Do Stringent Environmental Regulations Attract Foreign Direct Investment in Developing Countries? Evidence on the “Race to the Top” from Cross-Country Panel Data

ABSTRACT

It is widely believed that environmental regulations in a developing country increase abatement costs for firms and, in turn, make the country a less attractive investment avenue for multinational firms from advanced economies. Using panel data of 120 developing countries from 2000 to 2014, this study empirically investigates whether stringent environmental regulations deter foreign direct investment (FDI) in developing countries. The empirical results are the exact opposite of the pollution haven effect, namely, stringent environmental regulations significantly attract FDI, a circumstance that causes a “race to the top.” The results are robust when tested against various specifications.

KEY WORDS:

• economic development
• environmental regulation
• foreign direct investment
• governance

JEL CLASSIFICATION:

• F21
• O44
• P28
• L51

Acknowledgement

The authors are grateful to the Editor Ali M. Kutan and three anonymous referees for their helpful comments and suggestions. All remaining errors are the authors’ responsibility. Dong-Eun Rhee gratefully acknowledges that this research is supported by a Korea University Grant.

Notes

1. The pollution halo effect implies that FDI has a role in enhancing a host country’s environmental quality (Brucal, Javorcik, and Love 2018; Cole, Elliott, and Strobel 2008; Hoffmann, Lee, and Ramasamy 2005;). In this case, one may argue that there is also a simultaneity problem with the EPI. However, we use the current EPI, instead of the lagged EPI, since it is very hard to accept that current FDI inflows change a country’s current environmental policy contemporaneously. The reverse causality may be a long-term concern and not the issue addressed by year-level analysis. We think it is more realistic to accept that an investment decision is based on a country’s current policy and that current FDI inflows will not affect such a policy (or environmental condition) contemporaneously.

2. http://data.worldbank.org/data-catalog/world-development-indicators.

3. http://data.worldbank.org/data-catalog/worldwide-governance-indicators.

4. http://epi.yale.edu/.

5. The weights for environmental health and ecosystem vitality are 0.4 and 0.6, respectively, in 2014. Environmental health consists of health impacts, air quality, and water and sanitation; ecosystem vitality consists of water resources, agriculture, forests, fisheries, and biodiversity and habitat.

6. FDI net flows are defined as FDI inflows minus FDI outflows.