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Report October 2010

Best Policy Practices for

Promoting Inward and Outward

Foreign Direct Investment

Trade, invesTmenT policy, and inTernaTional cooperaTion


Best Policy Practices for Promoting Inward and Outward Foreign Direct Investment

by Steven Globerman and Victor Zitian Chen

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Forecasts and research often involve numerous assumptions and data

sources, and are subject to inherent risks and uncertainties. This information

is not intended as specific investment, accounting, legal, or tax advice.

Preface

This report identifies and discusses best practices to

attract and promote inward and outward foreign direct

investment. To better inform Canadian policy-making

at various levels of government, this report provides

an extensive and systematic review of the empirical

evidence on the public policies and other factors that

influence foreign investors. The report also evaluates

which policies and other factors affect the degree to

which foreign direct investment improves productivity

and leverages other benefits in the economies receiving

the investment.


conTenTs

executive summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . i

chapter 1—Introduction and Conceptual Background . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1

Conceptual Background. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2

chapter 2—Methodology and Main Findings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6

Categories of Variables for the Determinants of FDI . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7

Categories of Variables for the Determinants of FDI Spillovers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8

What Affects Foreign Investment? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9

What Determines Investment Quality? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14

chapter 3—Policy Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18

appendix a—Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20

Publications Related to FDI/FDO Determinants. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21

Publications Related to Determinants of Spillover Benefits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28

appendix B—Glossary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32


Acknowledgements

The authors thank Adrian Bibby for excellent research assistance. They also thank Ram Acharya, Danielle

Goldfarb, and Walid Hejazi for very helpful comments and suggestions on earlier drafts.

inTernaTional Trade and invesTmenT cenTre memBers

The Conference Board of Canada is grateful to the champion and lead members of the International Trade and

Investment Centre that, through their membership, support the Centre’s research program. 1

champion members

Export Development Canada

Foreign Affairs and International Trade Canada

lead members

Business Development Bank of Canada

Canada Economic Development

Canada Mortgage and Housing Corporation

Farm Credit Canada

aBouT THe inTernaTional Trade and invesTmenT cenTre

The International Trade and Investment Centre aims to help Canadian leaders better understand what global economic

dynamics—such as global and regional supply chains—mean for public policies and business strategies. The Centre brings

together business and government leaders in an off-the-record forum to discuss successful trade and investment strategies.

The Centre’s independent, evidence-based reports propose effective policy and business solutions for improving Canada’s

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For more inFormaTion

Please visit www.conferenceboard.ca/ITIC.

1 These organizations do not necessarily endorse the research conclusions of this paper.

Forest Products Association of Canada

Industry Canada

Ministère du Développement économique, de l’Innovation

et de l’Exportation du Québec

Natural Resources Canada

Ontario Ministry of Economic Development and Trade

RBC Financial Group

Sun Life Financial Inc.


execuTive summary

Best Policy Practices for

Promoting Inward and Outward

Foreign Direct Investment

at a Glance

Best policy practices for attracting foreign direct

investment, and for promoting “spillover”

productivity benefits from that investment, are

“framework policies”—such as transparent

regulations and solid infrastructure and education

policies.

It is less clear from the evidence whether

policies that specifically target foreign investors—such

as subsidies and tax breaks—are

best practices for attracting investment. Such

policies could even reduce any spillover productivity

effects from that investment.

Though there is less evidence on what directly

encourages outward foreign direct investment,

it is clear that the framework policies

that favour inward foreign direct investment

also encourage outward direct investment

over the longer term.

This report identifies and discusses “best practices”

to attract and promote inward and outward foreign

direct investment from the perspective of

national and sub-national governments. Foreign direct

investment can be thought of as investments in productive

assets that are managed by companies headquartered in

foreign countries, as opposed to financial investments in

equity shares of local companies by foreign investors.

When viewed from the perspective of the recipient (or

host) country, we are discussing inward foreign direct

investment—referred to as FDI in this report. When

viewed from the perspective of the sending (or home)

country, we are discussing outward foreign direct

investment—referred to as FDO in this report.

This report identifies and discusses “best practices” to

attract and promote inward and outward Fdi from the

perspective of national and sub-national governments .

While not without some disagreement, the broad consensus

of economists is that inward foreign direct

investment and outward foreign direct investment have

net economic benefits for host and home economies. As

a result, policy-makers have an interest in identifying

public policies that support inward and outward foreign

direct investment. There is also a potentially substantial

economic payoff to policies that leverage the economic

benefits of FDI and FDO.

This report offers an extensive and systematic review of

the empirical evidence on what factors affect FDI and

FDO. We identify the major policy and other factors

that influence the location decisions of foreign investors

and the decisions of domestics firms to expand abroad.

We review the evidence at both the national and subnational

levels to better inform Canadian policy-making

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ii | Best Policy Practices for Promoting Inward and Outward Foreign Direct Investment—October 2010

at various levels of government. A related focus is to

evaluate how such factors affect the quality of foreign

direct investments. Specifically, we ask which policies

and other factors affect the degree to which foreign direct

investment improves productivity in the economies

receiving the investment.

The limited available evidence suggests that best practices

for promoting outward direct investment are similar to

those for attracting inward direct investment .

Our detailed analysis of the literature indicates that:

1. Best practices that make locations attractive to foreign

investors include public policies that are conventionally

associated with promoting productivity and real

economic growth more broadly. This includes a reliable

and transparent legal and regulatory regime, an

educated and skilled workforce, good transportation

and telecommunications infrastructure, and an

environment that encourages innovation.

2. Such factors also contribute to greater “productivity

spillover” benefits from FDI.

3. Policies—such as subsidies and tax breaks—that

specifically target foreign investors are not necessarily

best practices for attracting investment. The evidence

is not clear that such fiscal incentives promote FDI in

the longer run. Such policies could even reduce any

spillover productivity effects from that investment.

This is particularly true if subsidies or tax breaks

result in FDI that geographically disperses industrial

and scientific capacity.

4. The limited available evidence suggests that best

practices for promoting outward direct investment

are largely similar to those for attracting inward direct

investment. Contrary to popular conception, an

environment favourable for inward direct investment

is not unfavourable for outward direct investment. This

is because policies promoting improved productivity

and real economic growth ultimately strengthen the

competitive advantages of domestically owned firms.

This, in turn, encourages and enables domestic firms

to expand internationally, including investing abroad.

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5. Further, because outward direct investment focuses on

accessing specialized skills and knowledge abroad,

it can lead to greater productivity benefits at home.

This is because skills and knowledge transferred

from host countries to the home country are likely

to convey productivity benefits to organizations

beyond the home-country multinational company

responsible for directly or indirectly transferring the

skills and knowledge to the home country.

6. These findings have important implications for

Canadian policy-makers at the federal, provincial,

territorial, regional, and city levels. In choosing locations

for foreign direct investment, investors largely

look at the quality of legal and regulatory governance,

physical and communications infrastructures, and

the workforce’s education and training level. These

components of a favourable FDI environment are

importantly influenced by public policy, including

government spending. While Canada and subnational

political units in Canada rate relatively

highly on these attributes, there is certainly scope for

improvement. In particular, improvements to roads

and ports could be accelerated. Also, encouraging

increased science and related technical education in

publicly funded schools would enhance the quality

of Canada’s workforce and promote the ability of

Canadian companies to create and quickly adopt new

technology. This, in turn, would strengthen the ability

of Canada to encourage FDI and capture its productivity

benefits.

7. The use of government agencies to attract FDI can

be an effective policy instrument at the national and

sub-national levels. Specifically, promotional agencies

can be effective tools to educate foreign investors

about the advantages of a location, as well as to

mitigate administrative procedures and delays that

impose costs and risks on foreign investors. The

activities of promotional agencies might be especially

relevant for sub-national governments, since

foreign investors are likely to be less aware of the

economic advantages of specific locations within

Canada than they are of the economic attributes of

the country, as a whole.


8. Higher taxes, by themselves, are a disincentive to

FDI, although their quantitative importance has been

difficult to estimate precisely; however, the public

services and amenities paid for through taxes—

including education, physical infrastructure, efficient

and reliable legal and regulatory governance, and so

forth—attract FDI, again at both the national and

sub-national levels. To the extent that lower taxes

require commensurate reductions in “desirable” public

services and amenities, FDI is likely to decrease, on

balance, as will the efficiency benefits from FDI.

9. A concentration of economic activity in geographic

locations encourages FDI and strengthens its productivity

benefits. The implication is that public policies

The Conference Board of Canada | iii

that intentionally (or unintentionally) geographically

disperse “agglomerations” of skilled labour and specialized

production capacity are ill-advised from a

best-practices perspective. This observation is particularly

relevant at the sub-national level.

10. There is no consistent evidence that requirements

imposed on foreign investors to buy inputs from

local suppliers, or to take in domestically owned

partners through joint ventures, enhance the benefits

from inward direct investment. Since such requirements

are likely to discourage FDI, holding other

things constant, they are undesirable from a bestpractices

perspective.

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cHapTer 1

Introduction and Conceptual

Background

chapter summary

This report systematically reviews the empirical

evidence on which factors influence the quantity

of inward and outward foreign direct investment.

The report also assesses which factors influence

the quality of that investment, or the degree to

which it confers productivity benefits on the

receiving country.

More attention has been paid to productivity

benefits from inward foreign direct investment,

but outward investment can also confer productivity

benefits to the home economy by introducing

new technologies, expertise, and inputs.

The factors that affect the degree to which

investments have spillover productivity benefits

tend to be similar for outward and inward foreign

direct investment—an example is companies’

capacities to absorb new technologies.

This report addresses the broad issue of whether

there are “best practices” to attract and promote

foreign direct investment from the perspective of

both host and home countries (or regions). In particular,

the report reviews and evaluates numerous empirical

studies that help answer two specific questions:

1. Which factors influence inward foreign direct

investment (referred to as FDI in this report) and

outward foreign direct investment (referred to as

FDO in this report)?

2. Which factors influence the quality of that FDI to the

host country and FDO to the home country? We focus

specifically on whether that investment confers additional

productivity benefits.

The evidence from the empirical studies provides the

basis for policy recommendations with regard to FDI

and FDO.

The report does not deal with arguments about whether

or not FDI and FDO have overall net economic benefits to

host and home countries. A long, complex, and extensive

body of literature deals with this broad concern, which

is well beyond the scope of this study. Furthermore, a

companion piece to this report to be prepared by The

Conference Board of Canada will discuss the economic

impact of FDO. The premise underlying this study—

which reflects the balance of the evidence—is that both

FDI and FDO convey net economic benefits, at least for

current volumes of both, such that it is in the economic

interests of governments to facilitate more of both types

of investments at the margin—that is, incrementally. In

this regard, knowledge about factors influencing FDI

and FDO should be of value to policy-makers, as should

insights into the factors that either increase or decrease

any spillover productivity or other economic benefits

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2 | Best Policy Practices for Promoting Inward and Outward Foreign Direct Investment—October 2010

from that investment. Hence, the specific questions

focused on in this report are fundamentally relevant to

the design and implementation of what might be identified

as “best practices” for two-way foreign direct investment.

Since the bulk of the relevant literature deals with foreign

direct investment policy issues at the national

level, there is relatively little evidence on best practices

for sub-national political units, such as provinces.

Nevertheless, we review what evidence is available for

sub-national units with regard to the specific research

questions identified above, and compare and contrast

findings for the different levels of government.

Furthermore, while the specific policy focus is on

Canada, much of the existing evidence concerns other

countries. Hence, some attention is paid to how results

for other countries might be applied to Canada.

often-recommended public policies to attract Fdi include

transparent regulatory regimes, investments in infrastructure

and education, corporate tax reductions, subsidies,

and eliminating limitations on foreign investments .

This report concludes that the main public policies

identified as best practices are neither unique to promoting

FDI and FDO flows, nor to promoting the benefits

of those flows. For example, policy recommendations

relevant to macroeconomic policy, rule of law, protection

of property rights, investment in physical infrastructure

and human capital, and so forth, are broadly appropriate

to influencing real economic growth, as well as FDI

and FDO. Specific policies of potential interest, such as

government subsidies to foreign investors, might influence

the magnitude of FDI but also condition its net

benefits, and sometimes in the opposite direction of

their influence on the size of FDI flows. In other words,

while such policies might increase the amount of foreign

direct investment, they could reduce any spillover

productivity effects from that investment. (See

Appendix C for a glossary of terms used in this report.)

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concepTual BackGround

Policy discussions in the literature are disproportionately

focused on FDI as opposed to FDO. In particular,

while the economic impacts of FDI have been widely

acknowledged and discussed, and numerous statistical

studies of these potential impacts exist, the economic

impacts of FDO are poorly understood; in part because

empirical studies addressing those impacts are few in

number. 1 As a result, far more attention has been paid

to policies that influence FDI and to the effects of FDI

on the host or receiving country than to policies that

influence FDO and to the effects of FDO on the originating

country. In addition, far more has been written

about the determinants of the location choices of foreign

investors than about the determinants of the economic

impacts of foreign direct investment.

FacTors THaT aFFecT THe QuanTiTy oF ForeiGn

direcT invesTmenT

A number of often-recommended public policies to

attract FDI can be identified in the literature. They

include the following eight policies:

1. Establish and maintain legal and regulatory regimes

that protect property rights, create transparent and

fair rules of law, and minimize the transaction cost

burdens and other unwanted consequences of regulation.

2. Implement macroeconomic policies that encourage

real economic growth with low inflation.

3. Invest in transportation and communication infrastructure

to lower the costs of coordinating and

carrying out international business transactions.

4. Invest in education and worker training programs to

improve the quality of labour available to employers. 2

1 For an overview of theory and evidence regarding the FDI process

and the impact of FDI on host countries, see Graham and

Krugman (1995) and Lipsey and Sjoholm (2005). For an overview

of the impacts of FDO on home countries, see Globerman (1994).

2 Establishing foreign investment promotion agencies is not extensively

discussed in the academic literature but represents a policy

initiative for numerous governments. We discuss the effectiveness

of such agencies on page 13 of this report, in the section “What

Affects FDI at the Sub-National or Provincial Level?”


Other more controversial public policies can also be

identified, including:

5. Reduce corporate tax rates.

6. Weaken or eliminate regulatory review processes

applying to foreign investors.

7. Offer financial subsidies to prospective foreign

investors.

8. Eliminate limitations on foreign ownership levels in

“sensitive” industrial sectors.

It should be noted that foreign direct investment is relatively

footloose, particularly at the sub-national level.

That is, foreign investors ordinarily compare alternative

geographic locations when making investment decisions.

Hence, the attractiveness of any host country to

foreign investors will depend on public policies implemented

not only by that host country’s government but

also in other countries and regions.

Initiatives 1–4 above clearly are not solely relevant to

investment decisions of foreign investors, since domestic

investors should also find that such initiatives make

their home country a more desirable location in which

to invest. Therefore, in the short run, at least, initiatives

1–4 might discourage FDO at the same time as they

encourage FDI. In the longer run, domestic firms are

likely to become more efficient, and therefore more

competitive internationally, as a consequence of governments

implementing these initiatives. Domestic firms

may therefore find FDO more profitable in the long run,

such that factors promoting increased FDI also potentially

promote FDO. This is not to say that domestic

investment will necessarily decrease as FDO increases.

Indeed, domestic investment, FDI, and FDO may all

increase as an economy becomes more productive.

In short, initiatives 1–4 are relatively uncontroversial

policy recommendations designed to increase a location’s

attractiveness to foreign investors. This is not the

case for the other initiatives identified above. For

example, reducing corporate tax rates should attract

increased quantities of FDI, other things being constant;

however, if the result is lower tax revenues that, in turn,

lead to reductions in publicly provided services and

amenities such as good public schools and safe and

clean cities, the impact of lower corporate tax rates on

The Conference Board of Canada | 3

FDI is more uncertain. For the same reason, the relationship

between domestic corporate tax rates and FDO

is ambiguous. Specifically, lower tax rates in combination

with a degradation of public goods amenities might

lead to increased FDO rather than increased domestic

investment by local firms.

Foreign ownership restrictions have been defended by

reference to a sector’s activities being “sensitive” or

otherwise critical to the national interest—thus necessitating

domestic rather than foreign ownership .

Weakening or eliminating FDI review procedures, as well

as sectoral restrictions on foreign ownership, should

encourage inward FDI. Nevertheless, they are controversial

initiatives. In particular, some observers continue

to argue that reviewing FDI inflows for approval

enables policy-makers to improve the host country

benefits from FDI by allowing the host government to

demand specific commitments or activities that augment

the net benefits from FDI to the host country. For

example, as a condition of approval, the host-country

government could demand that a foreign investor proposing

to acquire a domestically owned firm maintain

the level of research and development spending of the

domestically acquired firm. It is not necessary to assess

the merits of FDI review procedures such as those mandated

under the Investment Canada Act. Although we

do not review available evidence in this report, the evidence

generally discredits the argument that FDI review

procedures benefit the host economy and cast doubts on

the magnitude of net benefits claimed by governments

for the review procedures. 3

Eliminating restrictions on FDI also promotes increased

FDI flows to a host country. Foreign ownership restrictions

have been defended by reference to a sector’s

activities being “sensitive” or otherwise critical to the

national interest and, therefore, necessitating domestic

rather than foreign ownership. Without going into detail,

such defences of foreign ownership restrictions are

3 Globerman (2008) provides a critical analysis of the FDI review

process in Canada.

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4 | Best Policy Practices for Promoting Inward and Outward Foreign Direct Investment—October 2010

ordinarily vague and fail to withstand critical analysis. 4

Nevertheless, foreign ownership restrictions are politically

difficult to eliminate, since strong vested domestic

interests will lobby against their elimination.

To the extent that FDI review procedures and foreign

ownership restrictions indirectly reduce foreign competition

faced by domestic firms, they may contribute to

domestic investors earning economic profits, thereby

discouraging FDO, at least in the short run. However,

reduced FDO is not necessarily a desirable consequence,

since FDO can provide net economic benefits

to the home country as discussed below.

policies to attract Fdi may discourage Fdo in the short-

run, and stimulate increased Fdo over the longer-run .

In summary, suggested policies to attract FDI can be

readily identified in the academic literature. Those same

framework policies may discourage FDO in the short

run, but they arguably also stimulate increased FDO in

the longer run by contributing to an economic environment

in which domestically owned firms become more internationally

competitive over time. FDO is a business mode

through which domestically owned firms can participate

in international markets as they become more competitive.

The majority of relevant policy recommendations should

make a domestic economy more attractive to all investors,

both foreign and domestic. A literature review of empirical

studies can therefore assess the importance of specific

policies affecting both FDI and FDO.

FacTors THaT aFFecT THe economic BeneFiTs oF Fdi

The policy literature focusing on the determinants of

the economic benefits of FDI and FDO is both more

limited and more equivocal than the literature on the

determinants of FDI and FDO flows. The economic

benefits of FDI and FDO primarily derive from two

phenomena: 1) increased specialization of production

in the economy; 2) spillover efficiency benefits to the

host or home economy. More specifically, the primary

4 For an extensive and critical rejection of arguments in favour of

sectoral foreign ownership restrictions, see Sidak (1997).

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economic benefits of FDI and FDO derive from their

contribution to productivity and, therefore, to higher

real incomes in the host and home countries. 5 Both

FDI and FDO promote increased specialization of production

across and within industries, and even within

individual firms by serving as relatively efficient modes

for reallocating productive resources across geographic

locations. For well-known reasons, increased specialization

of production contributes to improved productivity

and higher real incomes for host and home countries.

While foreign direct investment can promote increased

international specialization of production, so can international

trade. In fact, the contribution of foreign direct

investment to the international specialization of production

has typically taken a back seat to international trade’s

contribution. Indeed, in some early theories of foreign

direct investment, FDI was seen to be a “second-best”

instrument of international specialization of production.

Specifically, foreign direct investment was seen as being

primarily motivated by the incentive to jump over tariff

and non-tariff barriers that discouraged exports by firms

enjoying efficiency or other competitive advantages in the

international marketplace. Later theories of foreign direct

investment de-emphasized the role of barriers to trade as

the motivation for foreign direct investment. In these later

theories, foreign direct investment is seen as a relatively

efficient and profitable way for firms to exploit specific

competitive advantages tied to the possession of intangible

assets. That is, trade and foreign direct investment are

increasingly seen as complementary phenomena. Modern

theories of international production also emphasize the

impact of spillover benefits, which are seen as important

potential consequences of the international transfer of

technology and other intangible assets. 6 In this report, the

“quality” of foreign investment is determined by the spillover

benefits derived from that investment.

5 FDI and FDO might also affect overall levels of economic activity,

including employment, at least in the short run. However, these

types of broad macroeconomic impacts are not seen as being

specific to foreign investment but are seen as distinct from

domestic investment. See Lipsey and Sjoholm (2005).

6 For an overview of models linking foreign direct investment to

international production patterns, see Dunning (1993). It is beyond

the scope of this report to review the evidence linking FDI to

increased trade specialization.


Spillover efficiency benefits encompass productivity

improvements enjoyed by firms other than those

involved in the direct investment activity, but which

arise from that activity. Most of the focus in the literature

has been on spillover efficiency benefits from FDI

to domestically owned firms in the host country. However,

some recent attention has been paid to spillover efficiency

benefits to home-country firms from FDO undertaken

by other home-country firms. Spillover efficiency benefits

from FDI can potentially arise from “leakages” of technology

and management expertise from foreign-owned

firms to domestically owned firms, through the general

skill upgrading of employees working for foreign-owned

firms who then migrate to domestically owned firms, and

so forth. Spillover efficiency benefits from FDO can

arise from leakages of new technology and management

expertise brought into the home economy by domestically

based multinational companies, the availability of

higher quality inputs to the home economy through

importing activities of domestically owned multinational

companies, and other phenomena. New theories of FDO

emphasize the importance of resource-seeking motives

for FDO, including efforts to acquire new brands, product

designs, and technologies in overseas markets to exploit

in the home country.

knowledge-seeking Fdo may generate potential spillover

efficiency benefits for other domestically owned homecountry

firms .

Relatively little has been written discussing the potential

determinants of spillover efficiency benefits from foreign

direct investment for host countries, and especially for

home countries. 7 Nevertheless, several characteristics of

host country and home-country firms have been linked

to the existence and magnitude of spillover efficiency

benefits. One is the so-called absorptive capacity of

host country firms—that is, the ability of those firms to

adopt and exploit new technologies and management

processes that are brought into the host country through

FDI. Absorptive capacity, in turn, is determined by a

number of factors, including the scientific and engineering

7 For a review and extension of the literature, see Blomstrom,

Kokko, and Globerman (2001).

The Conference Board of Canada | 5

expertise possessed by host country firms. Another factor

is the market structure of industries in the host economy.

On the one hand, stronger competition in host country

industries should intensify incentives for domestically

owned firms to adopt new technologies and administrative

processes, thereby promoting increased spillover

efficiency benefits. On the other hand, stronger competition

dilutes the economic profits that domestically

owned firms can expect to enjoy from early and more

complete adoption of new technologies and administrative

processes. A third broad factor is government policies

and regulations related to the activities of foreign-owned

affiliates. In particular, policies that require or encourage

foreign-owned affiliates to transfer technology more

quickly than they otherwise would to domestically

owned firms might enhance potential spillover benefits

from FDI by enriching the pool of appropriable technology

in the host country. However, if the relevant

policies reduce the ex ante profitability of foreign

investment in the host country, the overall pool of

appropriable technology might actually decline as a

result of substantial reductions in FDI.

Absorptive capacity is also a prominent conceptual

variable influencing the spillover efficiency benefits to

home-country firms from FDO. In particular, FDO is

often undertaken to seek and appropriate knowledge in

other markets that would be more costly to identify and

appropriate through some other mode of international

business such as importing. Since it is ordinarily difficult

for firms to completely protect their proprietary

technologies, knowledge-seeking FDO can be expected

to generate potential spillover efficiency benefits for

other domestically owned home-country firms. That is,

the indirect importation of technology into the home

country by parent companies of foreign affiliates

expands the potential efficiency frontiers of other

domestically owned firms in the home country. The

extent to which domestically owned companies can take

advantage of potential efficiency gains will be a function

of their absorptive capacity, among other things. Domestic

market structure conditions can also affect incentives to

exploit potential spillover benefits in the home country.

In short, a number of the factors that can be linked to

spillover benefits from FDI can also be linked to spillover

benefits from FDO.

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cHapTer 2

Methodology and Main Findings

chapter summary

An extensive literature review was undertaken

to identify empirical studies of the determinants

of FDI and FDO, as well as the determinants

of their productivity benefits.

Among policy-related variables influencing

FDI are the political, regulatory, and physical

infrastructures of a country or region, the

quality of the labour force, and the use of FDI

promotion agencies. The influence of tax rates

is not simple or clear-cut.

Factors encouraging FDI also promote FDO,

in the longer run, by strengthening the international

competiveness of domestic firms.

Benefits to the host country from FDI are

primarily related to the absorptive capacity

of the host country.

The major focus of this report is to identify, summarize,

and evaluate the empirical literature dealing

with the determinants of FDI and FDO, as

well as the determinants of their spillover efficiency benefits.

The following section discusses the methodology

underlying our data gathering and analysis.

The same basic procedure was followed to identify

empirical studies relevant to the determinants of foreign

direct investment and of FDI spillover efficiency benefits.

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A keyword search was done of the main databases that

could be expected to identify papers on these two topics

of interest. One is Business Source Complete, which

indexes about 1,300 scholarly journals in the areas of

economics, finance, and business. A second is JSTOR,

which indexes journal articles, as well as books, book

chapters, conference papers and proceedings, and working

papers in the subject areas of business, economics,

finance, law, political science, arts, and humanities. A

third is Google Scholar Beta, which extends our search

to non-indexed papers such as professional reports and

online repository documents. Prior to the preparation of

this report, the database search covered the time period

1970–2009; a follow-up survey was done to include

papers published in 2010.

The report’s main focus is to identify, summarize, and

evaluate the empirical literature dealing with the determinants

of Fdi and Fdo and spillover efficiency benefits .

In the first stage of the database search, a number of keywords

were used to identify potentially relevant studies.

After identifying a large list of potential studies, the sample

of studies was reduced by eliminating all non-empirical

studies—those that did not use statistical models to quantify

the determinants of foreign direct investment or the

determinants of spillover benefits from foreign direct

investment. The remaining studies provide the basis for

our analysis. The “Publications Related to FDI/FDO

Determinants” section in Appendix A identifies the studies


used to evaluate the determinants of foreign direct investment.

The “Publications Related to Determinants of

Spillover Benefits” section in Appendix A identifies the

studies used to evaluate the determinants of spillover

benefits from foreign direct investment. 1 We don’t claim

to have reviewed every published study on the two main

topics of interest. Nevertheless, we believe this report

provides a comprehensive overview of the relevant literature

that fairly summarizes empirical work on the topics

of interest.

eleven broad categories encompass the numerous specific

variables identified in statistical models of Fdi and Fdo .

For the studies referenced in these two sections of

Appendix A, one of us read and summarized all of the

publications listed in “Publications Related to FDI/FDO

Determinants,” while the other author read and summarized

all of the publications listed in “Publications Related

to Determinants of Spillover Benefits.” After reading

the articles, we developed a template for summarizing

them. The template sets out the major categories of

variables identified in the various studies. Specifically,

Table 1 identifies the main sets of variables we identified

in empirical studies addressing the determinants of foreign

direct investment. As can be seen, there are 11 broad

categories that encompass the numerous specific variables

identified in statistical models of FDI and FDO. Table 2

focuses on the determinants of spillover benefits from

foreign direct investment.

caTeGories oF variaBles For THe

deTerminanTs oF Fdi

While the clustering of variables into categories is

somewhat subjective, it provides a convenient way to

summarize the extensive and eclectic set of findings

1 This study is not meant to be a critical review of the relevant literature.

Hence, it does not assess the reliability of the underlying

methodologies; however, given the comprehensive coverage of our

review, it seems fair to conclude that our conclusions are unlikely

to be distorted by individual poorly designed or executed studies.

The Conference Board of Canada | 7

reported in the literature. The first category is identified

as “economic gravity relationships.” It includes variables

that are typically specified in so-called gravity models,

which represent the basic theoretical structure of most

Table 1

Broad Variable Categories for Determinants of FDI and FDO

category specific variables

Economic gravity relationships Geographical proximity

Trade values

Free trade agreement

Cultural proximity

Macroeconomic conditions Market size

Exchange rate

Market size growth

Per capita income

Industry characteristics Degree of competition

Productivity

Trade and investment openness

Institutional infrastructure Socio-political stability

Government efficiency

Legal protection

Corruption

Physical infrastructure Transportation

Electricity

Telecommunications

Openness to foreign investment Investment restrictions

Trade-related aspects of intellectual

property matters (TRIPs)

Foreign investment promotion

agencies

Openness to international trade Trade to GDP ratio

Tariff and other barriers

Financial markets Interest rate

Stock market capitalization

Labour markets Unit labour costs

Skill endowment/education

Technological capabilities R&D activities

Intangible capital

Taxes Corporate tax rate

Other taxes (direct and indirect)

Source: Steven Globerman and Victor Zitian Chen.

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8 | Best Policy Practices for Promoting Inward and Outward Foreign Direct Investment—October 2010

empirical studies of trade and capital flows. Gravity

models include variables such as physical distance

between trade or investment partners, similarity of

cultures and language, membership of the trading or

investing partners in a free trade area or common market,

and so forth. 2

The second category encompasses variables describing the

macroeconomic attributes of the home and/or host country,

including market size, per capita income, exchange rates,

rates of inflation, and so forth. The third category includes

industry attributes in the home and/or host country, including

ownership concentration, productivity levels, minimum

efficiency scale, and others. The fourth and fifth categories

include measures of the physical and institutional infrastructures

of host and/or home countries, such as the quality

of telecommunications and transportation facilities, the

strength of legal protection of property rights, rule of law,

and similar attributes.

The sixth and seventh categories encompass measures

of openness to foreign investment and foreign trade.

Examples of relevant variables include foreign ownership

restrictions and the ratio of trade to gross domestic

product. A related policy measure is the use of investment

promotion agencies by the host country.

Categories eight through ten include variables that identify

the availability of resources such as financial capital,

human capital, and technology in home and/or host

countries. Specific variables include skill endowments

and education levels of the population, labour costs,

financial market development, R&D activity, and capacity

to innovate. The final category focuses on taxes

and related variables in the home and host countries.

In reviewing our findings on the determinants of foreign

direct investment, we discuss in more detail the specific

variables used in the sample of studies, as well as their

empirical relationships to foreign direct investment.

Similar variables may be measured in different ways

across studies. Hence, it is arguably more reliable to

draw inferences from broad measures of a specific

attribute of the home or host country than from one or

2 For a discussion of gravity models of foreign direct investment,

see Blonigen (2005).

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more narrowly specified measure of that attribute. For

example, tax rates in host and home countries may be

specified in different ways depending on the studies in

question. If the general finding is that higher tax rates

in the host country discourage FDI, it is less important

whether the tax rate is measured as the ratio of tax revenues

to GDP or as the nominal average or marginal

corporate tax rate. In short, conclusions drawn with

respect to broad categories of variables are likely to be

more reliable than those drawn from specific variables

that make up the broader categories.

variables that studies assess as possibly affecting Fdi

and Fdo quantity and quality include trade openness,

proximity, market size, and corporate tax rates .

caTeGories oF variaBles For THe

deTerminanTs oF Fdi spillovers

The literature on spillovers is relatively small compared

with the number of empirical studies on the determinants

of FDI and FDO. Furthermore, virtually all of the

available studies focus on spillover effects for the host

country to the exclusion of impacts on the home country.

Hence, it is not surprising that the list of variables

identified and discussed in empirical studies of spillovers

is smaller than the list of variables identified and

discussed in empirical studies of the determinants of

foreign direct investment.

Table 2 clusters the relevant variables identified in our

review of the publications listed in the “Publications

Related to Determinants of Spillover Benefits” section

in Appendix A into six broad categories. It also identifies

the main specific variables associated with each

broad category. Unsurprisingly, there is substantial

overlap between Tables 1 and 2 in terms of both the

broad and the specific variables that form the focus of

the literature reviewed. This is expected in light of our

earlier discussion of the theoretical literature on the

determinants of foreign direct investment and the determinants

of spillover efficiency benefits.


Table 2

Broad Variable Categories for Determinants of

Spillover Effects

category specific variables

Absorptive capacity R&D performance

Innovativeness

Education/skill level

Openness of economy Trade/GDP

Migration/immigration

Nature of FDI and

FDO linkages

Regulations and related

policies

Wholly owned affiliates

Vertical linkages

Joint ventures

“Buy local”

Requirements to export

Location requirements

Infrastructure Transportation

Telecommunications

Industrial structure Industrial concentrations

Geographical concentrations

Source: Steven Globerman and Victor Zitian Chen.

WHaT aFFecTs ForeiGn invesTmenT?

As noted above, Table 1 summarizes the main categories

of variables used in the empirical studies of the determinants

of FDI and FDO that we reviewed. It also identifies

specific variables most frequently specified in the

empirical models discussed in the reviewed papers. Our

review of the literature is organized around the framework

set out in Table 1.

WHaT aFFecTs Fdi and Fdo aT THe naTional level?

1 . macroeconomic variables: market size

Of all of the variable categories identified in Table 1,

the category encompassing macroeconomic attributes

tends to be the most widely represented in empirical

studies of foreign direct investment. In particular, the

market sizes of the host and home countries, as well as

market size growth, are frequently specified in empirical

models. Table 3 summarizes the macroeconomic

The Conference Board of Canada | 9

Table 3

Summary of Empirical Findings on the Determinants of FDI and FDO:

Macroeconomic Variables

macroeconomic variables relationship to Fdi relationship to Fdo

Market size Positive Positive

Exchange rate (home per host) Mixed Mixed

Market size growth Positive Mixed

Per capita income Mixed Mixed

Inflation rate Negative n.a.

Exchange rate stability Positive Negative

Note: “Mixed” means that the positive and negative results for the variable in question

were about equal in number, and/or the majority of the results for the variable in question

were not statistically significant; “n.a.” indicates only a small number of studies

reported results for the variable in question, such that no reliable inferences about the

variable could be drawn.

Source: Steven Globerman and Victor Zitian Chen.

variables used in the studies we reviewed. The summarized

results are based on the number of times an estimated

result was reported for each variable in our sample

studies. Hence, results could be reported for a variable

more than once in any given study. We do not provide

the number of studies reporting results for each of the

variables discussed in the report. However, if there were

fewer than four studies reporting findings, we identified

results as being “not available.”

The variable most frequently included in the studies

is the market size of either the host or home country,

depending on whether the model focused on FDI or FDO.

In the overwhelming majority of studies, the market

size of the host economy is positively and significantly

related to FDI. Simply put, larger economies attract

inward direct investment. This finding reflects the simple

fact that market opportunities for foreign investors are

generally more abundant in larger economies. Also, in

the majority of cases, the market size of the home economy

is positively and significantly related to FDO. That

is, larger countries are sources of FDO. This latter result

reflects the fact that larger economies tend to be home

to multinational companies. It should be noted, however,

that the results for FDO are less consistent than those

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10 | Best Policy Practices for Promoting Inward and Outward Foreign Direct Investment—October 2010

for FDI. A plausible reason is that some relatively small

economies such as The Netherlands and Canada are also

home to a significant number of multinational companies.

2 . industry and infrastructure conditions

Table 4 summarizes empirical results for variables

describing industry conditions in home and host countries,

as well as infrastructure conditions. The main

conclusion to be drawn is that political stability, protection

of property rights, rule of law, and a relatively efficient

public sector are strong attractors of FDI. So is

good physical infrastructure in the host country, including

transportation and communication facilities. Very few

studies identify the impact of industry conditions and

infrastructure on FDO. If their impacts were estimated,

the findings would likely be mixed. On the one hand,

good infrastructure in the home country should make it

more profitable to operate in the home country and

therefore discourage outward direct investments. On the

other hand, good home-country infrastructure should

promote the emergence and growth of competitive

multinational companies that are willing and able to

Table 4

Summary of Empirical Findings on the Determinants of FDI and FDO:

Industry Attributes and Infrastructure

Industry

attributes

Competitive

conditions

Productivity and

growth

Infrastructure Socio-political

stability

Protection of

property rights

relationship

to Fdi

Mixed Mixed

Positive n.a.

Positive n.a.

Positive n.a.

Government efficiency Positive n.a.

Physical infrastructure Positive n.a.

relationship

to Fdo

Note: “Mixed” means that the positive and negative results for the variable in question

were about equal in number, and/or the majority of the results for the variable in question

were not statistically significant; “n.a.” indicates only a small number of studies

reported results for the variable in question, such that no reliable inferences about the

variable could be drawn.

Source: Steven Globerman and Victor Zitian Chen.

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undertake profitable FDO. In any case, it is clear from

the literature that effective public governance is a key

factor encouraging inward direct investment.

3 . openness to Foreign investment and Trade

Table 5 summarizes the findings from studies that

include measures of an economy’s openness to foreign

investment and trade. It is not surprising to find that

foreign investment approval procedures, such as those

mandated under Canada’s Foreign Investment Review

Act and its successor legislation (the Investment Canada

Act), discourage inward direct investment. Also unsurprising

is the finding that foreign ownership restrictions are

negatively related to FDI. Somewhat less expected are

the findings that subsidies to foreign investors, as well

as requirements imposed on foreign investors, such as

requirements to undertake a minimum level of exporting

or to purchase inputs from local suppliers, are not consistently

related in a positive or negative way to FDI.

One would have expected to find that requirements

Table 5

Summary of Empirical Findings on the

Determinants of FDI and FDO: Openness

to Trade and Investment

openness variable

relationship

to Fdi

Investment protection Negative Mixed

Foreign ownership

restrictions

Investment promotion

agencies

Negative n.a.

Positive n.a.

Subsidies Mixed n.a.

Requirements Mixed n.a.

Trade to GDP ratio Positive Mixed

Tariff and other

barriers

Mixed Mixed

relationship

to Fdo

Note: “Mixed” means that the positive and negative results for

the variable in question were about equal in number, and/or

the majority of the results for the variable in question were not

statistically significant; “n.a.” indicates only a small number of

studies reported results for the variable in question, such that no

reliable inferences about the variable could be drawn.

Source: Steven Globerman and Victor Zitian Chen.


imposed on foreign investors would discourage inflows

of direct investment, other things being constant. However,

it should be noted that very few studies focus on how

these variables affect FDI. Furthermore, it is possible

that the costs imposed on foreign investors by such

requirements are implicitly passed on to host country

firms in the form of lower acquisition prices.

Relatively few studies identify the relationship of openness

variables to FDO. In the few cases where findings

are reported, the results are mixed. In brief, available

studies provide no consistent evidence on whether the

openness of the home country to investment and trade

encourages outward direct investment.

4 . country resource attributes: labour Force

characteristics and r&d capabilities

Table 6 summarizes findings with respect to the

resource attributes of host and home countries, particularly

the characteristics of the labour force. Once again,

relatively little evidence is available on the determinants

of FDO. However, the evidence linking labour force

characteristics and FDI is quite consistent. Specifically,

foreign direct investment is attracted to host countries

Table 6

Summary of Empirical Findings on the

Determinants of FDI and FDO: Resources

resource variable

relationship

to Fdi

relationship

to Fdo

R&D activeness Positive Positive

Skill endowment Positive n.a.

Total employment Positive n.a.

Unit wages Negative n.a.

Unionization Mixed n.a.

Large, liquid

stock markets

Positive Positive

Interest rates Negative n.a.

Note: “n.a.” indicates only a small number of studies reported

results for the variable in question, such that no reliable inferences

about the variable could be drawn.

Source: Steven Globerman and Victor Zitian Chen.

The Conference Board of Canada | 11

possessing a skilled and educated workforce. On the

other hand, higher unit costs of labour discourage

inward foreign direct investment, although unionization,

per se, is not linked consistently, either positively or

negatively, to FDI. R&D capabilities, as well as an

active innovation system more generally, attract foreign

direct investment to host countries. Interestingly, R&D

also encourages outward direct investment from home

countries. This finding, again, presumably reflects the

fact that countries characterized by advanced innovation

activities are likely home to efficient and highly successful

multinational companies that, in turn, seek to

exploit their competitive advantages in foreign markets,

often through FDO.

available studies provide no consistent evidence on

whether the openness of the home country to investment

and trade encourages outward direct investment .

5 . Tax structures

Given the relatively few studies that link host and homecountry

tax structures to FDI and FDO, it was not worthwhile

to create a separate summary table. Suffice it to say

that most of those few studies focus on the corporate tax

rate. On balance, a higher host-country corporate tax rate

discourages inward foreign direct investment. Specifically,

we identified 14 studies that attempted to link corporate

tax rates to FDI. Nine of the studies identified a statistically

significant and negative linkage, while five studies

found no statistically significant relationship between the

two variables. 3 A handful of studies also focus on other

indicators of the tax structures of host and home countries,

such as income taxes or total tax revenues as a ratio of

GDP. While the individual number of such studies is

small, they tend to identify higher taxes as having a statistically

significant and negative impact on inward foreign

direct investment. A very few studies (four, to be precise)

discussed findings for the relationship between homecountry

tax rates and outward foreign direct investment.

3 In his review of the literature, Moran (2005) concludes that tax

considerations have become more important influences on the

location decisions of multinational companies since 1990. He also

asserts that multinational companies have become more responsive

to tax concessions and other investment incentives.

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12 | Best Policy Practices for Promoting Inward and Outward Foreign Direct Investment—October 2010

They all report that higher corporate tax rates are negatively

and significantly related to FDO. That is, higher

home-country corporate tax rates discourage FDO. This

seemingly surprising result might reflect the fact that high

corporate tax rates in developed countries often accompany

well-developed infrastructures for corporations in

which to do business; something that, in turn, discourages

outward direct investment. By the same reasoning, one

would expect higher corporate tax rates to attract FDI, if

the revenues collected were used to improve the infrastructure

used by host country businesses. That is, if

physical and other social infrastructure is funded by tax

revenue to any significant extent, the impact on FDI will

reflect the net effect of both government taxes and the

availability and quality of physical and related infrastructure.

specifically, physical and cultural proximity—including

a similar language, a shared border, similar political

institutions, and a strong trade relationship—all promote

bilateral foreign direct investment .

In short, and notwithstanding extensive discussions in

the popular business media about the important influence

of taxes on the investment decisions of multinational

companies, hard statistical evidence on the

linkages between taxes and direct investment decisions

is limited, and the available results do not necessarily

tell a consistent story. This conclusion is consistent with

Blonigen’s interpretation of the available evidence. 4 He

argues that the linkage is uncertain because the way in

which parent companies reduce double taxation on their

multinational companies can have different implications

for foreign direct investment activities. More generally,

it is difficult to measure the precise incidence of corporate

income taxes.

BilaTeral ForeiGn direcT invesTmenT

Next to the number of foreign direct investment studies

encompassing macroeconomic attributes, the second

single-largest number of studies focuses on bilateral

investment flows. That is, they focus on the determinants

of direct investment flows that take place between two

4 Blonigen, Foreign Direct Investment Behavior of Multinational

Corporations.

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particular countries, e.g., Canada and the United States.

These studies are usually set up as gravity models and

include such variables as physical and cultural proximity,

bilateral trade volumes, sharing a common physical

border, and sharing a common language. In effect, studies

of bilateral foreign direct investment flows consider

why two-way foreign direct investment between Canada

and the United States is likely to be larger than twoway

foreign direct investment between Canada and, say,

Germany. The earlier studies we reviewed in this section

address the issue of what makes a country such as

Canada attractive to FDI from any potential source

country. Numerous countries are sources of FDI in

multi-country models, unlike in bilateral models.

domestic r&d “activeness” and a more highly skilled

and educated workforce can encourage Fdi into canada .

The findings from studies of bilateral foreign direct

investment all report plausible results. Specifically,

physical and cultural proximity—including a similar

language, a shared border, similar political institutions,

and a strong trade relationship—all promote bilateral

foreign direct investment. Membership of the bilateral

partners in a free trade area or a customs union also

encourages increased bilateral foreign direct investment.

We identified 12 empirical studies that focused specifically

on inward and outward foreign direct investment at the

national level in Canada. The limited number of Canadian

studies militates against drawing strong conclusions from

the Canadian experience. Nevertheless, the results for

Canada are consistent with those from the full sample of

studies. In particular, domestic R&D “activeness” and a

more highly skilled and educated workforce are identified

as encouraging FDI into Canada.

There is no reason to believe that the results pertaining

more broadly to the determinants of FDI and FDO

should not apply to Canada, although the precise impact

of any specific determinant is likely to differ across

countries and regions. For example, improvements in

public sector governance are likely to have a larger

impact on FDI in developing countries than in developed


countries. 5 Furthermore, the precise determinants of

FDI will vary across industrial sectors. Since the economic

importance of specific sectors, such as energy,

differs across countries, FDI determinants are unlikely to

be identical, even for developed countries. Nevertheless,

the broad policy inferences that can be drawn from the

empirical evidence seem applicable to most countries,

including Canada.

WHaT aFFecTs Fdi aT THe suB-naTional or

provincial level?

There are far fewer empirical studies of the determinants

of FDI at the sub-national level than at the national

level. 6 Given the relatively few studies that focus on

FDI determinants at the sub-national level, we provide a

qualitative assessment of the relevant literature in this

section of the report, using the broad variable category

outline provided in Table 1.

only a small majority of relevant studies find that higher

unit labour costs have a statistically significant and negative

relationship to foreign direct investment .

The location attribute receiving perhaps the greatest

attention in studies of FDI at the sub-national level is

the market size of the relevant region or city. As in the

case of FDI studies at the national level, the evidence is

unambiguous in pointing to a strong and positive relationship

between FDI and larger market size; however,

the precise interpretation of the market size variable differs

in sub-national studies. Specifically, measures of

overall market size at the sub-national level can be

interpreted in some cases as indicators of agglomeration

economies, particularly when market size is measured

as total industrial or services-sector output, as opposed

to a measure of overall output such as total income.

5 Globerman and Shapiro, “Global Foreign Direct Investment Flows:

The Role of Governance Infrastructure,” 1899–1919.

6 We found only five Canadian-specific FDI studies at sub-national

(i.e., sectoral or provincial) levels and were unable to identify a

single empirical study that examines the determinants of FDO at

the sub-national level.

The Conference Board of Canada | 13

Agglomeration economies encompass the efficiency

benefits that firms enjoy by operating in close geographic

proximity to suppliers of specialized inputs and services,

as well as to organizations in the same industry that are

potential sources of spillover efficiency benefits and

other external economies of scale. Indeed, in a number of

studies, measures of geographical density of manufacturing

establishments are found to be positively and significantly

related to FDI in regions and cities. The

presence of foreign-owned firms in a location often

attracts other foreign investors from the same home countries

by signalling the advantages of operating in that

location, thereby strengthening agglomeration economies.

Physical infrastructure is another location attribute that

is regularly incorporated into FDI models applied at the

sub-national level. Available studies consistently report

a positive and statistically significant linkage between

measures of physical infrastructure and FDI, although

there is some variation in the particular components of

physical infrastructure that seem to matter most to foreign

investors. For example, in some cases, transportation

facilities are identified as being particularly important,

while in other cases, telecommunications capabilities are

cited. Such differences in emphasis are to be expected

given the fact that available studies focus on different

industries. For some manufacturing industries, access to

water or rail transportation is a critical determinant of a

location’s attractiveness, whereas service industries are

likely to be more concerned about the state of a location’s

telecommunications infrastructure.

Studies are more equivocal about the nature and importance

of labour market conditions to foreign investors. In

particular, only a small majority of relevant studies find

that higher unit labour costs have a statistically significant

and negative relationship to FDI. However, there is

more consistent support for a positive and statistically

significant relationship between FDI and the “quality”

of the available labour force in a region or city.

Although differences across sub-national regions in tax

rates and government subsidies are a conceptually

important issue, few available statistical studies address

the issue. A possible reason for this paucity of evidence

is the difficulty in measuring effective tax rates at the

regional or city level, particularly when effective tax rates

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14 | Best Policy Practices for Promoting Inward and Outward Foreign Direct Investment—October 2010

can vary substantially across different industries and

organizations, even within the same region or urban

area. The limited amount of evidence militates against

drawing strong conclusions about the practical importance

of taxes and subsidies to foreign investors.

Furthermore, what evidence is available tends to be

inconclusive. Specifically, there is no consistent evidence

that fiscal concessions to foreign investors in the

form of lower taxes and/or direct or indirect subsidies

promote increased FDI in the longer run.

We should be cautious in concluding that taxes and

other financial conditions in a region are unimportant to

foreign investors. Certainly, anecdotal evidence supports

arguments to the contrary. Indeed, the inconsistent

evidence might reflect, in part, the competition among

neighbouring political jurisdictions to keep tax rates and

other fiscal attributes comparable. 7 To the extent that

provinces and other sub-national jurisdictions base their

own tax policies on policies in other sub-national jurisdictions,

we might find little tax or fiscal policy variation,

and therefore observe only a small impact of fiscal

regimes on FDI location divisions.

There is no consistent evidence that fiscal concessions,

in the form of lower taxes and/or direct or indirect subsidies,

promote increased Fdi in the longer run .

Therefore, it might well be the case that an individual

province or city might gain a location advantage by

lowering corporate taxes and/or extending fiscal benefits

to foreign investors. However, the advantage is likely to

be short-lived, given the likelihood that other provinces

or cities will offer comparable fiscal benefits to foreign

investors. Moreover, improvements in infrastructure

may be less easy for other jurisdictions to duplicate. So

tax reductions that come at the expense of maintaining

and expanding public infrastructure could be a relatively

ineffective policy instrument to attract FDI for

7 For an illustrative discussion of tax competition among states in

Switzerland to attract FDI, see Ball and Bryan-Law (2010).

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any province or city. Rather, a more effective policy

approach could involve public investments in infrastructure,

even at the expense of higher taxes. 8

spending on foreign investment promotion agencies may

exceed the benefits if the agencies are operated inefficiently .

Many, if not most, countries, as well as many sub-national

political units, have foreign investment promotion programs.

These programs typically include the use of government

or quasi-government agencies to advertise and

promote the advantages of a particular location to prospective

foreign investors. In some cases, the mandate of

an agency might also include clearing bureaucratic hurdles

to FDI in a location, as well as providing assistance in

site selection, worker training, and even financing. 9 The

limited available evidence, primarily from several studies

of FDI in U.S. states, suggests that agencies promoting

FDI do, indeed, encourage FDI. However, this

evidence does not necessarily mean that the social

benefits of taxpayer funding of promotional agencies

will always exceed the relevant costs. As with other

public policies, spending on foreign investment promotion

agencies may exceed the associated benefits if the

agencies are operated inefficiently or attempt to implement

unrealistic mandates.

WHaT deTermines invesTmenT QualiTy?

Significantly fewer empirical studies focus on what

determines the quality of the investment—i.e., whether

there are productivity spillovers—rather than on what

determines the size of those investments. In Table 7,

we examine factors that determine the quality of the

FDI based on a qualitative evaluation of the empirical

literature. There is virtually no statistical evidence on

8 Bellak and Leibrecht (2009) argue that a policy of contributing to

improvements in production-related infrastructure compensates

foreign investors for higher taxes.

9 Contractor, “Promoting Foreign Direct Investment in Developing

Countries,” 107–142


Table 7

Factors That Determine the Degree to Which FDI or

FDO Has Spillover Productivity Benefits

variable impact

R&D Strongly positive

Education and skill level Weakly positive

Linkages to foreign affiliates Mixed

Domestic competition Mixed

Geographic density Strongly positive

Export orientation Mixed

Openness of economy n.a.

Regulation of foreign affiliates n.a.

Note: “Mixed” means that the positive and negative results for

the variable in question were about equal in number, and/or

the majority of the results for the variable in question were not

statistically significant; “n.a.” indicates only a small number of

studies reported results for the variable in question, such that no

reliable inferences about the variable could be drawn.

Source: Steven Globerman and Victor Zitian Chen.

what determines the quality of outward investments.

Only a handful of statistical studies look at the factors

that affect the quality of outward investments, and the

evidence is mixed. Specifically, there is no consistent

evidence of spillover benefits from FDO. 10 We therefore

focus on what affects the quality of inward direct

investments.

The primary focus of empirical studies of FDI quality

or spillover benefits is the absorptive capacity of host

country firms. The level of research and development

activity in the host country or among host country firms

is the most frequently specified measure of absorptive

capacity. The findings are unequivocal: R&D activity is

positively related to spillover efficiency benefits from

FDI (the estimated coefficients for the specific measures

10 See Zhao, Liu, and Zhao (2010), Iyer, Rambaldi and Tang (2008),

Singh (2007), Vahter and Masso (2007), and Braconier, Ekholm,

and Knarvik (2001). The potential economic benefits of FDO to the

home country are broader than just spillover benefits. Hence, one

should not conclude that FDO has no net economic benefits to

home countries.

The Conference Board of Canada | 15

used are uniformly statistically significant). It is certainly

possible to interpret measures of R&D activity as

broad indicators of scientific and technical activity in

the host economy, since R&D activity is highly correlated

with other indicators, such as patenting activity

and employment rates for scientists and engineers. In

fact, a number of studies specify absorptive capacity

using other variables besides R&D activeness. In particular,

measures of the education and skill level of the

domestic workforce, as well as the export orientation of

the host country work force, have been used. 11 Variables

measuring the education and skill level of the host

country workforce tend to be positively related to spillover

efficiency benefits from FDI, although the results

tend to be weaker than when absorptive capacity is

measured as R&D activeness. Specifically, the workforce

quality variable is sometimes statistically insignificant.

Empirical results for export orientation are distinctly

mixed. That is, in several cases, export orientation is

positively related to spillovers, while in other cases it is

either negatively related to spillovers or the estimated

relationship is statistically insignificant. A possible

explanation for the mixed results is that in some cases,

particularly when the host countries are emerging economies,

export orientation identifies labour-intensive

industries with relatively limited capabilities to adopt

relatively new production and managerial processes.

A number of available studies consider the empirical

relationship between FDI spillover benefits and the

nature of foreign ownership. In particular, they evaluate

whether the extent of foreign ownership is related to the

magnitude of spillover benefits. For example, several

studies consider whether FDI spillover benefits in a

sample of host country firms are larger when foreign

investment takes the form of joint ventures or minority

ownership than when it takes the form of majority or

wholly owned affiliates. These findings, which hold

obvious policy importance for foreign ownership

restrictions, can be prudently described as being mixed.

11 The presumption is that export-oriented firms are likely to be

relatively efficient compared with domestic firms that focus exclusively

on serving the local market, since the former must compete

against world-class competitors in foreign markets.

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16 | Best Policy Practices for Promoting Inward and Outward Foreign Direct Investment—October 2010

In several studies, spillover efficiency benefits to host

country firms seem to be larger when foreign ownership

primarily takes the form of joint ventures with domestically

owned firms. In other cases, spillover benefits

are either larger, or no smaller, when foreign investors

have dominant or wholly owned positions in host country

firms. To the extent that foreign ownership limitations

discourage FDI at the margin, the overall impact

of such limitations on spillover efficiency benefits is

likely to be negative, since discouraging FDI will

indirectly limit potential (and actual) spillover efficiency

benefits.

productivity spillovers from Fdi are larger when foreign

and domestically owned companies are located near

each other .

Does the concentration of industry matter for the quality

of FDI? As discussed earlier in this report, economic

theory is ambiguous concerning how industry attributes

like concentration of ownership affect FDI spillovers.

The empirical findings are also mixed. In some studies,

spillover efficiency benefits are larger when domestic

industries are more highly concentrated, and in other

studies they are smaller.

Geographic concentration does matter for the quality

of FDI. When activities are located close to each other,

there are more direct and indirect technology transfers

between organizations. One would therefore expect FDI

spillovers to be larger when foreign and domestically

owned establishments are near each other. This is,

indeed, a strong finding from the sample of empirical

studies that we reviewed. 12

12 Few studies seek to identify whether the presence of foreignowned

establishments has a stronger link to spillover benefits

than the presence of domestically owned establishments. Debaere,

Lee, and Paik (2010) find evidence from South Korean investment

in China that geographic concentration has particularly strong

beneficial impacts on spillovers when other Korean companies are

located in the specific region. Conversely, Lileeva (2010) finds that

U.S.-controlled and Canadian-controlled plants are both equally

likely to benefit from productivity spillover deriving from new technology

brought into Canada by FDI from the United States.

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Several other potential factors that affect FDI quality

are included in the empirical models we have reviewed,

although the number of relevant studies is small. Again,

we hesitate to draw any firm conclusions. The openness

of the host economy to international trade is one such

additional variable. Again, the expected empirical relationship

is ambiguous. On the one hand, a relatively

open economy might be expected to be relatively efficient

and competitive, in which case domestic firms are

more likely to have both the incentive and the capability

to exploit new processes and techniques brought into

the domestic economy through inward direct investment.

On the other hand, in a relatively open economy,

new processes and techniques might also be embodied

in imports of capital equipment that would reduce the

scope for spillovers to be tied to FDI. 13 As noted above,

the available empirical evidence on the linkage between

openness and FDI spillovers is limited, and what evidence

is available is mixed.

Finally, a few studies consider whether policies that

affect the behaviour of foreign-owned affiliates influence

the efficiency or innovation of host country firms.

In particular, two studies consider whether more productivity

spillovers flow from export-oriented foreign

affiliates than from non-export-oriented foreign affiliates,

and they differ in their findings. Specifically, one

study finds FDI spillovers are mainly transmitted from

export-oriented foreign affiliates to large domestic

firms, 14 whereas a second finds no significant relationship

between the export orientation of foreign-owned

firms and domestic innovation. 15 A third study examines

whether government programs requiring foreignowned

firms to source from local suppliers promotes

FDI spillovers, and finds no evidence that they do. 16

13 Keller and Yeaple (2009) examine technology spillovers to U.S.

manufacturing firms from inward foreign direct investment and

from imports. They find that the former are stronger than the

latter, particularly in high-tech sectors.

14 Blyde, Kugler, and Stein, “Exporting Vs. Outsourcing by MNC

Subsidiaries: Which Determines FDI Spillovers?” 18.

15 Cheung and Lin, “Spillover Effects of FDI on Innovation in China:

Evidence From the Provincial Data,” 43.

16 Driffeld, “Regional Policy and Spillovers From FDI in the U.K,”

579-594.


Other reviews of the FDI spillover literature broadly

support our qualitative assessment summarized in Table 7.

For example, Görg and Greenaway also highlight findings

that the absorptive capacity of domestic firms is a

key factor determining whether domestic firms benefit

from FDI spillovers, and that spillovers benefit companies

in close proximity to foreign-owned affiliates. 17 The

absorptive capacity of host economies is related to

technological activities and the availability of skilled

labour. They also note that what little work has been

completed on trade-related investment measures has

failed to establish a direct link between such measures

and the transfer of useful technologies to domestically

owned firms. One point of disagreement with our

assessment is Görg and Greenaway’s assertion that

economies with more open trade regimes benefit from

FDI more than countries with inward-oriented regimes.

There is no consistent evidence that Fdi spillover

benefits will be larger if governments require investing

companies to commit to activities that they would not

otherwise find profitable .

In summary, a strong absorptive capacity is likely to

result in greater FDI spillover efficiency benefits. For

developed countries such as Canada, this absorptive

capacity includes the active performance of R&D and a

strong innovative infrastructure. An important component

of a strong innovative infrastructure is a skilled and

relatively highly educated workforce.

There is no consistent evidence to suggest that host

governments can gain larger FDI spillover benefits by

requiring foreign-owned affiliates to enter partnerships

or joint-venture arrangements with domestically owned

firms or to commit to activities that they would not otherwise

find profitable. Examples of such activities might

include local content or export target requirements.

17 Görg and Greenaway, “Much Ado About Nothing? Do Domestic

Firms Really Benefit From Foreign Direct Investment?” 15.

The Conference Board of Canada | 17

In short, the policy implications for the quality of FDI

are roughly consistent with those for the magnitude of

FDI. Namely, the focus of government policies should

be on ensuring the efficient provisions of public goods

such as education and physical infrastructure, and on

promoting the technological capabilities of private firms

and non-profit institutions, such as universities, that

contribute indirectly to bolstering the absorptive capacity

of domestic organizations.

It is beyond the scope of this report to discuss government

financial support for R&D and other innovationrelated

activities. We merely note that the spillover

efficiency benefits of FDI are larger when related industrial

activities are near each other. Indeed, the literature

suggests that as activities become more spread out,

technological spillovers tend to decline dramatically.

Therefore, deliberate efforts on the part of policy-makers

to “spread out” industrial activity geographically, particularly

activities characterized as science- and technology-intensive,

are likely to weaken society’s overall

technological capabilities.

Our broad policy conclusions for making sure investments

are of the best quality—i.e., result in the greatest

productivity spillovers—are consistent with those of

other researchers. For example, Fan highlights the roles

that government policy can play by investing in infrastructure,

educating, and training, and by encouraging

domestic firms to invest in technology development. 18

Another study concludes that regions can improve both

their access to and benefits from FDI by creating good

physical and communications infrastructures, by cultivating

a highly educated workforce, and by encouraging

a high level of spending on R&D-related activities. 19

18 Fan, “Technological Spillovers From Foreign Direct Investment—

A Survey,” 20.

19 Copenhagen Economics and Magnus Blomstrom, Study on FDI

and Regional Development: Final Report, 5.

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cHapTer 3

Policy Conclusions

chapter summary

Public policies facilitating FDI and FDO, as

well as their spillover benefits, contribute

more generally to real economic growth.

Best practices encompass improving infrastructure,

investing in education, and promoting

the capacity of domestic firms to use new

technology.

National and sub-national governments both

have an interest in facilitating foreign direct

investment (both inward and outward), as well

as in leveraging the spillover efficient benefits from

foreign direct investment. In fact, policies that promise

to facilitate FDI and FDO, as well as their spillover

benefits, are largely consistent with public policies that

are recommended more generally for improving productivity

and economic growth. For example, improving

the physical and communications infrastructure of a

country or region, raising the education and skill level

of the workforce, and encouraging innovation-related

activities are important components of best practice

policies to encourage foreign direct investment.

In broad terms, best FDI practices can be seen as

“framework” policies. That is, they contribute to an

increased production capacity of the national or local

economy. It is less clear from the available evidence

that policies targeted specifically at foreign investors

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can fit the description of best practices. For example,

financial subsidies to foreign investors might attract

some FDI, at the margin; however, the impact of those

subsidies seems to weaken over time. Moreover, if the

subsidies, intentionally or unintentionally, encourage

investment outside concentrated “centres of excellence,”

the spillover benefits to domestically owned firms are

likely to be negligible. However, foreign investment

promotion agencies can be effective instruments to

encourage inward direct investment, particularly if they

focus on mitigating administrative costs and delays that

confront foreign investors.

in broad terms, best Fdi practices can be seen as “framework”

policies—i .e ., they contribute to an increased production

capacity of the national or local economy .

It is obvious that restrictions imposed specifically on

foreign investors, particularly limitations on foreign

ownership, will discourage inward foreign direct investment.

Supporters of foreign ownership restrictions

sometimes argue that such restrictions encourage foreign

investors to take on domestically owned partners, and

that such shared ownership promotes spillover benefits

from FDI. In fact, there is no consistent evidence supporting

this presumption. Moreover, requirements

imposed on foreign-owned firms to source more inputs

domestically or to export more do not seem to increase

the benefits of FDI to the host economy. Hence, such

targeted policies seem inadvisable.


Government subsidies to foreign investors will increase

inward foreign direct investment, at the margin, presuming

that they are not matched by other governments.

Given the existence of spillover benefits to FDI, targeting

subsidies to potential foreign investors would seem

to be an advisable policy; however, extending such subsidies

is not necessarily an element of best practices.

For one thing, if subsidies are linked to investing in

“have not” locations, the spillover benefits to the host

economy are likely to be severely compromised. For

another, the fiscal burden of significant investment subsidies

implies either that taxes must be increased to pay

for the subsidies or that government expenditures in

other areas, including possible expenditures on public

services, must be reduced. Either of these initiatives

will discourage inward direct investment. On balance,

national, but particularly sub-national, units might be

more effective in attracting FDI, and in leveraging the

benefits of FDI and FDO, by emphasizing governance

and infrastructure improvements, rather than fiscal subsidies

to foreign investors.

Tax policies are, perhaps, the most controversial aspect

of best practices. Popular opinion, as well as anecdotal

evidence, suggests that lowering tax rates should encourage

increased investment, including investment by foreigners.

However, difficulties in accurately measuring

effective tax rates, particularly at the sub-national level

and for specific industries and companies, limit rigorous

empirical examination of the relationship between

tax rates and foreign investment. Furthermore, since

taxes help fund the provision of public goods, and since

the supply of public goods encourages investment, the

The Conference Board of Canada | 19

full impact of lowering tax rates might be to discourage

investment, if the supply of public goods is diminished

as a consequence. Since public sector investments are

moderated by a broad range of social considerations,

there may be no policy inferences that apply uniquely

to best practices for promoting foreign investment.

However, it seems fair to argue that investments focused

on improving the efficient operations of government,

modernizing and enhancing physical infrastructure capacity,

and improving innovation capabilities are particularly

relevant components of best practices.

Good framework policies encourage both increased

Fdi and greater spillover benefits from that Fdi .

The available evidence is much more conclusive for

best practices for FDI than for FDO. In particular, the

available evidence suggests that good framework policies

encourage both increased FDI and greater spillover

benefits from FDI. While it is plausible that those same

policies promote increased home-country spillover

benefits from FDO, there is simply not enough evidence

to support or disprove this presumption. While more

research on the home-country spillover benefits from

FDO is clearly desirable, there is no basis for imposing

policies that discourage FDO at the margin. Both FDI

and FDO are modes through which international production

becomes more specialized geographically, and

the benefits to production specialization are very wellestablished.

Framework policies that encourage FDI

will, over time, also encourage increased FDO.

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The Conference Board of Canada | 29

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appendix B

Glossary

agglomeration economics: The productivity benefits that

derive from a concentration of input suppliers,

producers, and customers in a specific location.

absorptive capacity: The ability of firms to use new technology

to improve their productivity.

economic profits: Profits that are higher than necessary to

compensate for the investment risks assumed

by companies.

efficiency frontier: The productivity performance of the

most efficient organizations in an industry.

Framework policies: Public policies that shape the broad

business environment.

Gravity models: Economic models of international trade,

investment, and migration that emphasize the sizes of

national economies as key determinants of those phenomena.

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Human capital: The skills and knowledge embodied in

the labour force that are acquired through education and

experience.

market structure: The degree of competitiveness

characterizing a market; primarily reflects the number

of competitors and the ease with which new firms can

enter the market.

spillover productivity benefits: Improvements in the efficiency

of host and/or home-country firms arising from

inward (FDI) and outward (FDO) direct investment.

Trade-related investment measures (Trims): Domestic

regulations that a country applies to foreign investors,

often as part of an industrial policy. An example is a

requirement for foreign investors to buy inputs from

local suppliers.


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