Fiscal decentralization, endogenous policies, and foreign direct investment: Theory and evidence from China and India

a r t i c l e i n f o 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 the idea that the difference in fiscal decentralization is an important reason for the nine-fold difference in FDI per capita between China and India. Crosscountry regression results also support the inverted-U relationship. Foreign direct investment (FDI) helps facilitate economic growth in developing countries because it not only brings more physical capital but also embodies better foreign technology. 1 However, in reality, government policies toward FDI vary tremendously across countries. For example, China's central government encourages FDI inflows by authorizing long tax holidays and tariff reductions on imported inputs to foreign-invested firms. Meanwhile, local governments in China compete aggressively for FDI by offering favorable policies, including simplifying license application, charging low fees for land use, building facilitating infrastructure, etc. In contrast, we did not see such enthusiasm for FDI at the central or the local level of the Indian government until very recently. For instance, the corporate income tax rate on foreign-invested firms was 41% in India but well below 33% in China in 2004. 2 The de facto institutional barriers to FDI are also much higher in India. It takes almost 50% longer to obtain a license and it is five times more costly (relative to its own per capita income) to start a business in India than China, according to the World Bank (2005). India's infrastructure is also significantly inferior to China'ss aggregate FDI inflow was more than US$ 72 billion, approximately twelve times that of India, and China's per capita FDI was nine times greater according to UNCTAD (2008). Bosworth and Collins (2007) find that such a significant difference in FDI is surprising because it cannot be explained by the countries' differences in economic fundamentals. Srinivasan (2006) notes, " Although India has attracted far less FDI [than China], it is not because of the lack of potential opportunities in India, but largely because of …