Monday, February 4, 2013

Fiscal decentralization and FDI inflows

Here (ungated version here) is an abstract from an interesting paper on fiscal decentralization and foreign direct investment in India and China. Yong Wang argues that “endogenous policies toward FDI are favorable only when both central and local governments benefit”. Fiscal decentralization has a non-monotonic and significant impact on FDI.

A political-economy model is developed to explain why fiscal decentralization may have a non-monotonic effect on FDI inflows through endogenous policies. Too much fiscal decentralization hurts central government incentives, whereas too little fiscal decentralization renders the local governments vulnerable to capture by the protectionist special interest groups. Moreover, the local government's preference for FDI can be endogenously polarized; therefore, a small change in fiscal decentralization across certain threshold values may lead to a dramatic difference in equilibrium FDI inflows. Empirical investigations support that the difference in fiscal decentralization is an important reason for the nine-fold difference in FDI per capita between China and India. Cross-country regression results also support the inverted-U relationship.

Inverted-U relationship between FDI per capita and fiscal decentralization (measured by sub-national government’s overall revenue share).

China’s central and local governments are more aggressive in enticing FDI inflows than India’s. China’s central government encourages FDI inflows by offering fiscal incentives (tax holidays and tariff waiver on imported inputs to foreign-invested firms). Furthermore, the local governments as well offer favorable policies (simple license application, lower fees for land use, provision of infrastructure, etc).