How Do Business Regulations Affect Foreign Direct Investment?

In this study, we apply three sets of econometric models to examine the effects of business regulations on foreign direct investment (FDI) by using FDI statistics from 12 source countries to 64 host countries in 2000. Our log-linear results suggest that FDI inflows are strongly correlated with business regulatory costs in the FDI host countries. By using endogenous threshold models and the rolling-regression techniques, we find evidence of a nonlinear threshold effect in the relationship between FDI inflows and regulatory costs. When a host country's regulatory costs are sufficiently low, a further decrease in regulations may not stimulate and, in fact, may even decrease FDI inflows. On the other hand, beyond some threshold, FDI inflows significantly rise as the regulatory costs fall. In addition, we find that the marginal effect of business taxes on FDI depends on the level of regulatory costs; i.e., as regulatory costs rise, the marginal effect of taxes on FDI inflows falls. Our results suggest that the regulatory competition between FDI host countries may have different impacts on countries with different regulatory cost levels. While a fall in the costs can directly stimulate FDI inflows in heavily regulated countries such as Brazil and China, it might have no effect, or even a negative effect, on FDI inflows in low-cost countries such as Canada and the United States. In the low-regulatory-cost countries, tax incentives might be more effective to attract FDI than those in heavily regulated countries.