Public investment versus government consumption: how FDI shocks shape the composition of subnational spending in Mexico

Abstract

During the 1990s, many developing countries underwent simultaneous processes of global economic integration and decentralization. As a result, subnational governments became increasingly important actors in the international economy, including through policies to secure investments from multinational corporations (MNCs). These efforts have the potential to affect the management of public resources at the subnational level. Breaking from the literature's focus on fiscal incentives, we highlight how “active” foreign investment incentives—including commitments to build new infrastructure and develop worker training programs—have shaped subnational public finances in Mexico. We demonstrate that FDI attraction affected how subnational governments exercised their growing policy authority and fiscal resources. Based on panel data from Mexican states between 1998 and 2017, we find that FDI shocks are associated with statistically and economically significant increases in public investment by state governments, and decreases in public sector consumption of goods and non-personnel services. A case study of a representative investment project in Puebla highlights the importance of active investment incentives as a causal mechanism linking FDI attraction and subnational spending outcomes. Our results illustrate how FDI attraction can affect the distribution of subnational public spending and also develop a theoretically-relevant distinction between passive and active investment incentives.

Keywords:

• Foreign direct investment
• subnational governance
• investment incentives
• public goods provision
• global economic integration
• multinational corporations
• subnational public finance

Disclosure statement

No potential conflict of interest was reported by the author(s).

Notes

1 This literature is a sub-set of the broader literature on the politics of foreign direct investment. See Jensen et al. (2012) for a recent overview.

2 By supplier development we refer to policies aimed at enhancing the capacity of domestic firms in upstream sectors to become suppliers of inputs and intermediate goods to MNCs. These policies often include assistance in obtaining the international quality certifications generally required by multinationals.

3 Public investment refers to spending by subnational governments to create fixed physical capital such as roads, hospitals, and schools. Throughout the paper, we use “spending” and “expenditures” interchangeably to refer generically to outlays by subnational governments. See Section 3.2 for a detailed description of the various spending categories included in the empirical sections of the paper.

4 States’ own income made up only 8% of total revenues on average in 2017, compared with 6% on average in 1998, the first year included in our analysis. Own income includes tax revenue as well as fees and duties collected by state governments in exchange for licenses and the provision of public services. The exception is Mexico City, which generated between 35 and 40% of its income through these local taxes and fees. These calculations are based on the Estadísticas de Finanzas Públicas Estatales y Municipales series from Mexico’s Instituto Nacional de Estadística y Geografía (INEGI).

5 As described in greater detail in Section 3.2, the “transfers and subsidies” spending category consists primarily of resources assigned to so-called decentralized public entities such as state universities and trust funds operated by state governments and, to a much lesser extent, subsidies to firms and households.

6 Research on public goods provision by subnational governments has focused on the role of national-level institutions, the design of inter-governmental relations, and political variables at the local level. See Giraudy et al. (2019).

7 See, for example, Christiansen and Charlton (2003) on Brazil, Zhang and Chen (2007) on China, Thomas (2007) on Vietnam, and Samford and Gómez (2014) on Mexico.

8 It is also possible for FDI to “crowd out” domestic investment, for example when MNC entry causes less efficient domestic firms to exit an industry. In this way, crowding out is similar to the mechanism through which foreign investment increases aggregate industry productivity at the expense of domestic firm market share. As discussed below, crowding out is more likely when the productivity gap between foreign and domestic firms is greater.

9 Market-seeking FDI refers to investments by a multinational in order to serve the domestic market in the host economy. By contrast, efficiency-seeking FDI aims to take advantage of lower costs of production or access to third-country export markets. FDI can also be resource-seeking, that is, motivated by the presence of natural resources in destination economies. See Dunning and Lundan (2008).

10 However, Iršová and Havránek (2013) find the opposite with respect to trade openness. Studies of the role of intellectual property rights regimes likewise show ambiguous results (Narula & Pineli, 2019).

11 See Easson (2004) and Cleeve (2008) for taxonomies of fiscal incentives.

12 See Echandi et al. (2015); Madies and Dethier (2010) for reviews.

13 Fletcher (2002) helpfully distinguishes fiscal incentives as favorable tax provisions that are applied only to certain, qualified projects and thus represent a deviation from general policy.

14 To the extent that they are discussed at all, this type of incentive has been referred to alternatively and confusingly both as “financial” (Christiansen & Charlton, 2003) and “non-financial” (Li, 2006) as well as “infrastructure” and “other” incentives, categories which do not capture the full range of issues these incentives address nor identify the key conceptual differences among types of incentives. A separate literature has examined inter-jurisdictional competition for investment based on “public inputs” such as infrastructure and human capital. However, these studies focus on the relationship between levels of these public inputs and investment flows and do not directly address foreign investment incentives. See Madies and Dethier (2010) for a review.

15 We thank an anonymous reviewer for encouraging further development of this point.

16 As the example of strengthening upstream and downstream sectors highlights, the effect of active incentives is not necessarily limited to the particular industry of the targeted MNC. A good example of such “downstream effects” is the efforts by Costa Rican authorities to expand international air freight service to secure a major investment from Intel. See Spar (1998).

17 In addition, changes in overall corporate tax rates can serve as a proxy for the effect of fiscal incentives for scholars interested in incentives’ impact on investment levels.

18 In the case of Mexico, for example, the (now-defunct) national investment promotion agency, ProMéxico, published as recently as 2017 a list of FDI incentives offered by state governments. In addition to 16 different tax or fee exemptions, these included policies such as “infrastructure development”, “industrial land”, and “training and certifying for technical workers specialized according to the company’s requirements.” Ten out of Mexico’s 31 states publicly offered such active incentives. However, it is impossible to know how often and to what extent these were applied without considerable research into individual cases.

19 In fact, Li (2006, 63) states that he focuses on tax incentives partly because they are “more comparable cross-nationally than other types of incentives.”

20 While the literature on spillovers generally takes a country-level perspective, subnational governments play a central role in ensuring several host economy conditions, such as the availability of adequate infrastructure and human capital, particularly in larger developing economies. Their competency in these areas is what allows subnational governments to compete for FDI on the basis of active incentives (Bartik, 2019; Christiansen & Charlton, 2003; Tijerina Sepúlveda, 2017).

21 Kellenberg (2007) reaches this conclusion through a formal model, which shows that a policy of public input provision can lead to greater growth increases than fiscal incentives, although the results depend on country characteristics.

22 According to the IMF’s Government Finance Statistics, own tax revenue as a share of total revenue for regional governments in developing countries ranges from 43% in India to a low of 2% in South Africa. By contrast, the figures among developed countries are between 33 and 55%.

23 These considerations suggest the association between FDI and subnational spending composition may vary across countries according to the structure of inter-governmental relations. However, we do not test this proposition in this paper. Instead, our empirical work focuses on Mexico, a country characterized by high subnational dependence on revenue transfers. As we argue in this section, this characteristic makes the use of active investment incentives by state governments—and therefore an empirical relationship between FDI and the composition of spending—more likely.

24 See Boddewyn (2017); Boddewyn and Buckley (2017); Scherer et al. (2014) for recent contributions and discussions regarding this relationship.

25 Although the paper focuses on business associations rather than foreign investors per se, it illustrates the channel through which increased investment may generate new demand for public goods and services from subnational governments.

26 It is important to recognize that potential declines in these types of spending also must be taken into account in assessing the development implications of active investment incentives. This issue is addressed further in the results section and conclusion.

27 See Moreno-Brid and Ros (2009) for an overview of Mexican economic development in the 20th century. On the rise of technocrats within the PRI, see Centeno (2010).

28 Based on UNCTAD FDI Statistics, available at https://unctadstat.unctad.org/wds/ReportFolders/reportFolders.aspx?sCS_ChosenLang=en

29 These sectors alone made up 20% of all FDI flows into Mexico since 1999. Secretaría de Economía, “Información estadística de la Inversión Extranjera Directa”. Available at https://datos.gob.mx/busca/dataset/informacion-estadistica-de-la-inversion-extranjera-directa

30 Author interviews with former economic development officials from Puebla (July 9, 2019), Querétaro (July 11, 2019), and Aguascalientes (March 31, 2020).

31 A major fiscal reform in 1980 centralized most revenue collection at the federal level but gave states and municipalities the right to receive a certain percentage of all federal tax collection via participaciones, which make up the largest source of state income (Diaz-Cayeros, 2006). The figure cited in the text is based on INEGI’s Estadísticas de Finanzas Públicas Estatales y Municipales.

32 According to the Mexican Competitiveness Institute (IMCO), an average of 88% of respondents believed corruption in their state government was frequent or very frequent in 2016. See http://imco.org.mx/indices/el-estado-los-estados-y-la-gente/

33 See Section 3.3 for full definitions of the public expenditure categories for Mexican states.

34 In practice, of course, the potential for a given project to spur future economic growth depends on a variety of factors including its economic logic and technical quality as well as proper oversight and transparency in its implementation.

35 Calculation based on INEGI’s Estadísticas de Finanzas Públicas Estatales y Municipales.

36 These entities are autonomous and generally determine the ultimate use of these resources. In the case of educational institutes, which usually receive the majority of state resources transferred to decentralized public entities, a large share is devoted to paying the salaries and benefits of teachers and other education workers.

37 As discussed in Section 3.2, subsidies to firms and households make up a very small portion of this spending line. The figure cited in the text is based on INEGI’s Estadísticas de Finanzas Públicas Estatales y Municipales.

38 The federal entities include 31 states and the Federal District of Mexico City (the “Federal District” designation was dropped after a 2016 reform of its constitution). In the text, we at times use “states” to refer to the 32 federal entities for the sake of brevity.

39 On average, 83% of “transfers and subsidies” spending by states consisted of transfers to other public entities during the period under study, of which 62% was directed to public universities and other educational institutions and 21% to institutions of public health such as hospitals. In total, the transfers and subsidies category has accounted for between 40 and 46% of states’ expenditures between 1998 and 2017. Calculations are based on INEGI’s Estadísticas de Finanzas Públicas Estatales y Municipales.

40 The formal descriptions of these categories can be found at https://www.inegi.org.mx/programas/finanzas/ (in Spanish). Our “government consumption” category is the sum of “materiales y suministros” and “servicios generales”. Both refer to recurring spending to acquire inputs into the functioning of the public sector rather than resources devoted to the provision of public goods and services.

41 See Tsai, 2007; Weller & Barnes, 2014 for discussion and examples of qualitative investigation of mechanisms in mixed-method research.

42 In Stata, this is implemented using the “xtpcse” command. We use this approach because it assumes the errors are heteroskedastic and contemporaneously correlated across panels. Moreover, we also specify a panel-specific AR1 autocorrelation structure. We believe these assumptions are reasonable given the data and that this approach is the most conservative. In Appendix Table A6, we modify these assumptions and test different estimation strategies and assumed autocorrelation structures. The results are stable.

43 Warner (2014) employs a similar strategy to examine the effects of large public investment surges on economic growth.

44 We note here that four extreme outliers were removed from the sample after they were discovered through outlier analysis. These outliers are figures for total federal public investment per capita in Campeche from 2010 to 2013, which is an oil-producing state that often receives major federal investments in its oil sector. For a full explanation, see Appendix A.1: Outliers discussion.

45 This is calculated for all observations in the data-set. This 20.4% increase is slightly higher than the 19.4% increase obtained via regression for the logged DV shown in Table A4. This is because the regression drops observations with missing values for any covariates.

46 This 20.4% decrease is slightly larger than the 15.6% increase obtained via regression for the logged DV shown in Table A4. This is because the regression drops observations with missing values for any covariates.

47 While Mexican governors are not eligible for reelection, they face strong incentives to maintain their party’s control of their state and therefore often become involved in elections.

48 We thank an anonymous reviewer for making this point.

49 Natural resource FDI includes agriculture, mining, and oil and gas.

50 These calculations are based on the “Información estadística de la Inversión Extranjera Directa” series of the Secretaría de Economía.

51 To see how the public entities that receive these transfers actually spend the money, it would be necessary to consult the annual accounts of each individual entity, of which there are several dozen in each state.

52 Officials in the Marín administration had allegedly demanded bribes from the firm, leading the company to choose Guanajuato instead of Puebla as the site for a new facility to produce engines, which began operations in 2010.

53 In order to avoid the risk that states backtrack on these commitments, draft contracts were drawn up and initialed throughout the negotiation process. Author interview with former Puebla economic development official, July 9, 2019.

54 Author interview with former Puebla economic development official, July 9, 2019.

55 Most federal programs in Mexico involve co-investment with state government.

56 Author interview with former Puebla economic development official, July 9, 2019; and with former federal delegate from the Economy Secretary in Puebla, November 13, 2018. See also López, Socorro “¿Secotrade apéndice de Finanzas?”, Balance Financiero August 15, 2013.

57 One source of additional income was discretionary federal transfers, for which the governor and his top deputies successfully lobbied federal officials. Author interview with former Puebla Secretary of Economic Development official, July 9, 2019; and with former federal delegate from the Secretary of the Economy in Puebla, November 13, 2018.

58 The lag between the official announcement of an FDI project and its execution implies that changes in the levels of state public investment tend to coincide with the registry of foreign investment flows in official statistics. The mechanisms highlighted in this section underscore that causality likely runs from the decision of an MNC to invest in a state to changes in state public spending, not the other way around.

59 The administration also pushed a new legal framework through congress, which stipulated that PPS would not be considered public debt, absolving the government of reporting requirements. See “Oportunismo político con Audi” Balance Financiero, 11 October, 2016.

60 The model city project also encompassed four neighboring municipalities adjacent to the Audi site, although the majority of the projects were in San José Chiapa.

61 See Balance Financiero “Gobierno de Puebla destina más de 10 mil mdp para Audi”, 18 July 2016.

62 This move sparked a legal challenge from two of the five municipalities encompassed in the “Model City” zone.

63 Between 2014 and 2016, the state invested 812 pesos per capita, compared to an average public investment level of 585 pesos per capita in the period under study.

64 López, Socorro, “Gobierno de Puebla destina más de 10 mil mdp para Audi”, Balance Financiero July 18, 2016. This estimate is lower than others such as those reported in Ciriaco et al. (2017).

65 Author interview with former Secretary of Finance and Planning in Aguascalientes. March 31, 2020.

66 See Lozano Rodríguez, Javier. “Impacto de Inversión de Nissan en Aguascalientes Garantiza Crecimiento Económico de la Entidad”. La Jornada de Aguascalientes. August 31, 2013. https://www.lja.mx/2013/08/impacto-de-inversion-de-nissan-en-aguascalientes-garantiza-crecimiento-economico-de-la-entidad/

67 Author interview with former Secretary of Finance official in Aguascalientes. March 31, 2020.

68 See Gobierno de Aguascalientes, “Tercer Informe de Gobierno de Carlos Lozano de la Torre”, 2013. Available at: https://www.aguascalientes.gob.mx/cplap/Docs/Informes_de_Gobierno/Tercer%20Informe%20de%20Gobierno%202013/Informe_Ejecutivo.pdf

69 See Rodríguez, Ivet. “Incentivos a Kia equivalen a 11% de la deuda de Nuevo León”, Expansion, November 27, 2015 and Dávila, Darío, “Somete KIA a Nuevo León con incentivos” Sexenio, September 9, 2015.

70 See Comunicación Social San Luis Potosí, 15 September, 2014. Available at: https://www.visionindustrial.com.mx/industria/no incentivos-que-el-estado-de-san-luis-potosi-aporta-para-el-proyecto-bmw

71 Author interviews with former economic development officials from Puebla (July 9, 2019), Querétaro (July 11, 2019), and Aguascalientes (March 31, 2020).

Additional information

Notes on contributors

Theodore Kahn

Theodore Kahn is a researcher at the Fundación para la Educación Superior y el Desarrollo (Fedesarrollo) in Colombia. He previously held academic positions at Johns Hopkins University and the Universidad Iberoamericana-Puebla in Mexico. His research focuses on political institutions and development in Latin America, and he is the author of Government-Business Relations and Regional Development in Post-Reform Mexico (Palgrave, 2019).

Zack Zimbalist

Zack Zimbalist is a Visiting Foreign Professor in the Department of Political Science and International Relations at Tecnológico de Monterrey in Mexico. His research interests focus broadly on economic development, governance, political behavior, and public opinion in developing democracies. His research is published in Government and Opposition, International Journal of Public Opinion, Development Policy Review, and Development Southern Africa.