour and material inputs are drawn from the ELIOS dataset and
observed over the 1994-2000 period. Table 2 provides an overview of the distribution
of our sample by sectors and size classes, as well as across multinational status. The
size distribution highlights that our sample is biased in favour of medium-large firms,
however, the sectoral distribution is not significantly different from the distribution of
the universe of Italian firms with more than 50 employees.
The first step of the analysis is to assess the extent of the direct contribution of
multinational firms to the the productivity and innovation in Italy. To this end, one
can notice from Table 1 that multinational firms are relatively more concentrated in
science based and high and medium-high tech sectors. While on average 22.4% of
firms in our sample is active in science based industries, this share rises to 33.2% in
the case of foreign affiliates of multinational firms in Italy. Similarly, while only
45.9% of firms operate in high and medium-high tech industries, 55.6% of foreign
2 The overall sample resulting from the intersection includes 1,114 firms, but for the purpose of this
study, we required firms to have a complete time series on economic and financial data from 1993 to
2000 and this left us with a considerably lower number of firms.
7
affiliates are in those industries. However, not only foreign multinationals are more
likely to operate in high-tech industries. In fact, also domestic multinationals are
relatively more frequent in those industries: more than a half of domestic parent
companies are in high and medium-high tech industries. In sum, an increase in the
share of foreign multinationals is likely to the change in the structural composition of
the economy, increasing the relative weight of more technology-intensive industries.
Nevertheless, one should bear in mind that an increase in the share of domestic
multinationals is likely to yield a similar effect.
Besides the direct effect through the sectoral composition, multinationals are
likely to increase the overall performance within industries, due to their inerhently
higher productivity and propensity to innovate. We investigate this issue by
comparing the average TFP and propensity to carry out innovative activities of
foreign affiliates relative to Italian-owend firms, after controlling for sector, size and
geographic location. In the first column of Table 2, we report conditional differences
in the average TFP, as well as in a number of charactheristics of the innovative
behaviour (such as the propensity to introduce process and product innovation, to
carry out R&D, to establish technological collaboration with counterparts outside or
inside Italy and, within this category, we distinguish the propensity to cooperate with
competitors, clients, suppliers and Universities). Results suggest that, even accounting
for differences in size, location and sectoral distribution, foreign affiliates are about
3.7% more productive than domestic-owned firms, but they do not display
significantly higher propensity to carry out innovative activities. If we compare
performance of foreign multinationals to the sub-sample of domestic firms which are
indeed uni-national, the TFP premium reaches 6.2%. This suggests that Italian firms
which are themthelves multinational (which we have denoted as parent companies,
PC) may be very productive as well. Column 3 and 4 of Table 3 shed some light in
this respect. In particular, Italian PCs are 11% more productive than uninational firms
and denote a significantly higher TFP also relative to FAs (5.1% higher).
Furthermore, this group of firms exhibit a significantly higher propensity to innovate
product and process, to carry out R&D and to establish technological cooperation with
national counterparts, and with Universities in particular.
In sum, we have provided some evidence consistent with the idea that the
expansion of foreign multinationals in Italy may increase the average productivity of
the country, by means both of a sectoral shift and a within sector effect. However, our
8
results also point out that, after controlling for sector, size and location, Italian
multinationals are even more productive than foreign ones, exhibit a significantly
higher propensity to innovate and are more embedded in a network of technological
collaborations with national counterparts. This place them in a privileged position to
determine spillovers to the rest of the economy. We will investigate this indirect effect
in the rest of this section.
4. Econometric specification and results
As it is customary in the literature on productivity spillovers from
multinational firms, we specify an augmented production function, which will be
estimated only on a sample of domestic-owned firms.
)log()log()log()log()log( ijtitjitjitjijt AMLKY
+
+
+
=
γ
β
α
(1)
where log(Aijt) is specified as:
itijtjtit DFA
ε
η
φ
δ
+
+
+
=loglog)log( 1 (2)
The subscript j on the parameters associated with each physical input (capital,
labour and materials) indicates that we estimate the production functions sector by
sector, allowing the input elasticities to vary across 14 2-digit sectors3. Following
most of the recent literature estimating productivity spillovers from multinational
firms (see for example Smarzynska-Javorcik, 2004), we estimate the production
function parameters using Levinshon and Petrin (2004) modification of the Olley and
Pakes (1996) semi-parametric method4.
The residual of this production function, log(Aijt) (i.e. firm i TFP) is modelled
as a function of foreign (
∑
∈
=ji ijtijt KFORF *) and domestic
3 Allowing for sector-specific production function is important not only for an unbiased estimation of
TFP, but also because estimating an economy-wide production function would bias the estimated
external effect from foreign presence. In particular, imposing common input elasticities for all firms
will result in an overestimation of productivity for firms and sectors which have higher returns to
inputs. For example, if in a given sector the “true” return is higher than one estimated on the whole
economy, an increase in input use in that sector will determine a growth in output higher than one
would expect from the estimated (economy-wide) production function, and this difference will then
wrongly be considered productivity gain. To the extent that foreign presence is positively correlated
with sectoral returns to scale (i.e. multinationals are attracted to higher return to scale industries) the
estimated external effect will likely be biased upward.
4 Details on the LP method and on its implementation in Stata, can be found in Levinshon, Petrin and
Poi (2004).
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(∑∈−= ji ijtijt KFORD *)1( ) activities in the sector (j) where firm i operates, a firm-
specific fixed effect.
Externalities from domestic multinationals are captured by splitting the effects
from the activities at home of parent companies (P), from any effect stemming from
other firms belonging to an Italian owned multinational group different from a PC
(O).
itijtjtjtit OPFA
εηφδδ
++++= logloglog)log( 21 (7)
where ∑∈
=ji ijtijt KPCP * and ∑∈−−= ji ijtiijt KFORPCO *)1(*)1( .
From column 1 of Table 2 we would conclude that neither foreign nor
domestic multinationals cause any spillover to domestic firms. However, a
composition effect is at play here. In fact, if we allow heterogeneity of the domestic
firms, by estimating different externality effects accruing to exporters, multinationals
and non-internationalised firms, we obtain interesting insights. In particular, results in
column (2) suggest that domestic multinationals have a positive impact on non-
internationalised domestic firms and a insignificant effect on exporters and other
multinationals5. On the contrary, foreign multinationals do not seem to affect
productivity of Italian firms significantly. However, results suggest that some positive
effect from the presence of foreign affiliates could accrue to Italian exporters. In fact,
the coefficient on the interaction between log(F) and the exporter dummy is positive
although rather imprecisely estimated, and if we estimate only the effects from foreign
multinationals (column (3)) it turns marginally significant. One way to interpret these
results is to stress that exporters have the adequate absorptive capacity to benefit from
FA, and the competition effect is not as strong as it is with domestic multinationals6.
Conversely, non-internationalised Italian firms may lack the adequate absorptive
capacity to learn from the foreign firm, but they could benefit from the expansion of
Italian multinationals, which are more rooted in the home economy and should be
5 In fact, the spillover on exporters and domestic multinationals is the sum of the parameter on the
baseline category and the coefficient of appropriate interaction term. In both cases we cannot reject the
hypothesis that the sum is different from zero.
6 Extending the example about shoemakers, the degree of competition between the Italian affiliate of a
U.S. multinational, say Nike, and an Italian exporter, say Lotto, can be lower than the one between two
Italian producers.
10
associated with relatively lower barriers to learning than foreign affiliates (such as the
linguistic obstacles).
In sum, foreign and domestic multinationals appear to have complementary
effects on the Italian economy. An expansion of foreign firms’ activity in Italy seems
to benefit home exporters, while an increase in home activities of Italian
multinationals would benefit other national firms. A word of caution is required in
interpreting these results. When addressing the issue of the home effects Italian
multinationals one should to address also the role of an increase in foreign activities
on productivity in non-internationalised firms at home, rather than the effect of an
increase in home activities of domestic multinationals. In fact, an increase in foreign
activities may well deplete the home economy by moving production and employment
abroad, causing a negative externality for the rest of the economy. However, other
works in this line of analysis provide some evidence that firms investing abroad
increase their productivity and output at home and do not decrease employment. Or at
least they do so less than non internationalised firms (Barba Navaretti and Castellani,
2004).
5. Concluding remarks
In this paper we have identified parent companies of domestic MNFs as a
source of externality and compared their impact to the effect of foreign affiliates
(FAs) in host countries. Results from a sample of firms active in Italy over the 1993-
2000 period suggest that this distinction can have important implications for policy
towards multinationals, but highlights also the crucial role that heterogeneity in
(domestic) beneficiary firms can play. In fact, we estimated the intra-industry
productivity spillover from PCs and FAs on Italian exporters, parent companies and
non-internationalised firms and find that the former have a positive impact on purely
domestic firms, while the latter have an impact on exporters. The differential effect
can be explained by the different types of absorptive capacity required to benefit from
domestic and foreign multinationals, and by the different degree of competition
between Italian firms, domestic PCs and FAs. The policy message which we could
derive from these results is that there could be potential complementarities between
policies directed towards Italian outward investors and policies to attract foreign
11
investors in Italy. The former seem to have a larger effect on non-internationalised
firms, while the latter have a more significant externality on productivity of exporters.
12
Table 1 – Distribution of the sample firms, by internationalisation status, sector
and employment
Domestic firms Foreign Total
Uni PC Tot. dom.
Pavitt sectors
Science based 16.4% 24.1% 17.9% 33.2% 22.4%
Scale intensive 39.7% 36.8% 39.1% 41.7% 39.9%
Spec. suppliers 14.4% 20.7% 15.7% 15.5% 15.6%
Supplier dominated 29.4% 18.4% 27.3% 9.6% 22.1%
Technology classes
High tech 5.0% 5.7% 5.1% 12.8% 7.4%
Medium-high tech 33.1% 44.8% 35.3% 42.8% 37.5%
Low tech 34.7% 23.0% 32.4% 19.3% 28.5%
Medium-low tech 27.2% 26.4% 27.1% 25.1% 26.5%
Employment classes
< 100 10,6% 4,6% 9,4% 5,9% 8,4%
100-250 27,8% 20,7% 26,4% 24,6% 25,9%
250-500 36,9% 28,7% 35,3% 32,6% 34,5%
>500 24,7% 46,0% 28,9% 36,9% 31,2%
Total 100% 100% 100% 100% 100.0%
N. of firms 360 87 447 187 634
Table 2 – The direct effect of multinational firms on productivity and innovation
in Italy
FA
vs.
DOM
FA
vs.
UNI
PC
vs.
UNI
FA
vs.
PC§ N. obs.
b b1 b2 b1 – b2
TFP premium .037** .062*** .113*** -.051** 3170
Difference in the probability of
Process innovation -.026 -.004 .102* -.106* 634
Product innovation .052 .081* .138*** -.057 634
Carrying out R&D -.004 .024 .135*** -.111** 634
Technological Cooperation in Italy -.036 -.005 .143** -.148*** 634
Technological Cooperation abroad .028 .059* .130** -.071 634
Tech. Coop. with competitors in Italy -.006 -.005 .001 -.006* 306
Tech. Coop. with clients in Italy .006 .013 .027 -.014 559
Tech. Coop. with suppliers in Italy .011 .032 .078* -.046 634
Tech. Coop. with Universities in Italy -.018 -.004 .064* -.068** 597
Notes: each estimation controls for sector, geographic area and size dummies
§ Chi-squared test of H0: b1 - b2 = 0
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Table 3 - Heterogeneity of domestic firms and productivity spillovers in Italy,
1993-2000: Fixed-effects estimation
(1) (2) (3)
Log (Fjt) -0.005 -0.051 -0.062
(0.024) (0.061) (0.061)
(EXP)* Log (Fjt) 0.081 0.119*
(0.068) (0.068)
(PC)* Log (Fjt) 0.026 0.073
(0.069) (0.068)
Log (Mjt) 0.027 0.116*
(0.025) (0.062)
(EXP)* Log (Mjt) -0.121*
(0.066)
(PC)* Log (Mjt) -0.071
(0.066)
Log (Djt) -0.044
(0.033)
Log (Ojt) -0.253*** -0.247***
(0.049) (0.049)
Constant 4.517*** 4.392*** 1.860***
(0.816) (0.820) (0.606)
Year Dummies Yes Yes Yes
Observations 3576 3576 3576
Number of firms 447 447 447
Standard errors in brackets
* p<0.1, ** p<0.05, *** p<0.01
14
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