The value of quantitative measures to demonstrate improving investment environment

1. The value of quantitative measures to demonstrate improving investment environment Sinclair Davidson

2. 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”? Economics, Finance and Marketing

3. 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) Economics, Finance and Marketing

4. 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 Economics, Finance and Marketing

5. 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. Economics, Finance and Marketing

6. 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. Economics, Finance and Marketing

7. 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 Economics, Finance and Marketing

8. 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. Economics, Finance and Marketing

9. 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. Economics, Finance and Marketing

10. Patterns of Foreign Direct Investment Economics, Finance and Marketing

11. Patterns of Foreign Direct Investment Economics, Finance and Marketing

12. Patterns of Foreign Direct Investment Economics, Finance and Marketing

13. 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 non-controversial 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. Economics, Finance and Marketing

14. 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 tax-elasticity 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. Economics, Finance and Marketing

15. 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. Economics, Finance and Marketing

16. 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. Economics, Finance and Marketing

17. 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. Economics, Finance and Marketing

18. 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 Economics, Finance and Marketing

19. Economic Freedom and Foreign Direct Investment Economics, Finance and Marketing

20. Economic Freedom and Foreign Direct Investment Economics, Finance and Marketing

21. Economic Freedom and Foreign Direct Investment Economics, Finance and Marketing

22. Economic Freedom and Foreign Direct Investment Economics, Finance and Marketing

23. Economic Freedom and Foreign Direct Investment Economics, Finance and Marketing

24. Economic Freedom and Foreign Direct Investment Economics, Finance and Marketing

25. Economic Freedom and Foreign Direct Investment Economics, Finance and Marketing

26. Economic Freedom and Foreign Direct Investment Economics, Finance and Marketing

27. Economic Freedom and Foreign Direct Investment Economics, Finance and Marketing

28. Economic Freedom and Foreign Direct Investment Economics, Finance and Marketing

29. Economic Freedom and Foreign Direct Investment Economics, Finance and Marketing

30. Economic Freedom and Foreign Direct Investment Economics, Finance and Marketing

31. 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 Economics, Finance and Marketing

32. The UNCTAD Tax incentive and FDI investment survey Economics, Finance and Marketing

33. Economic Freedom and Foreign Direct Investment Economics, Finance and Marketing

34. 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. . Economics, Finance and Marketing

35. 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. Economics, Finance and Marketing

36. 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. • . Economics, Finance and Marketing

37. 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. Economics, Finance and Marketing