DP6488 Can Openness Deter Corruption? The Role of Foreign Direct Investment

Author(s): Felipe Larrain B., José Tavares
Publication Date: September 2007
Keyword(s): Corruption, Foreign Direct Investment, Instrumental Variables, International Trade, Tariffs
JEL(s): E5, F10, F13, F30, H10
Programme Areas: International Trade and Regional Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=6488

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.