The role of public services and taxes in attracting ‘foreign’ direct investment

The main thesis of this paper is that in setting budget and regional development policies, public officials at the regional and central government levels must internalize that businesses are quite unlikely to be willing to pay taxes that are not matched by their desired level and quality of public services. Thus the adequate provision of public services, and not just low taxes, would seem to be an important characteristic of regions or countries that want to attract FDI. In particular, relatively higher regional or national taxes may be acceptable or even competitive if investors see them compensated or offset by higher levels and quality of public services and infrastructure. Indeed, the local public finance and regional economics literature has traditionally emphasized the impact that local taxation and spending have on the location decisions of mobile households and businesses. At the international level, we empirically test this by using a panel data set 53 developing and developed countries in different regions of the world, spanning the period 1984-2002. The regression results generally indicate that government quality and private sector quality positively influence inflows of FDI, although the results differ somewhat for developing and developed countries. At the regional level within a country, we also find supporting evidence that the provision of public services level also matter for the direction and level of FDI flows. This comes to confirm many similar findings in the regional-local empirical public finance that have tested the Tiebout hypothesis.