ISP Working Paper Number 07-02

Are Government Policies More Important Than Taxation in Attracting FDI?

Timothy Goodspeed, Jorge Martinez-Vazquez and Li Zhang, March 2007

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Abstract:

This paper attempts to broaden the existing empirical literature on foreign direct investment by incorporating government expenditure policies, such as investment in infrastructure, and institutional factors that may impact business investment, such as corruption, along with other conventional determinants such as taxes, location factors, and agglomeration effects. We do so in an unbalanced panel data setting, where we use fixed effects to control for country specific idiosyncrasies and also year dummies in some specifications. Our data include both developing and developed countries in different regions of the world. The regression results indicate that better infrastructure and lower taxes attract FDI, with weaker evidence suggesting lower corruption also increases FDI. These results are robust and hold after controlling for fixed country effects, common year effects of FDI, and agglomeration effects. The magnitude of the response of FDI to infrastructure changes is similar to that of taxes in elasticity terms. The results add evidence to previous cross-sectional results and emphasize the importance of a range of government policies in addition to taxation in attracting foreign direct investment.