Federalism's Impact on Foreign Direct Investment Inflows

Many developing countries are actively seeking Foreign Direct Investment (FDI) because it they enjoy the transfer of skills, knowledge, and capital. Multinational corporations (MNCs) are more likely to invest in countries with lower political risk. Knowing this, what forms of governance will help a country attract FDI by lowering its political risk? Will being a democracy help; will being federal help? This study attempts to add to inconclusive existing literature on this topic. It utilizes the governance classifications of 71 countries made by Dr. Robert Inman’s in his paper “Federalism’s Values and the Value of Federalism”. Countries are classified as one of the following: constitutionally based federal democracy, an administratively based federal democracy, a unitary democracy, a federal dictatorship, or a unitary dictatorship. Then it studies the impact of the governance structures on the total investment in a country, the FDI inflows as a percentage of GDP, the net FDI inflows as a percentage of GDP, and the FDI inflows per capita in $US. The conclusions are as follows: 1) Democracy is the most importance governance factor in attracting greater FDI. 2) Federalism does not improve upon democracy in attracting more FDI. 3) Federalism does not help nondemocratic countries attract FDI. 4) Federalism is still important because it impacts economic rights, which in turn help attract greater FDI. ______________________________ * Contact: aakashmadhu@gmail.com. The author would like to thank Professor Robert Inman for graciously serving as my advisor throughout this project and patiently explaining ideas to me, Professor Martin Asher for coordinating the WRS program and providing useful comments and thoughts, and the entire WRS community for their input during our meetings and presentations. Any errors in this paper are solely mine. Federalism’s Impact on Foreign Direct Investment Inflows Aakash Madhu Wharton Research Scholars 2 Introduction Academics in a variety of disciplines proclaim numerous benefits to adopting a federal form of governance. Two sets of literature examine the importance of federalism; one group provides a theoretical framework for understanding the potential positive impacts of federalism and the other attempts to empirically study the relationships between federalism and proposed beneficial outcomes. “Federalism’s Values and the Value of Federalism” by Dr. Robert P. Inman, the advisor to this project, served as a starting point for understanding the empirical relationships between federalism and a number of beneficial outcomes that theory claims should exist. In particular, that study examined whether or not “federalism [serves] as a means to more efficient public and private economies, as the foundation for increased political participation and democratic stability and as an important check on governmental abuses of personal rights and liberties. ” The results of the study will be discussed later in its relationship to this project. As this broad study indicates, academics often claim that federalism improves the performance of economies. This paper takes a much narrower approach towards understanding this relationship, and attempts to understand whether or not federalism contributes to increased amounts of Foreign Direct Investment (FDI). Why should it be useful to understand the relationship between the form of governance and FDI? One answer would be that FDI is an essential factor for economic growth. This however is not a trivial claim because “[t]he role of foreign direct investment (FDI) in the growth process has long been a topic of intense debate. ” 1 Inman, Robert. (2007) “Federalism’s Values and the Value of Federalism”, CESifo Economic Studies 53, 522-560. 2 Balasubramanyam, V.N. , Salisu, M. & Sapsford, D. (1996) “Foreign Direct Investment and Growth in EP and IS Countries”, Economic Journal 106(1), 92-105. Federalism’s Impact on Foreign Direct Investment Inflows Aakash Madhu Wharton Research Scholars 3 Nonetheless, there exists both theoretical and empirical research that argues the position that once a country attracts FDI, it experiences increased efficiency and growth. Despite the lack of resolution to this question, an empirical analysis of the relationship between federalism and FDI can serve useful since “many less developed countries (LDCs) have been actively seeking FDI inflows since the early 1980s, based on the belief that FDI can bring several benefits, including technology transfers, managerial skills and access to international markets. ” Presumably, these countries will continue to seek FDI due to their assumptions about its benefits. Understanding how they can best achieve their desired results seems to be a reasonably useful exercise. Theoretical Literature In his paper “The Economic Role of Political Institutions: Market-Preserving Federalism and Economic Development”, Barry Weingast provides much of the theoretical arguments for the hypothesis of this project. It examines the idea that historically, federalism played a critical role in the growth of numerous countries, including “England in the 18 century and the United States in the 19 and 20 centuries . [and also] China over the past 15 years. ” The arguments he utilizes to justify his claims are worth exploring because the same theoretical arguments can help to justify the hypothesis made and to ultimately explore the meaning of the empirical results herein contained. The first step is to understand what Weingast defines as “Market-Preserving Federalism”. This paper attempts to contribute something to the understanding of this 3 Yang, Benhua. (2007) “Autocracy, Democracy, and FDI Inflows to the Developing Countries”, International Economic Journal 21(3), 419-439. 4 Weingast, Barry. (1995) “The Economic Role of Political Institutions: Market-Preserving Federalism and Economic Development”, Journal of Law, Economics, & Organization 11(1), 1-31. Federalism’s Impact on Foreign Direct Investment Inflows Aakash Madhu Wharton Research Scholars 4 classification also, as an aside to the primary hypothesis; this will be discussed later. Weingast establishes five criteria that classify a governance structure as marketpreserving federalism. They are the following: (F1) A hierarchy of governments, that is, at least “two levels of governments rule the same land and people,” each with a delineated scope of authority so that each level of government is autonomous on its own, well-defined sphere of political authority. (F2) The autonomy of each government is institutionalized in a manner that makes federalism’s restrictions self-enforcing. (F3) Subnational governments have primary regulatory responsibility over the economy. (F4) A common market is ensured, preventing the lower governments from using their regulatory authority to erect trade barriers against the goods and services from other political units. (F5) The lower governments face a hard budget constraint, that is, they have neither the ability to print money nor access to unlimited credit. 5 Once these conditions are met, a number of consequences follow. Discussions on those relevant to the hypothesis of this paper follow. The first consequence described by Weingast is the “induced competition among lower units of the federal structure. ” In thinking about this in context of a well known federal government, the United States, one can consider competition among states, which are lower units of the federal structure. States have autonomy in deciding numerous issues and thus can vary quite significantly 5 Weingast, Barry. (1995) “The Economic Role of Political Institutions: Market-Preserving Federalism and Economic Development”, Journal of Law, Economics, & Organization 11(1), 1-31. 6 Ibid. Federalism’s Impact on Foreign Direct Investment Inflows Aakash Madhu Wharton Research Scholars 5 from each other in their legal and political environments. Due to conditions set out from market-preserving federalism, it follows that “political competition implies that jurisdictions must compete for capital, labor, and economic activity by offering menus of public policies (e.g., levels of taxation, security of private rights, social amenities, and public goods). ” Those actors that seek to utilize these policies will choose the correct menu for them. The application to FDI follows in a relatively straight forward manner. First, assume that countries actively seek FDI. Although this paper does not focus on this issue, it cites Yang (2007), who claims that they do. Then assume that if the country as a whole seeks FDI due to some presupposed benefits, local entities would seek FDI for themselves to reap the benefits locally. This makes sense if one considers that managerial skill transfer and technological knowledge transfer are some of the assumed benefits; jurisdictions that obtain these would be more capable of competing with the other lower units. One can imagine that a particular set of menu choices regarding economic policies such as tax rates, operating rules and restrictions, labor laws, etc. would be optimal in attracting a multi-national corporation (MNC) to invest in that particular lower unit of the federal structure, whether it is a state or whatever else. Since competition exists, this menu of options would be more favorable to MNCs than a menu created by one entity, such as what would occur in a dictatorship for example. Consequently, MNCs would invest more in those jurisdictions with optimal menu options and therefore in countries with federal governance structures. Nathan Jensen, in his paper “Federal Institutions and Multinational Investors: Federalism, Government Credibility, and Foreign Direct Investment”, provides a separate 7 Ibid. Federalism’s Impact on Foreign Direct Investment Inflows Aakash Madhu Wharton Research Scholars 6 analysis that specifically tries to deduce why federalism should induce higher FDI. His discussion does not require market-preserving federa