Can Openness Deter Corruption? The Role of Foreign Direct Investment

37 Pages Posted: 2 Jun 2008

See all articles by Felipe Larrain

Felipe Larrain

Pontificia Universidad Catolica de Chile

José Tavares

Centre for Economic Policy Research (CEPR); Nova School of Business and Economics

Date Written: September 2007

Abstract

The economics literature provides ample evidence that higher corruption discourages FDI inflows. In this paper we address, for the first time in the literature in a systematic way, the exact reverse link, i.e., the empirical effect of FDI inflows on corruption. We present a simple model that illustrates the two-way relationship between foreign direct investment and corruption, identifying exactly the direction of causality that we address: how do "exogenous" variations in FDI affect the degree of corruption in the host country. Our dataset covers a wide group of countries for the period 1981-2000, and we confront the issue of causality by constructing an original set of instrumental variables relying on geographical and cultural distance between FDI source and host countries to measure exogenous time-varying changes in FDI inflows. We find that FDI inflows (as a share of GDP) significantly decrease corruption in the host country. The quantitative impact of FDI inflows on corruption is stronger than the impact of trade openness and tariff rates on corruption and is validated by the use of instrumental variables. The results are robust to the inclusion of several determinants of openness, in addition to trade intensity and the average tariff level, including dependence on natural resources, ethnic fractionalization, size of the economy and government expenditure. Quantitatively, the impact of FDI inflows on corruption is of the same order of magnitude as the impact of per capita income on corruption.

Keywords: Corruption, Foreign Direct Investment, Instrumental Variables, International Trade, Tariffs

JEL Classification: E5, F10, F13, F30, H10

Suggested Citation

Larrain, Felipe and Tavares, José, Can Openness Deter Corruption? The Role of Foreign Direct Investment (September 2007). CEPR Discussion Paper No. DP6488, Available at SSRN: https://ssrn.com/abstract=1138952

Felipe Larrain (Contact Author)

Pontificia Universidad Catolica de Chile ( email )

Av. Vicuna Mackenna 4860
Macul. Correo 17
Santiago
Chile
56 2 354-4027 (Phone)
56 2 553-2377 (Fax)

José Tavares

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

Nova School of Business and Economics ( email )

Campus de Carcavelos
Rua da Holanda, 1
Carcavelos, 2775-405
Portugal

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