Foreign Direct Investment and the Dark Side of Decentralization

"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." Copyright (c) CEPR, CES, MSH, 2007.