Download Economic Freedom - Catallaxy Files

The value of quantitative measures to
demonstrate improving investment
environment
Sinclair Davidson
The secret of success
• Little else is requisite to carry a state to the highest degree of opulence from
the lowest barbarism, but peace, easy taxes, and a tolerable administration of
justice; all the rest being brought about by the natural course of things.
– Adam Smith 1776
– There isn’t much more to add to that statement.
– Operationalizing it is something of a challenge.
– Important questions:
– What is “easy”?
– What is “tolerable”?
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Measurement issues dominate
• When you can measure what you are speaking about, and express it in
numbers, you know something about it, when you cannot express it in
numbers, your knowledge is of a meagre and unsatisfactory kind; it may be
the beginning of knowledge, but you have scarcely, in your thoughts
advanced to the stage of science.
– William Thomson (Lord Kelvin)
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Measurement issues dominate
• When you can measure what you are speaking about, and express it in
numbers, you know something about it, when you cannot express it in
numbers, your knowledge is of a meager and unsatisfactory kind; it may be
the beginning of knowledge, but you have scarely, in your thoughts advanced
to the stage of science.
– William Thomson (Lord Kelvin)
– Important caveat:
– it is often the case even after measurement that our knowledge
remains “of a meagre and unsatisfactory kind”.
• The curious task of economics is to demonstrate to men how little they really
know about what they imagine they can design.
– Friedrich von Hayek
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World Bank view of economic growth
• The neo-classical view suggested that government had simply offered a
suitable environment for entrepreneurial activity.
• The Revisionist view pointed to pervasive market failure and government
intervention.
• The market friendly view suggested that government intervened in those
areas where markets were less effective.
• Multiple paths to growth – the World Bank is left in a position of arguing that
there is no single recipe for success in east Asia.
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Four hypotheses that can explain economic growth
• The luck hypothesis suggests that small differences in otherwise similar
economies can result in large differences in outcomes. In other words good or
bad luck drives final outcomes.
• The geography hypothesis suggests that ecological and physical
characteristics of economies drive economic outcomes.
• The culture hypothesis suggests that values and beliefs drive economic
outcomes. Culture can impact upon acceptance of entrepreneurial risks,
saving rates and trust within the economy.
• The institutions hypothesis suggests that the rules, regulations, laws and
policies that an economy has impacts upon economic outcomes.
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What are Institutions?
• Institutions form the incentive structure of a society and the political and
economic institutions, in consequence, are the underlying determinant of
economic performance.
– Douglass North
• The institutional environment is the economic, legal, and social
infrastructure within which entrepreneurs realise their economic potential,
undertake their investment decisions and generate economic prosperity.
• Economists often use the term property rights regime to describe institutions
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Measuring Institutions
• Fraser Institute, Economic Freedom of the World Index: This index purports
to measure “personal choice, protection of private property, and freedom of
exchange”. Data are back cast to 1975.
• Heritage Foundation, Index of Economic Freedom: This index purports to
measure “the fundamental right of every human to control his or her own
labor and property”. Data are available from 1995.
• World Bank, Doing Business Index: This index purports to measure “objective
measures of business regulations and their enforcement across 185
economies”. Data are available from 2002.
• The PRS Group, International Country Risk Guide: This product purports to
measure “political, economic, and financial risk ratings”. Data are available
from 1980. This is a commercial product.
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Patterns of Foreign Direct Investment
• The OECD defines foreign direct investment (FDI) as being, “cross-border
investment by a resident entity in one economy with the objective of obtaining
a lasting interest in an enterprise resident in another economy”.
• Why would firms choose to invest across a national border rather than simply
export into that market, or licence production in another economy.
– John Dunning who argues that multinational firms own firm-specific
intangible assets and can best exploit the value of those assets by
investing across national borders.
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Patterns of Foreign Direct Investment
Figure 1: World FDI as a percentage of Gross Domestic Product (flow)
5
FDI % GDP
4
3
2
1
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
2012
0
Source: UNCTADstat
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Patterns of Foreign Direct Investment
Figure 2: World FDI as a percentage of Gross Fixed Capital Formation
FDI % Gross Fixed Capital Formation
25
20
15
10
5
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
2012
0
Source: UNCTADstat
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Patterns of Foreign Direct Investment
Figure 3: World FDI as a percentage of Gross Domestic Product (stock)
35
30
FDI % GDP
25
20
15
10
5
2012
2010
2008
2006
2004
2002
2000
1998
1996
1994
1992
1990
1988
1986
1984
1982
1980
0
Source: UNCTADstat
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Determinants of FDI
• Exchange rate effects: There is a large literature in this area that is often
contradictory.
• Institutions: While the relationship between institutions and FDI are noncontroversial in principle empirical verification is often difficult.
– Measurement problems.
– Ali, Fiess and MacDonald (2010) investigate a panel of 69 economies over
the period 1981 – 2005 and find that FDI is attracted to those economies
with secure property rights (as defined by the International Country Rick
Guide).
– Azman-Saini, Baharumshah and Law (2010) find that FDI contributes to
economic growth contingent on economic freedom (as defined by the
Fraser Institute’s Economic Freedom variable). Their analysis covers 85
economies over the period 1976 – 2004.
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Determinants of FDI
• Trade protection: “Tariff-jumping FDI”. There is little empirical work in this
area, and that which does exist tends to be contradictory.
• Trade effects: existing trade linkages between economies play a role in
determining FDI flows between the two economies.
• Taxes: The obvious view is that lower tax rates give rise to higher levels of
FDI. The recent literature, however, provides a nuanced perspective of the
role of taxes in promoting FDI.
– A meta study by De Mooij and Ederveen (2003) suggests a median taxelasticity of -3.3 implying that a one per cent decline in host country tax
rates leads to a 3.3 per cent increase in FDI.
– The empirical relationship between FDI and taxation is a function of the
types of taxes being considered, the measurement of FDI and taxation,
and how double taxation is treated between the host economy and home
economy.
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Economic Freedom and Foreign Direct Investment: Data
• Economic Freedom: This is a measure that incorporates five areas; size of
government, legal system and property rights, sound money, freedom to
trade internationally and regulations. The rating is between 0 – 10 with higher
ratings implying greater economic freedom. Source: The Fraser Institute.
• Freedom to Trade Internationally: This is a measure that incorporates four
factors; tariffs, regulators trade barriers, black market exchange rates, and
controls over the movement of people and capital. The rating is between 0 –
10 with higher ratings implying greater freedoms to trade. Source: The Fraser
Institute.
• Tariffs: This is a measure that incorporates the unweighted mean tariff rate
within an economy, the standard deviation of the tariff rate and the revenue
government raises from taxes on trade. The rating is between 0 – 10 with
higher ratings implying lower tariff barriers. Source: The Fraser Institute.
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Economic Freedom and Foreign Direct Investment: Data
• Regulatory trade barriers: This is a measure of non-tariff barriers and
compliance costs associated with exporting and importing. The rating is
between 0 – 10 with higher ratings implying lower barriers to trade. Source:
The Fraser Institute.
• Foreign ownership/investment restrictions: This is a measure that
includes two factors; the prevalence of foreign ownership within an economy
and the level of restrictiveness that applies to foreign investment within an
economy. The rating is between 0 – 10 with higher ratings implying higher
foreign ownership or lower restrictions. Source: The Fraser Institute.
• Fiscal Freedom: This is a measure of the tax burden imposed by
government and has three determinants; the top marginal tax rate on
individual income, the top marginal tax rate on corporate income, and the
total tax burden as a percentage of GDP. The rating is between 0 – 100 with
higher ratings implying greater Fiscal Freedom i.e. a lower tax burden.
Source: The Heritage Foundation.
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Economic Freedom and Foreign Direct Investment: Data
• Payment: This is a measure of the number of different payments that a firm
has to pay to comply with its tax liabilities per year. The higher the measure
the greater the number of different payments. Source: The World Bank Doing
Business.
• Time: This is a measure of the time taken for a firm to prepare, file, and pay
three types of tax; income tax, consumption tax, and labour taxes (including
payroll taxes, social security contributions etc.). The higher the measure the
greater the time taken. Source: The World Bank Doing Business.
• FDI % GDP: This measures inward foreign direct investment as a percentage
of GDP as a flow variable. Source: UNCTADstat.
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Economic Freedom and Foreign Direct Investment:
Method
• Following the finance asset-pricing literature, I form rank the data and form
portfolios.
– Some of the data are placed into a single-sort portfolio.
– Some of the data are placed into a two-sort portfolio.
• Once data are in portfolios I calculate the average ‘return’ of that portfolio
which is FDI % GDP.
• Example: I first rank the data by GDP growth and then by Economic
Freedom. I then allocate the various economies to having above or below
average GDP growth and above and below average Economic Freedom. I
calculate the level of FDI as a percentage of GDP for each combination
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Economic Freedom and Foreign Direct Investment
Figure 4: FDI, Economic Opportunity and Economic Freedom
Source: UNCTADstat, Fraser Institute, World Bank Development Indicators, Author calculations
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Economic Freedom and Foreign Direct Investment
Figure 5: Economic Freedom and FDI
7
6
FDI % GDP
5
4
3
2
1
0
1
2
3
4
5
Quintile
Source: UNCTADstat, Fraser Institute, Author calculations
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Economic Freedom and Foreign Direct Investment
Figure 6: Freedom to Trade Internationally and FDI
8
7
FDI % GDP
6
5
4
3
2
1
0
1
2
3
4
5
Quintile
Source: UNCTADstat, Fraser Institute, Author calculations
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Economic Freedom and Foreign Direct Investment
Figure 7: Tariffs and FDI
8
7
FDI % GDP
6
5
4
3
2
1
0
1
2
3
4
5
Quintile
Source: UNCTADstat, Fraser Institute, Author calculations
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Economic Freedom and Foreign Direct Investment
Figure 8: Regulatory Trade Barriers and FDI
8
7
FDI % GDP
6
5
4
3
2
1
0
1
2
3
4
5
Quintile
Source: UNCTADstat, Fraser Institute, Author calculations
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Economic Freedom and Foreign Direct Investment
Figure 9: Ownership and Investment Restrictions and FDI
10
9
8
FDI % GDP
7
6
5
4
3
2
1
0
1
2
3
4
5
Quintile
Source: UNCTADstat, Fraser Institute, Author calculations
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Economic Freedom and Foreign Direct Investment
Figure 10: Fiscal Freedom and FDI
6
FDI % GDP
5
4
3
2
1
0
1
2
3
4
5
Quintile
Source: UNCTADstat, Heritage Foundation, Author calculations
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Economic Freedom and Foreign Direct Investment
Figure 11: OECD, Fiscal Freedom and FDI
Source: UNCTADstat, Heritage Foundation, Author calculations
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Economic Freedom and Foreign Direct Investment
Figure 12: GDP per capita, Fiscal Freedom and FDI
Source: World Bank Development Indicators, Heritage Foundation, Author calculations
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Economic Freedom and Foreign Direct Investment
Figure 13: Payments and FDI
6
5
FDI % GDP
4
3
2
1
0
1
2
3
4
5
Source: UNCTADstat, World Bank Doing Business, Author calculations
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Economic Freedom and Foreign Direct Investment
Figure 14: Time and FDI
7
6
FDI % GDP
5
4
3
2
1
0
1
2
3
4
5
Source: UNCTADstat, World Bank Doing Business, Author calculations
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Economic Freedom and Foreign Direct Investment
8
8
7
7
6
6
5
5
4
4
3
3
2
2
1
1
0
0
Economic Freedom
FDI % GDP
Figure 15: Economic Freedom and FDI 2000 -2010
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
World FDI % GDP
Average Economic Freedom
Source: UNCTADstat, Fraser Institute, Author calculations
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The UNCTAD Tax incentive and FDI investment survey
• The survey collected evidence across 51 economies looking at specific tax
incentives schemes.
• These tax incentives are then collected into one of six categories:
– Tax holiday / tax exemption
– Reduced tax rate
– Investment allowance / Tax credit
– Duty/VAT exemption / reduction
– R&D allowance
– Deduction for qualified expenses
• I form an index and calculate the FDI % GDP
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The UNCTAD Tax incentive and FDI investment survey
Figure 16: UNCTAD tax incentive scores and FDI
7
6
FDI % GDP
5
4
3
2
1
0
2
3
4
5
Source: UNCTEDstat, UNCTAD (2000), Author calculations
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Economic Freedom and Foreign Direct Investment
Table 3: Comparison between APEC and Non-APEC economies
Non-APEC
APEC
Economic Freedom
Freedom to Trade Internationally
Tariffs
Regulatory trade barriers
Foreign ownership/investment restrictions
Fiscal Freedom
Payment
Time
FDI % GDP
7.33
6.97
7.66
7.29
7.11
72.13
19.28
320.54
4.37
6.62
7.09
6.65
6.15
6.49
70.68
34.50
348.01
4.84
0.004
0.721
0.007
0.001
0.044
0.677
0.000
0.646
0.733
Source: UNCTADstat, Fraser Institute, Heritage Foundation, World Bank
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Discussion
• Easy taxes and tolerable administration of justice “works” in attracting FDI.
– Correctly – is associated with higher levels of FDI.
• But relationships are not always monotonic.
• Often there is a hurdle level that must be overcome.
• Variables are not precise.
– Measurement is coarse.
– Aggregation levels are high.
– Leads and lags (?)
• What is missing from all the analysis is entrepreneurial decision making.
.
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Discussion
• Things to worry about when changing the institutional environment:
– Status quo bias.
– Regime uncertainty.
– History matters.
– Inherited institutions.
– Unintended consequences.
– Information constraints.
– Calculation problems.
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Discussion
• An important question is whether or not economists’ advice to policy-makers
can be improved by further refining institutional measures or by generating
new measures?
– Policy makers are interested in forward looking measures.
– New measures likely to be of academic interests.
– Not likely to be of policy making interest.
• .
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A controversial proposal
• Does taxation really matter?
– Yes.
– It is uncontroversial that high rates of corporate and personal taxation
impose high deadweight costs.
– No.
– If multinational firms can profit shift then FDI is likely to occur anyway.
– If host economies want to attract FDI and are less concerned about
earning tax revenue from that FDI then allow profit-shifting.
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