Foreign Direct Investment and the Dark Side of Decentralization

65 Pages Posted: 21 Dec 2006

See all articles by Sebastian G. Kessing

Sebastian G. Kessing

Wissenschaftszentrum Berlin fuer Sozialforschung (WZB) - Market Processes and Governance; CESifo (Center for Economic Studies and Ifo Institute for Economic Research)

Kai A. Konrad

Max Planck Institute for Tax Law and Public Finance; Centre for Economic Policy Research (CEPR); CESifo (Center for Economic Studies and Ifo Institute for Economic Research); IZA Institute of Labor Economics

Christos Kotsogiannis

University of Exeter

Abstract

Both in the developed and developing world, decentralization of fiscal policy is frequently argued to foster investment, because allowing investors to choose between competing locations should make it difficult for each jurisdiction to tax the investment's returns. We point out that this 'horizontal' dimension of decentralization cannot eliminate ex post incentives to tax investments once they are irreversibly located in a jurisdiction, and that the negative ex ante investment effects of such 'hold up' problems are actually stronger when decentralization inevitably leads to multiple levels of taxation power in each location. Empirically, we detect significant negative effects on FDI of the 'vertical' dimension of decentralization, measured by the number of government layers, in a data set containing many countries and many suitable control variables. Indicators of overall fiscal decentralization do not appear to affect the investment climate negatively per se, but our theoretical arguments and empirical results suggest that policymakers should consider very carefully the form and degree of government decentralization if they aim at improving the investment climate.

Suggested Citation

Kessing, Sebastian G. and Konrad, Kai A. and Kotsogiannis, Christos, Foreign Direct Investment and the Dark Side of Decentralization. Economic Policy, Vol. 22, No. 49, pp. 5-70, January 2007. Available at SSRN: https://ssrn.com/abstract=953123 or http://dx.doi.org/10.1111/j.1468-0327.2007.00172.x

Sebastian G. Kessing (Contact Author)

Wissenschaftszentrum Berlin fuer Sozialforschung (WZB) - Market Processes and Governance ( email )

Reichpietschufer 50
D-10785 Berlin
Germany

CESifo (Center for Economic Studies and Ifo Institute for Economic Research)

Poschinger Str. 5
Munich, DE-81679
Germany

Kai A. Konrad

Max Planck Institute for Tax Law and Public Finance ( email )

Marstallplatz 1
Munich, 80539
Germany

HOME PAGE: http://www.tax.mpg.de/en/pub/home.cfm

Centre for Economic Policy Research (CEPR)

90-98 Goswell Road
London, EC1V 7RR
United Kingdom

CESifo (Center for Economic Studies and Ifo Institute for Economic Research)

Poschinger Str. 5
Munich, 81679
Germany

IZA Institute of Labor Economics

P.O. Box 7240
Bonn, 53072
Germany

Christos Kotsogiannis

University of Exeter ( email )

Exeter EX4 4QX, Devon
United Kingdom

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