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Productivity and Taxes as Drivers of FDI

Productivity and Taxes as Drivers of FDI

Note

Note thatFDIN, as defined in equation ( 11 ), would be the actual flow of FDI, whenε∗ 00( AH, CH, KH, wH)is below ε . That is,FDINis the actual FDI only ifε∗ 00( AH, CH, KH, wH)≤ ε .( 12 )Otherwise, the actual FDI would be zero. For this reason we refer tonotional FDI. The actual FDI, denoted byFDIA, is therefore defined by:FDINas theFDI A C C K w∗ ∗ 0A( H, H, SH, H, H)∗ ∗ 0⎧FDI N( AH, CH, CSH, KH, wH) if (12) holds⎪= ⎨⎪⎩ 0 otherwise( 13 )We refer to ( 12 ) as the selection-condition equation. It specifies when there will by anyFDI flow to the host-country. Equation ( 11 ) is referred to as the flow equation whichdescribes the actual FDI flow only if the selection-condition equation is satisfied.2.2 Aggregate Productivity Shock: Flow and SelectionNote that the parameterAHis a host-country specific productivity factor thatapplies to all firms in this country. We examine how a shock to this factor affects theaggregate level of FDI flowing to the host-country. Suppose first that the domestic wagerate ( w ) is fixed. A positive productivity shock has three positive effects on the notionalHFDI (namely,FDIN), as specified in equation ( 11 ). First, it raises the marginalproductivity of capital, thereby increasing the amount of investment that is made by eachinvesting firm (which is acquired by FDI investors). Second, it raises the value of suchfirms and, consequently, their acquisition price which constitutes a part of the notional11

FDI flows. Third, it increases the number of firms purchased by FDI investors (bylowering the threshold productivity level ε0). 7,8Turning to the selection-condition equation ( 13 ), note that a positive aggregateproductivity shock (while still maintaining the wage ratewHconstant) increases theprofitability of investments and, consequently, reduces the likelihood that no firm willmake any investment. Formally, a rise inAHreduces the likelihood that the thresholdidiosyncratic productivity ε0exceeds the upper bound on the idiosyncratic productivityε . That is, a positive aggregate productivity shock raises the likelihood of satisfying theselection condition, so that the notional FDI turns to be realized.Thus, a positive aggregate productivity shock, keepingFDI (both through the flow and selection-condition equation).Now, we drop the supposition that the wage ratewHfixed, raises the actualwHis fixed. When wages are notfixed (but are rather determined by the labor-market clearing equation ( 9 ) ), then theincrease in the demand for labor raises the wage rate ( w ) in the host-country (and theHfixed setup costw L ), thereby countering the above three effects on the notional FDI.HCHWith a unique equilibrium, the initial effects of the increase in AHare likely to dominatethe subsequent counter-effects of the rise inan increase in the host-country’s aggregate productivity factor (wH, so that the notional FDI still rises. Thus,AH) raises the volume of7 For a formal derivation of the results see Razin and Sadka (2007).8 We assume plausibly that the third effect which represents the marginal investing firm is rather smallrelative to the margin of investment of all investing firms (the first effect). We ignore the third effect in theempirical investigation.12

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