Democratic governments attract foreign direct investment (FDI) by offering lower tax burdens, while autocratic governments will tend to lower regulatory standards.
This is the finding of a new paper published in Economics and Politics by SPP Assistant Professor Michael Dorsch and his colleagues Fergal McCann of the Central Bank of Ireland, and Eoin McGuirk of the University of Gothenberg entitled Democratic Accountability, Regulation and Inward Investment Policy.
Using data from surveys of managers of foreign firms operating in 30 Eastern European and Central Asian countries that measures the extent to which they consider labor regulations and tax rates to be obstacles to doing business, the paper finds that “foreign firm’s perceptions of the regulatory burden relative to the tax burden are significantly higher in countries with stronger democratic institutions.” The findings provide some explanation as to why environmental damage and labor abuses caused by industry are often greater in autocracies than in democracies.
“Our findings have clear welfare implications,” the paper explains. “We suggest that competition for FDI has the capacity to impose significant social costs on citizens of autocratic countries, whose governments have an incentive to offer a regulatory carte blanche to attract foreign firms to invest and contribute to the government’s tax base. The paper can also be interpreted as an explanation for why countries with seemingly adverse political conditions, and even political instability, continue to receive foreign investment.”
Political leaders face a trade off in attracting foreign investment, between lowering taxes and revenues or lower regulations and the potential popular support that comes with that. Which policies leaders choose depends on how politically accountable they are to the population at large.
The paper can be read in full here. Or you can download a copy of the working paper here.
Photo Credit: Solvay Martorell